These are personal opinions....not the opinions of BMO Financial Group
William J. McDonough: Promoting Financial Resilience
L. Jacobo Rodriguez: the trend should be toward regulatory simplicity because regulators are unlikely to be able to keep up with the rapid pace of innovation in financial markets.
Friday, December 19, 2003
Here's a presentation by David Wright of the Fed which gives some interesting insights into their thinking on IRB implementation.
Thursday, December 18, 2003
Found a couple of papers that look like they could be really useful:
Measurement and Estimation of Credit Migration Matrices
Metrics for Comparing Credit Migration Matrices
Wednesday, December 17, 2003
Moody's: Recovery rates on defaulted corporate bonds continued the upward trajectory in 2003 that began last year after hitting an historic bottom in 2001. (Free registration required)
I was quoted on ERisk's feature article this week. (Free registration required).
Tuesday, December 16, 2003
LSTA: "The Model Credit Agreement Provisions are designed to promote liquidity and efficiency, increase legal certainty, reduce transaction costs in connection with originations activity, and limit legal review for primary and secondary sales to an "exceptions" basis, reducing the time and expense of unnecessary negotiation of boilerplate and other mechanical provisions". Lenders who use them are sure to become better looking and have fresher breath too.
John Hawke, Comptroller of the Currency: "...the monumental prescriptiveness of Basel II seems at times to be motivated by a conviction that if only the rules can be made sufficiently detailed and escape-proof the Holy Grail of competitive equality can be discovered."
Monday, December 15, 2003
More from the FDIC. This time, they've introduced a model which provides a "systematic and quantitative means of measuring potential losses ....resulting from potential bank and thrift failures. Developed in association with the good folks at Kamakura (who are the smartest guys I've met in a long time, for no other reason than they are based in Hawaii.)
Friday, December 12, 2003
Standard & Poor' reacts to the FDIC paper. Basically the message from S+P is that any bank which wants to reduce capital will be downgraded. So, no highly rated bank is going to be able to achieve material capital reduction. Just like I said.
Also from S+P, Tanya Azarchs says that credit derivatives have not, "helped banks avoid meaningful amounts of losses in the credit cycle just ending now".
Wednesday, December 10, 2003
The FDIC published a paper
which argues that Basel II will result in too much of a reduction
in capital for US banks. Looks like banks which actually
expected to demonstrate a low risk profile and qualify for reduced
regulatory capital under Basel II are in for a rude shock.
I'm working on formatting this site manually, I didn't
like the way Blogger did it. Please bear with me.
Sunday, December 07, 2003
In a paper published by the BIS, Jeffery D Amato and Eli M Remolona have realized that unexpected losses are unavoidable in corporate credit portfolios.
In another BIS paper, Frank Packer and Chamaree Suthiphongchai look at the relationship
between CDS spreads for corporates, banks and sovereigns. For
very highly rated sovereigns, spreads are lower than either banks
or corporates, but the situation is reversed for ratings worse than
BB. Interesting, this seems to echo the default data from S+P which
shows that, compared to corporates, highly rated sovereigns have lower
default rates, but the relationship is reversed for low rated issuers.
Thursday, December 04, 2003
Moody's has published a pretty comprehensive study of default and loss experience for structured finance transactions. First read leaves me feeling that there are a lot of red herrings in the analysis, maybe useful to someone but not to me.
There are, however, a couple of intriguing findings. First, no surprise, default rates are higher for transactions with lower quality ratings. Aaa default rates are better than Aa, which are better than A etc. etc. The surprise is that the default rates look quite a bit higher than for similarly rated corporates. E.g. the average one year payment default rate for Baa is 1.28%. Baa corporates are, on average, much lower.
Also interesting is the finding that loss severity tends to increase for worse rated tranches. This confirms my intuition that the fact that lower rated tranches tend to be relatively "thin" exposes them to greater risk of large loss. The definition of loss severity used by Moody's seems a bit perverse: PV of losses divided by tranche size at origination. Why "at origination"? This might understate the loss severity for any tranche that has been partially paid down since origination.
Using Moody's definitions, however, the magnitude of the loss is better than I would have expected. Aaa loss severity is will below 10%, and the losses on Ba and B tranches are in the 20-40% range.
It is very helpful to see this data, despite its idiosyncrasies.
Friday, November 28, 2003
The Economist (Registration Required). Goldman
Sachs is now regarded on Wall Street as little more than
a hedge fund with an investment-banking business attached.
Tuesday, April 29, 2003
Is there "enough" capital in the banking system?
Here's another imponderable relating the the new
Basel Accord.
The Basel Committee has stated that it doesn't want
the new capital rules for banks to materially change the amount
of capital that banks, as a whole, are required to hold. The Basel
Committee thinks that the aggregate amount of capital held around
the world is about right.
