Risk and Regulation
I thought I’d elaborate a bit on my post from yesterday about Basel III. I’m not sure I got across just how fundamentally problematic I think the Basel approach is.
The overall trend in the financial industry for a couple of decades now has been towards a “scientific” approach to risk-management. The idea is, rather than relying on old-fashioned rules of thumb, you actually try to measure the risk one is taking by holding a certain portfolio. Then, once you know what your risk is, you know how far wrong things can plausibly go, and you know how much you can borrow (or someone else can lend) against your position.
Of course, measuring risk is a tricky thing, because you’re trying to predict future events and all you have is historical performance data. And, as the old saying goes, past performance is no guarantee of future results. Nonetheless, the risk-managers have tried to do their best with the tools they have: historic price data, default rates, and correlations. And they’ve developed a collection of tools like value-at-risk and stress-tests designed to probe both likely outcomes and 2- or 3-sigma possible events.
All of this data does give real information. I don’t want to belittle the utility of knowing the historic correlations between the risks you’re taking, or how much money you would lose if there’s a two-sigma negative move across all asset classes. But precisely because you now feel like you know what your risks are, you’re going to be inclined to hedge them, until you get your risk position down to something de minimis. Indeed, if you’re a bank, you’ll start to think of yourself as a financial intermediary whose job isn’t so much to take risk as to serve as a kind of risk-middleman. And if you’re a conventional asset manager, you’ll start to think of your job as compiling an asset pool with a risk-profile designed to match some benchmark. And so forth.
Everybody still has to make money, though. And since taking any additional measurable risk is now stigmatized, the game becomes how to increase returns without increasing measurable risk. And that, predictably enough, means that more and more money piles into products with risks that either cannot yet be measured or, even worse, that the financial world is not aware exist.
Developments in banking regulation in the last decade, meanwhile, have turbocharged this process, and I’m increasingly convinced contributed mightily to the financial crisis. At the heart of the financial crisis, after all, was banks investing in highly-rated debt backed by lousy mortgages. But why did they hold so much of this debt? In part because they could plausibly argue that it was risk-free or nearly risk-free. Double- and triple-A-rated debt had very low risk-weighting. Similarly, anything hedged with a double- or triple-A-rated financial counterparty had a very low risk-weighting. Use of an internal ratings-based approach (encouraged under Basel II) could reduce capital requirements even below the standard approach carried over from Basel I. If the exposure was classified as market risk rather than credit risk (which it might be, depending on the bank’s internal organization and the structure in question), again the Basel II framework was based on Value-at-Risk, which is based on historic performance data – which in the case of highly-rated tranches on mortgage deals showed very low volatility (because there hadn’t been a crisis since the product took off).
The big-picture point to take home is: the regulatory framework recommended by Basel II assumes that banks are in the best position to measure their own risks, and that a regulatory framework that aligns regulatory capital requirements with the risk being taken is to be desired. In other words, the regulatory framework was pushing banks hard in the direction they were already going: towards avoiding measurable risks and hence (since you still have to make money) into risks you can’t easily measure (or don’t know exist).
Basel III retains this basic framework, but increases (somewhat) the amount of capital that banks need to hold generally. Therefore, it should further increase the incentive to avoid measurable risks and to hold positions whose risks are not well-measured.
The boys in Basel are undoubtedly correct that regulators are not going to be better at measuring risk than the banks themselves. So the question isn’t whether there is a better way to measure risk – the question is whether we want to incentivize banks to hold portfolios that have little apparent risk (but may have substantial unmeasured risks) or whether we want to incentivize banks to hold portfolios with meaningful measured risks, and to hold appropriate capital against those risks, so that when the unmeasured risks do rear their ugly heads they don’t represent a multi-sigma event on the bank’s portfolio. One way to achieve that would simply be to increase the minimum risk-weight. This would discourage banks from holding large portfolios of government debt (which may be one reason that Basel didn’t make that recommendation) and other highly-rated, apparently low-risk securities. Instead, they’d have to get back into the business of making risky loans – a business that, in the last decade, was increasingly ceded to the unregulated hedge fund community.
I don’t want to make it sound like this is an easy call to make. But it is striking that after a crisis driven by huge bank exposures to a largely unmeasured risks, Basel III doesn’t appear to have questioned the assumption that measured risks are all we have to worry about.
“Everybody still has to make money, though. And since taking any additional measurable risk is now stigmatized, the game becomes how to increase returns without increasing measurable risk. And that, predictably enough, means that more and more money piles into products with risks that either cannot yet be measured or, even worse, that the financial world is not aware exist.”
Awesome.
— Tony Comstock · Sep 14, 05:33 PM · #
Isn’t your real issue here with the ratings agencies and not with Basel III and measures like VaR? Clearly, the high ratings on risky bundled mortgage securities were off by a mile. This was the inevitable result of how the ratings agencies make money: by charging the people who sell the stuff they’re rating.
— rj · Sep 14, 07:48 PM · #
rj: I’m skeptical of the “conflict of interest” explanation of how the agencies got it so wrong.
First of all, the conflict has existed for decades. Why only now was there a problem? Second, I’m unconvinced that if the agencies were paid by investors anything would be different. After all, investors really wanted to buy this stuff. They would have put the same pressures on the agencies to give things the desired ratings that the issuers did.
