- Tue March 17, 2015

Hits keep on coming

Are eurozone banks weighing risks successfully? No, says the Basel Committee, particularly when it comes to assessing government bonds and loans as risk-free assets. Time, the Basel guys say, to change the rules – though that could saddle the region’s struggling banks with yet more extra capital demands.

In the film A Few Good Men, Tom Cruise’s character, Lt. Daniel Kaffee, is having a particularly bad day. Facing a 6am flight to Guantanamo Bay to interrogate a belligerent colonel about a fenceline shooting, the greenhorn lawyer is told that his boss, a ballsy, brassy woman with a dim view of her charge, will be tagging along. “And the hits just keep on coming,” he reflects to himself.

Eurozone lenders, used as punching bags by politicians and public alike over the past six years, must know the feeling. Some have since gone the way of the Dodo; others were nationalised by reluctant governments. Survivors, from first-tier German and French superlenders to tiny Spanish co-operatives, were forced to raise capital and shed risky assets to comply with an endless list of new rules.

Yet the nightmare remains far from over. In late January, the Basel Committee on Banking Supervision announced plans to overhaul the way that banks disclose risk. The new rules, to be imposed from the end of 2016, are part of a concerted drive to boost transparency, raise (yet again) the amount of capital banks hold, and force lenders to reassess the riskiness of assets held on their balance sheets.

Not before time, say critics, who believe that lenders still under-report a host of imponderables. Take the zero-risk treatment afforded to the €2.5trn (US$2.83trn) in government bonds and loans held by eurozone banks. At a time when sovereign risk is rising across the region, Basel’s steering committee is asking why European rules permit banks to hold zero capital against the risk of sovereign default. The question became more pertinent on January 25 when Syriza, the radical leftist party, won the Greek elections and set about finding ways to cut the country’s soaring national debt, raising the risk of a sovereign default in South-Eastern Europe.

The new rules underline the importance of assigning a risk weighting to sovereign debt securities, Basel’s council of wise men and women said – a view widely shared around the market.

“European regulators and supervisory authorities have had to address the fact that sovereign risk was poorly accounted for in regulatory capital and stress tests historically,” said Henry Wayne, global adviser on regulatory reform and risk at Citigroup. “There is a real desire and drive under way to better quantify sovereign risk.”

Sovereign risk is a thorny political issue both for eurozone governments, and for the 19-member monetary union. When a sovereign is troubled, as Greece has been for years, “there is always the potential for contagion to spread first to local markets, and then through the banking industry, to other countries,” said Citi’s Wayne. “It is the speed of that contagion, and the leverage implied in positions, that determines the impact. No investor wants to see that happen.”

There’s a sense on the Basel level, bankers said, that Europe needs to start addressing that issue. With the January 22 introduction of a €1.1trn quantitative easing programme by the European Central Bank, which will lead to yet more eurozone government debt being bought and spread across the region, getting risk weightings spot-on becomes more important than ever.

Even now, however, eurozone leaders remain in a state of permanent denial over the threat of default. Risk is, of course, everywhere, doubly so within a collective of disparate states held together by a fragile monetary union.

“European regulators were embarrassed by Basel’s findings,” said a banker interviewed for this article. “The implication that failing to assign a risk weighting to sovereign debt holdings was a risky way to operate really stung. It also revived some nasty realities about risk that Europe hoped had gone away.”

Italian lenders are notably exposed: at the end of 2014 they had €266bn in government loans and €433bn in government bonds on their books, or 18% of total banking sector assets, with Spain not far behind. The UK by contrast, an EU member sitting outside the eurozone, long ago asked domestic lenders to expand their capital buffers expressly to ward against sovereign exposure.

Basel’s findings will heap yet more misery on European lenders, faced with the need to secure upwards of €20bn in fresh capital over the next two years to comply with new regulations. Banks across the eurozone raised €40bn to comply with a series of stress tests overseen in late 2014 by the ECB, the region’s new financial regulator. Some may now look to offload some of their holdings of government securities.