Remember that the objective of the new Accord is
to achieve a better alignment between a bank's risk profile and
the level of capital that it holds. Banks with relatively high risk
profiles would need to hold more capital to compensate, and lower risk
banks could, presumably, release some of the excess capital that the overly
simplistic rules from the 1988 Capital Accord say they must hold. Although
it isn't explicitly stated in the Basel Committee?s voluminous consultative
documents, the new capital formula has been calculated to bring banks
to a level of default risk roughly equivalent to 50 bps per annum, or
a weak BBB credit.
For the moment, let's just assume that a bank's
risk profile can be accurately measured and that holding varying
amounts of 'capital", in the form described by the Basel Committee,
is an appropriate means to bring banks with different risk profiles
to a minimum level of solvency.
If the Basel Committee believes that there is enough
capital in the system for all banks, with their existing risk profiles,
to achieve the desired common level of solvency, then the objective
of the new capital rules must be to reallocate that capital from
banks which are overcapitalized today to those which are undercapitalized.
If this were not the case, then there would be no need for the new
rules.
But it's not quite so simple.
Regulatory requirements are only one of the factors
which determine how much capital a bank decides to hold. Another,
kinda important, factor is the level of capital that rating agencies
think is necessary for a bank to maintain its credit rating. Coincidentally,
or maybe not, most of the banks which hope to demonstrate that they
are worthy of a regulatory capital reduction because of their solid
risk management systems which give them a lower than average risk
profile, are also the banks which hope to achieve credit ratings
substantially better than weak BBB.
This means
that, after the new regulatory capital rules are implemented,
the banks which might receive regulatory permission to reduce capital,
will also need need to maintain their capital at current levels to
maintain their credit rating. Unless the rating agencies wake up one
morning and decide that they have been overly conservative in their estimates
of capital required by the banks they rate, it seems unlikely that these
"lower risk" banks are going to be in a position to release very much
of their "excess capital" into the system.
The higher risk banks, on the other hand, will have
no choice but to pony up more capital. That's what the new Basel
rules are designed to achieve.
So with lower risk banks holding the same amount
of capital, and higher risk banks adding to theirs, simple arithmetic
dictates that the total amount of capital held by the banking system
is certain to increase.
Ooops. That wasn't what was intended.
Maybe the Basel Committee needs to go back to the
drawing board on this one.
Thursday, April 24, 2003
In the Technical Guidance the Basel Committee provided for banks completing the QIS 3.0, a new definition of default was provided.
This was a step backwards from the definition provided in the January 2001 Consultative documents.
The QIS 3.0 definition of default is as follows:
399. A default is considered to have occurred with regard to a particular obligor when either or both of the two following events has taken place.
- The bank considers that the obligor is unlikely to pay its credit obligations to the banking group in full, without recourse by the bank to actions such as realising security (if held).
- The obligor is past due more than 90 days on any material credit obligation to the banking group.77 Overdrafts will be considered as being past due once the customer has breached an advised limit or been advised of a limit smaller than current outstandings.
400. The elements to be taken as indications of unlikeliness to pay include:
And here's a snapshot of the problems I see with this definition
- The bank puts the credit obligation on non-accrued status.
- The bank makes a charge-off or account-specific provision resulting from a significant perceived decline in credit quality subsequent to the bank taking on the exposure.
- The bank sells the credit obligation at a material credit-related economic loss.
- The bank consents to a distressed restructuring of the credit obligation where this is likely to result in a diminished financial obligation caused by the material forgiveness, or postponement, of principal, interest or (where relevant) fees.
- The bank has filed for the obligor?s bankruptcy or a similar order in respect of the obligor?s credit obligation to the banking group.
- The obligor has sought or has been placed in bankruptcy or similar protection where this would avoid or delay repayment of the credit obligation to the banking group.
1. Default is only recognized when the criteria are satisfied with respect to bank obligations. This ignores the fact that companies may default on other classes of debt (bonds, sub-debt). If a bank holds bonds and extends bank loans to its customers it may be required to calculate different default rates for the same universe of borrowers than another bank which simply provides bank loans.
The focus on default on bank debt only means that virtually all rating agency and KMV default information will be irrelevant because the rating agencies have focussed on bond defaults, and KMV has taken a comrehensive view that a company defaults when it fails to pay or restructures any debt obligation.
2. Selling a bank loan at a loss is not necessarily a default; it may simply reflect prudent portfolio management. A bank which chooses to reduce its exposure to deteriorating credits before they become impaired should not be required to calculate higher default rates than another bank which holds the same asssets to maturity or until they become impaired.
