The United States will sue Standard & Poor’s, a private ratings agency, for its role in causing a global financial crisis from which the world is still recovering. The move is being seen as an attempt to invoke an obscure legal provision in order to bring justice to the ratings agency for its contribution to the crisis.
Standard & Poor’s is just one of a handful of global ratings agencies that makes a business of assessing the risk of various assets for banks and investors. They are being accused by the U.S. Department of Justice of lying about the riskiness of the financial assets that turned toxic throughout 2007 and 2008, causing a chain of events that nearly destroyed the financial system and created the deepest recession since Black Friday caused the Great Depression in 1929.
After the liquidity freeze – when cash stops flowing through the financial system – beginning in fall of 2008 with the collapse of Lehman Brothers, economists, pundits, and financial analysts issued a litany of explanations for what Harvard economist Jeffrey Frieden calls the “run on the shadow-banking system.”
Over four years later, a consensus has emerged about the key causes of the so-called “death-spiral.” One cause was a fundamental misunderstanding by banks, investors and regulators about the inherent risks in the financial assets that were underwriting new investments in the global economy.
The most famous of these, the mortgage backed securities, were just one type of collateralized debt obligation (CDO), a kind of financial asset that pools the revenue streams from a group of debt instruments. CDOs and the derivatives created from them (CDOs squared), and the derivatives used to insure against their failure, credit-default swaps (CDSs), all carried risks that investors did not fully understand. When the death-spiral began, these assets became toxic, infecting the entire financial system in a complex chain reaction. That chain reaction would have caused widespread bank failure if it was not for taxpayer funded bailouts in countries around the world. Standard & Poor’s is the first ratings agency brought to trial for its alleged negligence in misquoting the risks that these assets carried.
If the allegations are true, then the ratings agencies may have misled investors like a marketing firm that engages in false advertising for a client; seducing consumers, or in this case investors, into purchasing flawed products.
But that is only half of the story.
How rules on risk-weighting assets provided fuel to the fire. Can Basel III prevent a future crisis?
The other half of the story is about how banks became over-exposed to systemic risks as a result. It is usually told in highly technical financial-speak about Value-at-Risk (VaR) models and market risk-risk-weighted assets (mRWAs). In the lead-up to the financial crisis, banks and regulators relied on the likes of Standard and Poor’s to determine the riskiness of financial assets. They used complicated VaR models to calculate the risk-weights that ultimately determined how much capital banks had to have on-hand to fulfill their obligations to depositors. When the crisis struck, it was discovered that banks had not held enough capital in reserve. They needed to be re-capitalized or go bankrupt; hence, the bail-outs.
Regulatory authorities monitor and manage the risks on banks’ balance sheets by requiring them to hold cash and other capital in reserve against future potential liabilities – what banks may owe depositors. Under international standards known as the Basel Accords, banks are required to set aside an amount of capital calculated as a percentage of total liabilities, what is known as a capital requirement or formally as the capital adequacy ratio.
Banks are also asked to set aside an amount of capital that is proportionate to the riskiness of each asset in their portfolio. Safer investments require that less capital be held in reserve, so banks and regulators “weigh” financial assets according to risk in order to calculate the size of the capital requirement. A bank’s portfolio is thus risk-weighted to create the value known as mRWA, which is the denominator in determining the size of a capital requirement.
The analysts that criticized the ratings agencies for their role in the crisis also laid blame on the regulatory authorities for their failure to ensure that a proper risk-weighted asset framework was in effect. They argued that the banks had been allowed to use mathematical sorcery in their risk-weighting determinations to downplay the risks in their portfolio. Banks were accused of doing this to make an end-run around the regulations and reduce the size of their capital requirement obligations.
Kevin Young, an economist at the University of Massachusetts – Amherst and expert on global financial regulations, explained that, “Basel II gave banks – in particular large sophisticated banks – a lot of discretion with respect to how risk was assessed. Essentially, Basel II provided a model of risk and capital adequacy requirements that come out of that… but the ‘parameters’ or ‘inputs’ to that model could be estimated by banks themselves,” what is referred to as an internal-ratings based approach.
