I was delighted to read the article (more like a dissertation) called ‘The Great Game Will Never End: Why the Global Financial Crisis Is Bound to Be Repeated’ which was published in the Journal of Risk and Financial Management and written by my good friend Professor David Blake of the Finance Faculty, Bayes Business School, City University of London, with substantial input from Professor Kevin Dowd of Durham University, another of my most-valued collaborators.
The article is available through this link: https://www.mdpi.com/1911-8074/15/6/245
David, with Kevin’s expert input, explains, inter alia (and it really is inter magnifica alia) how banks have manipulated calculations of Value-at-Risk for derivative products in order to diminish the capital that the banks have to hold against these instruments. These calculations were shown to be woefully inadquate in the Archegos case, as David demonstrates. David also demonstrates how previous crises have tended to come to a head in connection with real estate lending, and how derivatives on real estate lending particularly contributed to the Global Financial Crisis.
I raised two points, one from my personal experience as a lending banker, and the second one political, and to do with how the Global Financial Crisis mainfested itself in the UK.
The first issue is the methodologies for calculating risk and the capital to be held against it.
Internal Ratings-Based methodologies and their antecedents
As a former lending banker I was interested in Basel 3 IRB – Internal Ratings-Based methodologies for calculating the capital that banks have to hold against all types of business, including derivatives. We have Basel 3 Standard IRB, which is roughly equivalent to the Risk-Adjusted Return on Capital models that US banks adopted towards the end of the 1980s and which were formalized as Basel 2 RAROC. We also have Basel 3 Advanced IRB, which is what all the Global Systemically Important Financial Institutions will be running, and which enables banks to hold even less capital against the same book of business as they held pursuant to Basel 2 RAROC.
My experience was firstly with Basel 1, then with internal RAROC models at US banks, and after that with Basel 2 RAROC, and I can explain how the amount of capital was calculated for the two main types of business that the bank (Manufacturers Hanover Trust/Chemical, and BankBoston) dealt with: lending and derivatives.
How the risk and capital for off-balance sheet business were calculated
An off-balance sheet piece of business like a derivative required a Fractional Exposure Limit as an input to the internal approval process, which entailed both the approval of the credit limit for the transaction and the computation of the capital to be tied up by it, the two being inextricably linked. The computation of this ‘FEL’ was based on the same Black-Scholes models that now deliver what is called VaR. The product unit had to compute this ‘FEL’ and then the relationship management unit had to obtain credit approval based on it, but not on it alone.
The ‘FEL’ was the same whether the trade counterparty was the US Treasury or Carillion; the relationship management unit had to add the dimension of the creditworthiness of the counterparty to come up finally with the amount of capital required to undertake that piece of business with that counterparty, which differed from one counterparty to another.
How two percentages are combined to ascertain the risk and capital for any piece of business
For a lending deal the relationship management unit had to supply both the assessment of the creditworthiness of the counterparty (Counterparty Weighting) and also the assessment of the characteristics of the loan (Facility Weighting). For a derivatives deal the ‘FEL’ served as the Facility Weighting. Each weighting was a percentage. They were first of all multiplied together to produce the Credit Conversion Factor – a combined percentage which was then applied to the face value of the transaction to produce what is now known as its Risk-Weighted Asset, which then had to be supported with the bank-wide quotient of capital, whether that be 4%, 8%, 10% or whatever.
The Credit Conversion Factor was normally a double diminution: the FEL would be at most 10% of the face value of the transaction, and then the Counterparty Weighting might come out to 30%: 10% x 30% = 3% and the capital was 10% of the 3% = 0.3% of face value. It is easy to see how the capital cushion gets spread very thinly around a large volume of business: the FEL was never above 100%, and the Counterparty Weighting would rarely be so. Risk-Adjustment always delivered a Risk-Weighted Asset far below the nominal value of the transaction.
IRB’s aim is to deliver a Credit Conversion Factor for all types of business. VaR in my estimation is a plug-in to that, in the past being called the FEL and now the VaR for off-balance sheet business.
The CCF for on-balance sheet business is Facility Weighting x Counterparty Weighting.
The CCF for off-balance sheet business is VaR x Counterparty Weighting.
Double or complete diminution of the assessed risk and of the capital
As we have seen, an FEL of 10% of face value combined with a Counterparty Weighting of 30% means that the risk-of-loss is assessed at only 3% of the face value of the transaction. This 3% is the ‘Risk-Weighted Asset’. The methodologies deliver a Risk-Weighted Asset for each piece of on- and off-balance sheet business, and also for Operational Risk, which is the risk inherent, for example, in processing payments: if a payment is lost, the customer has to be reimbursed.