3. There is no comment on the fact that a default should be considered to have occurred when payment or delivery occurs under credit default swap contracts. If this were to be identified as a default it would raise an issue as to how banks who had not entered into credit default swaps would know that payment or delivery had occured.
4. The requirement for LGD to include discount effects is reiterated, but there is no guidance on what an appropriate discount rate might be. I think the relevant discount rate is one which would an third party would use to evaluate an investment in distressed or defaulted assets. This is probably at least 15-20% per annum.
Tuesday, April 1, 2003
Should banks "manage" their mid-market portfolios?
So here's a dilemma. Banks are starting to think about applying the portfolio management lessons learned from the large corporate portfolio to their mid-markets. (Just for the moment, let's put aside the observation that lots of banks haven't really changed their large corporate stripes, despite the evidence that this is an unattractive business).
Banks are starting to think about ways to improve the diversification of their mid-market portfolios by adopting standard risk measurement tools and adjusting their loan documentation to permit loans to be more freely traded. These are good things, right? Better diversification through better liquidity... hard to argue with that.
But lets stop and think a minute. Banks are currently in an eviable position in the mid-market. They have customers knocking on their doors trying to borrow money, and none of these potential borrowers is asking for an amount of money that adds up to a "hill of beans" on the banks' balance sheets. What's more, these mid-market customers are willing to pay reasonable spreads on their borrowings. In short, mid-market lending is a pretty attractive credit business.
If banks try to make it an even better business, by trading mid-market credits amongst themselves to improve their portfolio composition, I think this opens the door for other (i.e. unregulated) credit market participants to do what they have done in the past, and disintermediate another traditional bank market.
If banks improve the liquidity and transparency of risk in the mid-market, this seems to me to be inviting institutional investors to come and join the party (where the spreads are far better than the corporate market). But, due to their lower cost structures and tax status, many institutional investors have the opportunity to assume mid-market credit risk at a lower price than banks. Just as large corporations found that they could raise funds from institutional investors at better than bank rates through securitization, the possibility exists that mid-market customers will find that institutional investors are willing to invest at lower spreads than the banks.
If institutional investors are willing to hold mid-market credit risk at lower spreads than banks, then, in a more liquid and transparent market, mid-market spreads are sure to shrink. So the banks' initial desire to improve a reasonably attractive business could easily lead to a very unattractive outcome: more lenders willing to hold mid-market risk at narrower spreads. This may very well be a good result, from a pubic policy perspective who could argue with lower spreads for small businesses, but from a banks perspective it marks the end of another traditionally profitable niche.
Sunday, March 30, 2003
As if nothing had happened, I'm back. Here's what's on my mind right now.
What is the optimal number of risk ratings that should be used to evaluate corporate default risk?
Clearly there is a trade off between granularity and validation. A very granular rating system is desirable because it allows companies with small differences in risk to be placed in separate rating categories. Pricing and economic capital allocation can then be calibrated to an appropriate level for each rating. Default risk models with provide default risk estimates (in basis points), such as KMV's Credit Monitor, are clearly geared to satifying the need for granularity.
But granularity comes at the cost of validation. To my knowledge, there is no way to certain that each of the default risk measures coming from models, like Credit Monitor, are accurate. Validation work has largely focussed on evaluating a credit model's ability to properly rank-order companies on the basis of their default risk (power curves, or CAP curves), and to a lesser extent evaluating the total number of defaults predicted by a model against the actual number observed. (For example, see Kurbat and Korablev) But, this doesn't really tell us whether specific default risk probabilities are accurate.
To manage this uncertainty, I think the credit risk analytical frameworks at most institutions, certainly most banks, involve sorting companies into a discrete number of ratings, and then using a single probability estimate for every company in the rating. Yet, there is no consensus on the number of ratings that should be used.
Moody's and S+P both use rating scales which have 16 categories which apply to companies that normally have access to the debt markets (AAA plus 3 subdivisions for each of AA, A, BBB, BB and B), and another 6 or 7 grades in the CCC and worse range. That makes a total of about 23 non-default grades. But this scale was developed years ago, when the desire for abosolute (rather than relative) accuracy was modest.
If you look at the default rates for each of the rating agencies grades, it is hard to conclude that they are actually able to discriminate among 16 classess of default risk. If we define a grade having successfully discriminated a level of default risk if the default rate for that grade is higher than all better grades, then there is precious little evidence that default rates of companies in the AA and AAA range, and to a lesser extent, in the A range are actually different. If fact, I think the agency ratings historical experience shows that they are able to resolve no more than 12 discrete classes of default risk.
If this is true, then it seems logical that individual institutions, who have a smaller universe of companies in their portfolios, will never be able to demonstrate that they can resolve more than 10 or 12 grades of default risk.