This also heralds the start of a new period of regulatory uncertainty for lenders already wearied by public opprobrium and political censure. The Basel Committee has said it wants to reduce banks’ reliance on credit rating agencies when it comes to gauging the riskiness of their portfolios. In December, it asked lenders, both in the eurozone and across the world, to become better at evaluating the viability of their own assets.

Yet many fret that Basel’s loftier aim is to find a way to corral and define “risk”, then to standardise it across the entire financial spectrum. At first glance, this makes some sense: if capital adequacy can be defined and determined, why not create a risk-adequacy template to which all lenders can adhere. So-called Pillar 3 disclosure rules being compiled by Basel appear set to force banks to use fixed modelling structures when assessing the relative riskiness of, say, a pool of US mortgages, a Dutch govie, or bonds issued by a Japanese carmaker.

Besides, if the events of recent years have shown us anything, it is that banks, if left to their own devices, can be calamitously generous in their assessment of internal asset and external market risk. “This latest financial crisis shows us that modelling risk has drawbacks,” said Adrian Docherty, head of bank advisory at BNP Paribas. “We aren’t good at black swans. Holes appeared in balance sheets in 2008 that you could drive a bus through.”

There will of course be intense pushback at any attempt to levy any such rules on lenders, and by implication on the sovereign and federal governments that oversee them – and for good reason. One bank assesses risk at a wholly different level to another, based on a multiplicity of factors, ranging from the scale of the lender to its geographic spread, to its own internal perception of the quality of various corporate or government debt securities.

“You absolutely do not want to create ‘conformity’ on what a risk is,” said Jerome Legras, head of research at Paris-based Axiom Alternative Investments. “Every bank should make its own decisions. The worst possible outcome would be for regulators to create a conformity basis” on the precise risk weighting of an asset. Basel’s aim of setting realistic and acceptable levels of harmony on what risk really is and how it’s assessed is admirable but, said Legras, “you don’t want to be harmonising too much”.

Besides, strip away a bank’s ability to gauge internal risk and you raise the question of why it exists at all. The truth, though it may irk Basel’s well-meaning but meddlesome rule-makers, is that lenders have become much better at evaluating risk. How they arrive at the precise risk weighting of an asset may differ from every single one of their peers. Bank A, moreover, may view an asset as 85% likely to default, while Bank Z’s comparative weighting may be in the single digits, proving that no two banks are born, live, or die equally.

In truth banks, said the head of SSA origination at a major eurozone lender, “understand the relative risk of assets held on their books better than anyone. We spend so much of our time working out risk profiles of assets – it’s core to every discussion we have. In the old days, no one ever asked about risk-weighted assets; indeed no one really knew what they were or cared about them.”

This is an argument and a discussion that will run and run. Lenders, which exist to generate a superior return on capital resources, will fight any attempt to standardise risk (and thus boost transparency, and thus eat into profit), having already endured a wearying series of stress tests and asset quality reviews stretched over many years. Governments will resent any renewed attempt to exert outside influence on their financial sectors.

Nor will Basel find it easy to do what it wants, when it wants. Arriving at a level of risk acceptable to everyone will be nigh-on impossible. The committee would need to demonstrate full transparency and present their entire methodologies, leading to the potential for legal action when, rather than if, their assessments on the riskiness of a specific asset, asset class, lender, corporate, or sovereign, turn out to be wide of the mark.

There may indeed never be a better time for banks to be consistent with each other. The world is a riskier place than ever, and volatility, whether in the form of political uncertainty, military conflict, or climate change, is only likely to rise. Yet the perception exists that regulators “are always seeking to do something”, said Axiom’s Legras: in short, attempting to meddle in a market simply in order to have something new to be getting on with. Unfair? Maybe, but for both weary lenders and their sovereign overseers, that won’t stop the hits from coming.

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