IRB comes in two flavours and it is the Advanced flavour that is of most concern. Benevolent Facility Weightings and VaRs, combined with benevolent Counterparty Weightings, lead to Risk-Weighted Assets that underestimate the risk. The outcome is that central banks and financial regulators declare their banking systems resilient and well-capitalized on the basis of the ratios of banks’ equity to their Risk-Weighted Assets. This leads to non-sequiturs such as that Monte dei Paschi di Siena, a bankrupt institution weighed down by bad loans, has a ratio of equity to Risk-Weighted Assets of a healthy 12%+.
The outcome of the methodologies is extreme when it comes to business with public sector counterparties. If the counterparty is the Republic of Italy – rated BBB by Standard and Poor’s – the CCF will be 0%, regardless of what the VaR or Facility Weighting may be. A Eurozone ‘sovereign’ always has a Counterparty Rating of 0%, so that the product of Counterparty Rating x VaR or Facility Rating will always be 0%.
The GFC in the UK and the acceptance of a politically convenient narrative
One more aspect of the GFC as regards the UK is, in my view, overdue for debate: whatever happened in the US and the rest of the world, the organizations that went under here in the UK, aside from Royal Bank of Scotland Group, were Halifax Bank of Scotland (which took Lloyds Banking Group down), Northern Rock, Bradford & Bingley, Alliance & Leicester, and Britannia (from the Potteries). All of them were provincial, secondary banks, mostly freed from the restraints of mutuality, that went big on real estate lending into the UK rust belt. And didn’t New Labour love them! Making new buildings shoot up where Margaret Thatcher’s tenure had left empty space, showing dramatic growth compared to the stick-in-the-muds in the City of London…until it all went wrong and New Labour did the following:
1. elevated Royal Bank of Scotland Group to the level of the examplar of what had gone wrong
2. blamed the City of London, or at least City of London practices, even if carried out in Scotland
3. followed the US/rest of the world narrative because it exculpated them from their share of the blame
This angle is an unpopular one politically, but it serves to add another explanation as to why nothing has changed: there was no proper Truth Commission, and the processes that were undertaken used the accepted and politically convenient narrative as their kicking-off point instead of using the real one.
Current dangers of the UK having followed a false narrative
The problem with following the false narrative has been that we now have the same conditions as existed in the UK before the GFC: elevated house prices, irresponsible lenders throwing money in at a high loan-to-value, and one new factor: the Bank of England supporting this by either buying Collateralized Loan Obligations backed by real estate loans into its Quantitative Easing programme or by accepting them as eligible collateral.
In both cases the Bank of England is providing the funding to whichever institution is making the original loan. The Bank of England has become a major player in the UK mortgage market, taking a market position somewhat like the Granite subsidiary of Northern Rock: Northern Rock originated the mortgage but sold it on to Granite, which then obtained wholesale funding for it. Northern Rock lacked retail funding in the amount needed to enable the explosive growth of its mortgage lending.
Similarly UK banks as a whole have lacked the retail funding needed to enable the growth in volume of mortgage lending, so the Bank of England has stepped in. In a real sense the Bank of England has fuelled house price growth and failed to act impartially towards the marketplace. It has favoured borrowers by replacing savers on banks’ balance sheets, and provided new funds in huge quantities for mortgage lending.
Who has done the credit risk assessment on these Collateralized Loan Obligations?
The Bank of England has done no credit assessment on the portfolios of loans sitting underneath the Collateralized Loan Obligations.
The credit assessment on the individual loans is done by the lending institution itself, using an Advanced IRB methodology as approved by the Bank of England’s Prudential Regulatory Authority. Mortgage lending qualifies, under Advanced IRB, as particularly low risk, requiring to be supported by very little capital at all.
The credit assessment on the CLOs is done by a public credit rating agency. The public credit rating agency places reliance on the widely-accepted low-risk nature of mortgage lending, on the credit assessment processes in place at the lending institution, on the approval by the Prudential Regulatory Authority of these processes, and on the legal structuring of the CLO.
The Bank of England’s criteria to buy a CLO or accept it as collateral are set in relation to the CLO’s public credit rating.
The credit assessment is circular.
Who takes the loss if the Collateralized Loan Obligations fail? The taxpayer, again…
These CLOs are in effect just Residential Mortgage-Backed Securities of the type that went so badly wrong during the GFC. If the Bank of England fails to receive the due payments of interest and capital on them, it has a reinsurance policy with HM Treasury under which it can claim these amounts. It is the taxpayer that will reimburse the Bank of England.
The upshot is that a new bailout mechanism for the UK banking system, required if house prices now crash, is already in place. It will not need to be hammered out in the early hours with curry brought in to HM Treasury from the Kennington Tandoori to sustain the weary negotiators. The losses will crystallize in the Bank of England and will then automatically be passed to taxpayers.
This is what happens when politically convenient explanations for disasters are accepted at face value.