Basel II: A Contracting Perspective

1. Federal Deposit Insurance Corporation September 13, 2006 Basel II: A Contracting Perspective Edward J. Kane Boston College

2. BASEL II IS RE-REGULATION

3. But Basel II Doesn’t Fit The Usual Dynamics of Regulatory Arbitrage New rule = uniform capital requirements on all commercial loans in Basel I. [Potential compliance costs are (Kreqd – Kpreferred). But GAP shows opposite sign at most banks.] Avoidance = Still, any bank that was burdened can almost costlessly close the gap by securing low-risk loans and thereby increase its portfolio risk to raise Kpreferred). Long Lag in Re-Regulation = new capital- requirement structure is still being worked out. With bank capital so high, the only urgency should be to get it right.

4. The basic concepts of Basel II

5. CONTRACTING CONCEPTS CONTRACT: Any commitment bytwo or more parties to exchange a set of reciprocal rights and obligations: a “deal.” COUNTERPARTIES: Serve as both principals and agents. STAKES: Value of contract performance or breach to stakeholders STAKEHOLDERS: Negotiators need to establish who the stakeholders are and what each seeks from the agreement.

6. Model of U.S. Stakeholders and Clienteles I. Federal Reserve Board and NY Fed (lead negotiators for the U.S.) a. Quantitative Staff at Fed (advancement & “street creds”: e.g., John Mingo) b. Successive Leaders of Basel II push  John McDonough  Roger Ferguson  Susan Bies c. Broad Stability Mission (MP; Dollar; Financial Stability; Prestige) d. Special Clientele: Larger Financial Holding Cos. and Their Quant. Staffs II. Other Federal Regulators: The “FDIC+” a. FDIC Mission: Resolving Insolvencies and Protecting the Integrity of the DI fund. Special Clientele: Community Banks; Conference of State Bank Supervisors b. OCC Mission: Authorizing new powers and Supervising National Banks Special Clientele: Money-Center and Regional Banks c. OTS Mission: Protecting mortgage market, Strengthening S&L charter, and supervising S&Ls Special Clientele: S&Ls & S&L Holding Cos. III. Congress & Administration IV. Taxpayers

7. Main Stakeholders in Europe I. CHANGING MIX OF CENTRAL BANKS AND FINANCIAL SUPERVISORY AUTHORITIES a.Mission of Central Banks: Stability of Every Kind b. Mission of FSAs: Application of Basel Across Countries and Institution Types (Uniformity Rather Than Financial Stability) c. IOSCO et al. d. Clienteles: Systemically Important Institutions (Trend is for European central banks to transfer responsibility for fin. stability to FSAs.) II. ECB and Other Authorities in European Union a. Mission: To promote pol. and econ. integration (uniform rules) b. Clientele: Sponsors of political and economic integration in Brussels and elsewhere. III. Elected Officials in National Governments

8. Sources of Welfare for Regulators Mission Fulfillment Reputational Standing of their Organization With clientele With National Politicians With Foreign Regulators With Taxpayer-Voters Personal and Career Rewards to Staff and Leaders Sources of Welfare for Regulated Institutions Competitive Advantages, Including Loyalty of Clients and Broader Reputational Standing of Firm Regulatory Forbearances Personal Rewards to Staff & Leaders (Incentive Bonuses; Career Trophies and Opportunities) First-Order Stake of U.S. Regulators Is Enhancing Financial Stability; First-Order Stake of EU Regulators is Enhancing Financial Integration.

9. FINANCIAL SAFETY NETS ARE SOCIAL CONTRACTS Counterparties are Major Sectors of an identifiable political or economic Community Three Contract Segments: • “Clauses” that define and assign responsibilities for preventing disruptive financial-institution insolvencies. • Clauses that define a range of tax-transfertechniques for financing this supervisory activity and losses it fails to prevent. • Clauses that dictate the political and economic incentives under which operators discharge their responsibilities. Incompleteness of Contract: • Goal Variables (Financial Stability and Integration) are not “Describable” • Operational Triggers and remedies for breaches are specified only in the U.S. • Optionality of Actions: Operators of National Nets are authorized to make decisions about their actions improvisationally and under great time pressure.

