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Gaming the system

November 9, 2011

It’s not easy being a European bank right now. Everyone is telling them to boost capital, otherwise known as raise money, exactly at the time that much of their investments are losing value on the market because of the European debt crisis.

If I were the person running such a bank, I’d be looking at fewer and fewer options. Among them:

  1. Ask China for some of their money
  2. Ask investors for some of their money
  3. Ask a middle eastern country for some of their money
  4. Cut bonuses or dividends
  5. Change the way I measure my money

Of the above possibilities, 5) is kind of attractive in a weird way.

And guess what? That’s exactly the option that the banks are choosing. According to this article from Bloomberg, the banks have suddenly noticed they have way more assets than they previously realized:

Banco Santander SA (SAN), Spain’s largest lender, and Banco Bilbao Vizcaya Argentaria SA (BBVA), the second-biggest, say they can go halfway to adding 13.6 billion euros ($18.8 billion) of capital by changing how they calculate risk-weightings, the probability of default lenders assign to loans, mortgages and derivatives. The practice, known as “risk-weighted asset optimization,” allows banks to boost capital ratios without cutting lending, selling assets or tapping shareholders.

Spanish banks aren’t alone in using the practice. Unione di Banche Italiane SCPA (UBI), Italy’s fourth-biggest bank, said it will change its risk-weighting model instead of turning to investors for the 1.5 billion euros regulators say it needs. Commerzbank AG (CBK), Germany’s second-biggest lender, said it will do the same. Lloyds Banking Group Plc (LLOY), Britain’s biggest mortgage lender, and HSBC Holdings Plc (HSBA), Europe’s largest bank, both said they cut risk-weighted assets by changing the model.

“It’s probably not the highest-quality way to move to the 9 percent ratio,” said Neil Smith, a bank analyst at West LB in Dusseldorf, Germany. “Maybe a more convincing way would be to use the same models and reduce the risk of your assets.”

Ya THINK?!

European firms, governed by Basel II rules, use their own models to decide how much capital to hold based on an assessment of how likely assets are to default and the riskiness of counterparties. The riskier the asset, the heavier weighting it is assigned and the more capital a bank is required to allocate. The weighting affects the profitability of trading and investing in those assets for the bank.

One reason I couldn’t stomach any more time at the risk company I worked at is things like this. We would spend week after week setting up risk models for our clients, accepting whatever they wanted to do, because they were the client and we were working for them. Our application was flexible enough to allow them to try out lots of different things, too, so they could game the system pretty efficiently. Moreover, this idea of the “riskiness of counterparties” is misleading- I don’t think there is an actual model out there that is in use and is useful to broadly understand and incorporate counterparty risk (setting aside the question for now of gaming such a model).

For example, the amount of risk taken on by CDS contracts in a portfolio was essentially assumed to be zero, since, as long as they hadn’t written such contracts, they were only on the hook for the quarterly payments. However, as we know from the AIG experience, the real risk for such contracts is that they won’t pay out because the writers will have gone bankrupt. This is never taken into account as far as I know- the CDS contracts are allowed for hedging and never impose risk on the overall portfolio otherwise. If the entity in question is the writer of the CDS, the risk is also viciously underestimated, but for a slightly more subtle reason, which is that defaults are generally hard to predict.

Here’s not such a crappy idea coming from Vikram Pandit (it’s in fact a pretty good idea but doesn’t go far enough). Namely, standardize the risk models among banks by forcing them to assess risk on some benchmark portfolio that nobody owns, that’s an ideal portfolio, but that thereby exposes the banks’ risk models:

Pandit is championing an idea to make it easier to compare the way banks assess risk. To accomplish this, he wants to start with a standard, hypothetical portfolio of assets agreed by regulators the world over. Each financial institution would run this benchmark collection through its risk models and spit out four numbers: loan loss reserve requirements, value-at-risk, stress test results and the tally of risk-weighted assets. The findings would be made public.

Then, Pandit wants the same financial firms to run the same measures against their own balance sheets – and to publish those results, too. That way, not only can investors and regulators compare similar risk outputs across institutions for their actual portfolios, but the numbers for the benchmark portfolio would allow them to see how aggressively different firms test for risks.

I think we should do this, because it separates two issues which banks love to conflate: the issue of exposing their risk methodology (which they claim they are okay with) and the idea of exposing their portfolios (which they avoid because they don’t want people to read into their brilliant trading strategies). I don’t see this happening, although it should- in fact we should be able to see this on a series of “hypothetical” portfolios, and the updates should be daily.

As a consumer learning about yet more bank shenanigans, I am inspired to listen to George Washington:

Categories: finance, news
  1. JL
    November 17, 2011 at 2:26 pm

    this is an interesting idea, but you’re right- it doesn’t go far enough. Banks will look at this as the same optimization problem, only with 2 constraints, maximize their portfolio value and minimize the benchmark value.

    I also think this will make analysis of individual banks stronger, but the system weaker. There would be a ton of pressure on banks with valuations that are outliers in both directions to move back to the herd: internally when they are too conservative, externally when to liberal. The implicit standardization of risk modeling that would probably result.

    I think my experience doing risk analysis was a lot like yours: us valuation geeks can justify a fair valuation or VaR number until we’re blue in the face, but the trader/manager will make the final call.

    I think that more explicit disclosure is the only way to go. Full cusip-by-cusip disclosure has been the rule in the insurance industry for years due to NAIC regulations (though not with CDS, unfortunately) without catastrophic consequences.

  2. ask
    December 1, 2011 at 8:56 am

    hi.. thanks for your tips..

  1. November 18, 2011 at 6:50 am
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