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Alistair Milne
Senior Lecturer in
Banking and Finance
7th February, 2006
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Do Banks really need Pillar 1 IRB compliance?
Alistair Milne
Cass Business School
[email protected] http://www.cass.city.ac.uk/faculty/a.milne/
PRIMIA/ISDA meeting, London
February 7th, 2006
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Overview• WACC calculations: lower regulatory capital
may not worth so very much
• Problems with capital allocation– lack of data, we can’t really measure the tail– RAROC sometimes inconsistent with market pricing
• The way forward: distinguish economic capital and prudential (regulatory) capital
– RAROC can be made to work better when not tail focussed
– Tensions with regulators reduced, when they are not interfering in business decisions
• Is IRB business relevant?– Yes, but not for the reductions in capital
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WACC calculations
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What competitive advantage?
• Proposition 1: lower regulatory capital provides
me with a competitive advantage
• Proposition 2: estimating tail risks and allocating economic capital provides me with a competitive advantage
• Both must be qualified– Competitive advantage of lower regulatory capital is
small– Tail risks relatively unimportant to pricing
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WACC arguments• WACC = weighted average cost of capital
– Sum of debt and equity components
• Equity capital small proportion of total funding
• Higher (lower) regulatory capital may result in less than 1:1 impact on equity capital– e.g. if following rating agency assessments
• Higher (lower) regulatory capital makes equity capital less (more) risky, lowers (raises) cost of equity– Assuming perceived risk not affected by regulatory
requirements
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Table 3: Change in cost of mortgage lendingS ta n d ar da p p r oa c h
IR B C h a n g e
V a lu e of loa n s € (1 ) 1 0 0 .0 1 0 0 .0R isk w eigh tin g (2 ) 5 0 % 2 5 %C a p ital re qu ire m en t: tie r 1 € (3 ) (1 ) (2 ) 4 % 2 .0 1 .0 -1 .0C a p ital re qu ire m en t: tie r 2 € (4 ) (1 ) (2 ) 4 % 2 .0 1 .0 -1 .0
C os t of T ier 2 d e bt e m p loye d € (5 ) (4 ) 5 % 0 .1 0 .1C os t of o th e r d eb t e m plo ye d € (6 ) [(1 ) - (3) - (4)] 5 % 4 .8 4 .9G ross cos t of d eb t e m plo ye d € (7 ) (5 ) + (6) 4 .9 5 .0T a x € (8 ) -(7 ) 3 0% -1 .5 -1 .5A fte r tax cos t of d e b t e m ploye d € (9 ) (7 ) + (8) 3 .4 30 3 .4 65 0 0 .0 35
L e ve ra ge a d ju ste d C O E (1 0) 4 % + [1 5% - 4% ] (2 ) 1 (2) 2 ] 1 5 .00 % 2 6 .00 %
A fte r tax cos t of t ier 1 e q uity € (11) (3 ) (10 ) 0 .3 0 0 .2 6 -0 .0 4 0
A fte r tax b rea k e ve n loa n ch a rge (1 2) [(9 ) + (11 )] (1) 3 .7 30 % 3 .7 25 % -0 .0 0 5%P re ta x b re a k e ve n loa n ch a rge (1 3) (1 2) [1 - 30 % ] 5 .3 29 % 5 .3 21 % -0 .0 0 7%
H u rd le in te re st rate o n len d in g
R e d u c e d IR B ca p ital r e q uire m e n t for m or tg a ge s
R e g u la tory re q uirem en ts
C o s t of d e bt
C o s t of e q uity
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Conclusions on reg cap• Total regulatory capital in UK commercial
banking sector reduced by 15% (advanced Basel II versus Basel 1988)– Mortgage reg cap by 25%
• But £1mn of reg cap worth lot less than £1mn shareholder value
• If we assume 1:1 impact, ignore “leverage effect” increases cost of funding by less 5 bp– With leverage adjustment, less than 1 bp– Main impact the tax advantages of debt (maybe
£1mn reg cap = £100,000 shareholder value)
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Problems with capital allocation
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“Economic capital”: Logic• Equity capital to maintain AA rating,
commonly 99.97% on one year horizon– average AA default frequency .