10. Three Main Strands to U.S.Safety Net • Supervisory Activity Undertaken by Fed, FDIC, OCC, and OTS • Insolvency Resolution: Federal Deposit Insurance (purview of FDIC) • Liquidity Assurance: Federal Reserve Discount Window and Payments-System Administration

11. FOR EACH COUNTERPARTY, PERFORMANCE INCENTIVES VARY ALONG FOUR DIMENSIONS. TOGETHER THESE DIMENSIONS DETERMINE WHERE AND HOW MUCH ACCOUNTABILITY FOR CONTRACT PERFORMANCE EXISTS • Vision: Transparency of Opportunistic behavior • Bonding: Self-imposed costs for engaging in opportunistic behavior • Deterrency: comes from rights and ability of each side to reward good behavior (“carrots”) and to punish opportunistic behavior (contingent ‘sticks”) • Incompleteness: Logically Defensible Loose Ends: It would be prohibitively costly to enumerate all possible observable events and delineate resulting counterparty rights and duties in an enforceable way. Complicated formulas expand loopholes for the regulated institutions and generate options for individual-country regulators to authorize definitional and measurement inconsistencies across countries that generate competitive advantages and competitive regulatory forbearance.

12. Gaps in Basel II Contracting • Every contract promises the “performance” of a set of mutual duties. Economists emphasize that performance only occurs when contractual remedies and reputational concerns establish incentives that make performance desirable • Non-Enforceability: No access to legal “remedies” for damages caused by “breach of contract” (i.e., nonperformance). Ordinarily, only “performance” (completion of contractual duties) releases a counterparty from past or future liability for damages. • Basel II does not offer remedies for breaches of duties. Pillar II powers are weak in most countries and exercise of these powers is not transparent enough to support Pillar III. No capital is budgeted for interest-rate risk.

13. Three Phases of Basel Dealmaking • “Predeal understandings”: Ideally, these establish a prior consensus that imposes a mix of hard and soft constraints on contract terms that U.S. officials could negotiate in Basel. • Understandings are less sharply worded, and less enforceable than a contract. • Because understandings are largely privatecommunications, particular constituencies can interpret their understandings in ways that might be inconsistent with understandings given to another sector. • Dealmaking in Basel • Postdeal Reconciliation of Individual-Country Regulatory Options allowed by Basel with Sectoral Understandings

14. How Does Recognizing These Phases Improve our Understanding of Basel II? • When seen as part of a Regulatory Dialectic, this perspective helps us to see that the Value of Basel II Lies in the Forum Created for Better-Informed, Timely Re-regulation • Continuing negotiations demonstrate commitment to monitor changes in financial contracting technology and to respond to regulatory arbitrage in a relatively prompt and coordinated way. • It helps to explain Complexity and Incompleteness of the Evolving Deal • Why have negotiations been so protracted? Because so many counterparties are involved. • Why is deal so full of loose ends? Because hard-to-understand options must be conveyed to national regulators and banks to enable them to rework predeal understandings with major sectors so as to sell the deal to competing constituencies in their home countries.

15. Incompleteness in Basel Dealmaking • Few Commitments made by Counterparties are Explicit; Most Are Implicit • Looseness in Methods by which performance of obligations are to be triggered, monitored, and enforced • Weaknesses in defining or observing triggers or enforcing obligations convey adverse implicit options to one’s counterparties

16.  Basel I & II seek only to standardize performance obligations for Pillar I: Minimum Regulatory Capital  Not Part of the Basel II Contract: 1) Explicit Performance Standards for Supervisory Review 2) Remedies for Breaches of Implicit Follow-Up Responsibilities 3) No Protocol Has Been Established for Unwinding the Positions of a Large Cross- Border Institution. This Means Large Banks Can Benefit From Taking Sizeable Tail Risks.