Since the crisis, the Basel Committee on Banking Supervision (BCBS) has been working on a new version of the Basel Accords – Basel III. The new accords are intended to reduce the chance of another financial blow-up and a key component is to ensure that banks hold enough capital on-hand. In order to do that, the committee is looking for a way to prevent banks from manipulating risk-weights in a dishonest way. Basel IIIwill retain the internal-ratings approach, but has called for new ways to model risk after the crisis largely discredited the standard models.
On January 31st, the Basel Committee published “a report on the regulatory consistency of risk-weighted assets for market risk.” The report is part of the Regulatory Consistency Assessment Programme (RCAP) initiated in April of 2012. RCAP is designed to ensure that the core elements of Basel III get implemented in a similar way in different jurisdictions, what is known as international “regulatory harmonization.” RCAP has three main goals, or “levels,” ensuring the timely adoption of Basel III, regulatory consistency across jurisdictions, and consistency of outcomes. The January 31st report is considered a Level III report, attempting to tackle a problem that may threaten “consistency of outcomes” – the ability of Basel III to prevent banks from once again using risk-weight determinations to reduce their capital requirements to levels that are not commensurate with risk.
Basel III falters
The January 31st report, entitled “Analysis of risk-weighted assets for market risk” had the objective of obtaining “a preliminary estimate of the potential for variation in mRWAs across banks and to highlight aspects of the Basel standards that contribute to this variation.”6 Researchers from the Basel Committee gave a hypothetical financial portfolio to a sample of “16 global banks with significant trading activity” from six different countries. They asked the banks to risk-weight the portfolio and come up with the capital requirement for it. The results show significant variation in the amount of money that each bank would have to set aside to meet the same capital requirement – the variation ranged from a low of $13 million to a high of $35 million, a twenty-two million dollar difference.
The press release announcing the publication of the report says, “Full, timely and consistent implementation of Basel III is fundamental to raising the resilience of the global banking system.” Basel III was originally scheduled to begin implementation last month, but regulators in the EU are still haggling over the final law, with passage expected in the coming weeks. A decision was also made by regulators in the US in November to delay the scheduled January 2013 implementation until 2014. Three weeks ago, I reported that the compliance deadline of another component of Basel III, the liquidity requirement had also been delayed from 2015 until 2019.
There are also concerns about harmonization of the rules across jurisdictions. On the same day that the BCBSannounced the release of its report, Michel Barnier the European Commissioner for Financial Services told a conference, “It is essential that the United States and Brasil and Russia apply the same rules that we decided together. It is a condition for world financial stability, not only for the G20, but for global stability.” But risk-weight asset determinations in the EU can still rely on the ratings from agencies like Standard and Poor’s, while the US has explicitly forbidden the use of private ratings agencies in those determinations with the 2010 passage of the Dodd-Frank Act.
Differences between nations in how Basel III is implemented have important implications. The banks are concerned that stricter capital rules at home may make them less competitive relative to banks in other jurisdictions that may not be required to comply with the same standards. Having a level playing field for global banks is one reason that international harmonization is being sought. But diversity may be a good thing. Young explained that:
“‘Cookie-cutter’ approaches to national economies haven’t worked out so well for the world – the Basel Committee was quick to realize that… [They have] the hugely challenging task of accommodating a wide diversity of countries… Another reason that diversity might be desirable is to reduce herd-like effects. If banks all measured risk in the exact same way then they would have the exact same response to common events, which could have some nasty effects from time to time.”
Other experts have criticized Basel III and the regulators that are implementing it for not moving faster and for retaining the risk-weighting approach to measuring capital requirements. Anat Admati, a Stanford economist made this argument on Wednesday in an op-ed for Bloomberg. She wrote:
“In addition to the unnecessarily long transition period, Basel III’s equity requirements are far too low… The requirement for common equity was indeed raised from 2 percent to 7 percent. However, this ratio relates the bank’s equity to its so-called risk-weighted assets, a measure that tries to account for the risk of assets. Referring to risk-weighted rather than total assets weakens equity requirements significantly.”
The Basel report and the battle that is beginning with the ratings agencies in the U.S. demonstrate just how difficult it is to impose a set of international banking regulations that is both effective and globally consistent while accounting for national differences.