• Equity capital is in limited supply– ration according to rate of return– sometimes related to “return on equity”
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Data problems – credit risk• Larger corporates/ sovereigns fairly OK
– CreditMetrics/MKMV– US ratings history back to 1950s or earlier– Difficulties with LGD
• Retail (including smaller corporates): – a variety of scoring models, good for PD– a little work on CVaR– best UK institutions around 10-12 years data
• UK FSA transitional arrangements accept 5 years of data for Basel computations! 2 years for LGD
• Other low default portfolios, – even more severe data problems
• Correlations?
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Data problems – op risk• Even greater than for credit risk
• High frequency/ low impact– Most firms have databases, for a few years– Little comparability between firms– Mostly EL (minor contribution to EC)
• Low frequency/ high impact– By their nature no data– Low correlation with market/ credit risks?
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Result is dishonesty!• We lack data, so instead of the impossible
(99.97%) we extrapolate – standard deviations, using arbitrary multipliers– PD as in Basel risk curves (Vasicek single factor model plus
arbitrary correlation loading)
• OP risk : low frequency high impact AMA , no statistical basis at all
• We are confusing:– Risk/return tradeoff (does not need extreme tail)– prudential safety (does not need statistics)
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RAROC difficulty (1)• Liquidity facilities
– eg Lines of credit to a AAA/AA corporates– eg commercial paper underwriting
• Bank backs such exposures with capital– to maintain liquidity over (say) 24 months
• Loss highly unlikely: 99.98% appropriate• VERY safe lending, outside tail no risk at
all!– 15% required return on this committed capital leads
to unreasonably high pricing …– Cannot compete with market prices
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RAROC difficulty (2)• Capital in trading operations
• Liquidity is “lifeblood”, need to survive temporary market fluctuations without being forced to close positions
• Well known examples LTCM, Metallgesellschaft
• Investors (shareholders) need to distinguish extreme tails and normal range of market fluctuations, only latter is priced risk
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RAROC difficulty (cont)• Underlying issue is “skewness of returns”
• Shareholder concern is in obtaining enough return to compensate for risk– Can be computed as “NPV” net present
value
• NPV calculation approximated by RAROC– But may overstate costs of diversifiable risk– And penalises investment returns with sharp
left skew
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Some tentative solutions
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How to make RAROC work• Don’t focus on extreme tail risk
– use standard deviation of returns• allow for diversification (eg portfolio or market beta)
– or calibrate to e.g. 95% threshold
• Different from prudential capital– This is minimum capital, an inequality
• no real cost to having even more capital (risk unchanged)
– 99.97 appropriate, but do not pretend at precision– Deal with data problems by being very conservative– Use standarized scenarios (inc. op risk events)
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Reducing reg cap via IRB?• Makes NO difference to risk
– So should be totally excluded from RAROC
• Fits with Modgliani-Miller (1958, 1961)– Capital structure is irrelevant– But there are tax effects
• So you may want to seek out IRB tax gains
• IRB has no other competitive impact– So no little or no customer impact
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Implication for Basel accord• Pillar I is over-engineered
– Confuses data based risk measurement with prudent capital standards
– No reason to closely align regulatory and economic capital
• Minimise costs of Basel compliance– Focus on own model building– Choose minimum compliance cost e.g. foundation
IRB, standardized approach to Op Risk– Use scenarios for Pillar 2 ICAAP
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Implications for capital allocation
• Base economic capital on low threshold (95%) or standard deviations
• Correlation with market is better than portfolio correlation and easier
• Op Risk– Don’t allocate low frequency high impact– High frequency low impact in Expected Cost
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Final remarks
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What competitive advantage?
• Proposition 1: lower regulatory capital provides me with a competitive advantage
• Proposition 2: estimating tail risks and allocating economic capital provides me with a competitive advantage
• Both must be qualified– Competitive advantage of lower regulatory capital is
small– Tail risks relatively unimportant to pricing
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Summary: prudence v. risk• Prudential capital
– banks must be credit worthy, even in the most adverse circumstances (extreme tails)
• Risk versus return– bank interest margins/ fees/ trading returns compensation for
entire distribution of risk (use sd or low threshold like 95%)
• Confusing the two can lead to either overpricing or insufficient capital backing
• Regulatory capital (IRB) is of no direct business relevance– Except good to show the world you can do it
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Further reading…• Three lessons on Bank Capital Allocation
– Alistair Milne, March 2006
• Analysis of impact of IRB on funding costs– Giles and Milne (2004) (around 1 basis pt!, tax
effect only)
• Some of my academic contributions:– Dimou, Lawrence, and Milne (2005)– Milne and Onorato (2005a, 2005b)– Lawrence and Milne (2004)