17. National Options GrantedUnder Basel II National Regulators may authorize any (or all ) of three different schemes to calculate risk-based assets • Standardized approach (weights tied to external-agency risk assessments, with a national option as to what CROs actually participate) • Two Internal-Ratings-Based (IRB) approaches (in which banks specify PD, LGD, and EAD for each credit and apply adjustments for cross-portfolio correlations): raise unsolved validation and incentive-conflict issues. • Foundational • Advanced (AIRB)

18. Elements of a “Good Contract” • Easy to Understand (Interpretation Costs and Adverse Options are Imbedded in “fine print”) • Creates incentives for its fulfillment IMPLICATIONS OF BAD CONTRACTING: 1. Regulatory Dialectic tells us fine print will be exploited to the disadvantage of taxpayers. 2. When and as a bank weakens, Use of Total Assets in the Denominator of Insolvency-Avoidance Leverage Tests Outscores Basel II’s Complicated Risk-Weighting Procedures on Both Counts. 3. Technical staffs at Fed and large banks are not accountable for misleading higher-ups about what quantitative techniques can accomplish.

19. Before Basel II can be Finalized in U.S., Four Layers of Dealmaking would have to be Completed • International Layer of Dealmaking: Between U.S. delegates and other members of the Basel Committee on Banking Supervision • Interregulator Layer of Dealmaking: Between Fed and Leaders of “FDIC-Plus” • PreBasel Understandings • PostBasel Process of Reconciling Contradictory Understandings • Industry-Regulator Layer of Dealmaking: Between Regulators and their Clienteles, PreBasel and PostBasel • Political Layer of Dealmaking: Regulators have to Sell Deals that clear first three levels to Politicians and Taxpayer/Voters (similar layers exist in the EU)

20. Understandings • US regulators eliminated the Foundational approach and specified that very large US banks would be required to use the AIRB approach. • Individual banks that designed and operated state-of-the-art risk-management systems would be rewarded with lower levels of capital (presumption that PCA “leverage ratios” could be over-ridden). • FDIC+ was assured that overall level of US bank capital would not be allowed to decrease much under Basel II, in line with their accountability for complying with FDICIA’s anti-forbearance PCA requirements.

21. Quantitative Impact Studies • QIS4 surveyed 26 bank holding companies. Showed great variation in effects. If these BHCs met only their Basel II capital requirements, 17 of them would be classified as undercapitalized by PCA standards (a few others may have lied). • Surprising in that it seems as if bank quant staff filled out the survey to demonstrate benefits to their superiors (i.e., to generate evidence that “risk” could be removed from the system), without recognizing the contradictory organizational need to quiet the fears of the FDIC+. • Supports hypothesis that quants at large banks and the Fedare the engine driving the Basel II train.

22. QIS4 showed that large-bank and FDIC+ predeal understandings about individual-bank and system capital could not be reconciledwithoutintersectoral renegotiation. • FDIC+ has firmed up their understandings about the leverage ratio and capital reductions for FDIC+ clienteles (Basel IA), with consequence that giant banks are now asking that their deal be revisited. • Large banks want more options, perhaps to use either AIRB or a standardized approach specifically tailored to the activities of large complex banking organizations.

23. Finding Some Middle Ground • FDICIA Prompt Corrective Action standards use leverage-ratio triggers to identify zombie firms and back up these standards by mandatory Inspector General “material loss reviews” that establish ex post accountability for imprudent supervisory forbearance. • Middle Ground: Strengthen leverage-ratio tests for troubled banks and substitute toughened risk-weighted tests for leverage-ratio tests at well-capitalized banks. • Leverage-Ratio Triggers could be strengthened at lightly capitalized or undercapitalized banks by substituting standardized loan-loss reserve calculations for incentive-conflicted estimates prepared by bank personnel. • In setting standards for well-capitalized banks, risk-based adjustments might be tolerated if the standards at both ends could be strengthened.

24. What Seems Much More Likely to Happen? • Post-Basel Negotiations will focus on equalizing competitive effects on firms in every regulatory clientele rather than on rewarding improvements in risk management made by individual institutions. • Regulatory capital allowed by Basel IA for community banks and still-to-be-determined large-bank options will be calibrated to reduce regulatory capital across the board at a level approaching the U.S. regulators’ stated 10 percent threshold for redesigning the IRB option.

25. Sometimes it is Better to Keep Negotiations Open than to Seal a Deal Post-Basel Contracting Forum Large Banks