Don’t get me wrong – I think the agencies are a huge problem. But not because of the conflict of interest. Rather, the problem is that by having an independent body certify that something is nearly risk-free, you give an investor a huge excuse for not doing their own homework on risk.
I basically think that what the agencies claim to do – give a systematically better assessment of credit risk than the market – is impossible for them to do. Given that it’s impossible, it’s not terribly surprising that they fail to do it, conflict of interest or no.
— Noah Millman · Sep 14, 08:21 PM · #
If investors really wanted to buy the stuff, <i>even if it was junk</i>, then how do you explain the spreads between higher and lower rated tranches of CMO/CDO? Just because something has risk doesn’t mean that no prudent investor would want it. It’s easy to say in retrospect that everyone knew or should have known the investment-grade stuff was junk, but that’s just not logically possible.
If you think it’s impossible for a ratings agency to give a systematically better assessment of credit risk than the market, it stands to reason that nobody can. So why does it matter whether risks are shifted from quantifiable to harder-to-quantify instruments when it’s all just a shot in the dark?
Also, how would you explain how agencies didn’t do systematically better at predicting risk, but did systematically worse? Either 1) They’re on to something (and should just do the inverse); 2) They propped up ratings to satisfy the people who paid the bills or; 3) It’s dumb luck happening to multiple agencies simultaneously in the same way.
— rj · Sep 14, 09:04 PM · #
Noah, it seems like you’re backing your way into some sort of anti-too-big-to-fail position.
rj, lots of people knew it was junk. Well maybe that’s not quite right. I guess knowing would mean taking a counter position. How about, “suspect strongly enough to take their money to another table.”
— Tony Comstock · Sep 14, 09:43 PM · #
Plus, undeniably, a lot of people were lying as well. You might say that’s a type of risk more suited to law enforcement and regulatory agencies than portfolio managers.
— rj · Sep 15, 12:48 AM · #
Looking at the capital requirements in isolation accentuates the concerns you raised. The capital requirements are as strong as the underlying methodologies of gauging risk are. The evidence is not flattering. VaR seems to have done a terrible job. And it is true that it is not going anywhere. The same perverse incentive structures are still there.
As far as I can see, the BCBS itself admits that VaR and IRBA are failures but, simultaneously, cannot be replaced. No feasible better methodology is readily available. What happens is a kind of pile-on design. The Basel II risk methodologies do a terrible job of modellng fat tail risks. However, simultanously they might produce some reasonable estimates of normal world risk. The fat tail risk hole cannot be plugged within that methodology by other means than by beefing up the capital requirements. So you still have a hole.
The story doesn’t end there, however. There’s another layer of risk-taking controls that Basel III is about to introduce. They target the methodology holes by at least somewhat limiting the damage that fat tail risks can do. Liquidity requirements impose constraints on risk-taking. In addition, the leverage ratio clips the banks’ ability to take on tail risks. Leverage ratio is insensitive to risk assessments.
Further, the leverage ratio will be relatively hard to game, or so it seems. In essence, there’s this playground where banks can play the regulatory arbitrage game as much as they want, but the playground is fence as well. Of course, the problems that all that risk might end up somewhere else, but there’s not much you can do about it apart from imposing the same rules on everybody.
I’m not saying that Basel III will be good, or even adequate. Only time will tell. But focusing exclusive on capital requirement numbers does not give a full picture of the package. You need to have a look at the other elements of the accord as well.
— Mika · Sep 15, 06:37 AM · #
Mika: if I understand correctly, the leverage ratio they are talking about is 33:1. Which is really high. I don’t think that provision has much teeth.
rj: I think you misunderstand me. The people who wanted to buy AAA-rated ABS thought it really was super-low-risk. They didn’t think it was junk. The model that the agencies used to rate this stuff – the Gaussian Copula model – wasn’t developed by the agencies; it was used by the banks first. I’m just saying that the problem exists whether the agencies are paid by issuers or by investors or by the government: everybody wants to make money, so if the only problem is “this is a new product so there may be unknown risks; neither the data set nor the model is that reliable a guide” there will be pressure rate the damn thing so everybody can get on with business.
A AAA rating is a stamp saying “this investment is safe; you will not lose money.” I’m really trying to figure out any good reason why somebody should be authorized to hand out those stamps.
— Noah Millman · Sep 15, 06:56 AM · #
The AAA debacle isn’t a risk model failure, it’s a brilliant example of the market working as intended. There was high demand for investments bearing the AAA mark, and the market met that demand. Isn’t that how it’s supposed to work?
— Tony Comstock · Sep 15, 08:11 AM · #
Noah:
I don’t think the dataset was as limited as you make it out to be. Sure, these instruments* were sometimes new, but banks have been calculating future default rates for as long as there have been mortgages. Therefore, if it was a little clearer which mortgages each instrument contained or based its swap rate on, we would have had better numbers.
Courts are still in an uphill battle to sort out who owns what and who sold what to whom, but that’s also not a problem within the purview of the Basel III project. The same is true of so-called “liar’s loans,” which caused further problems making accurate calculations.
The fat tail issue is real, but that’s built into every decision in life that has an assumed non-random distribution of outcomes. The only way to cut down on that risk is to increase the confidence interval of your VaR and whatnot, but that still leaves out some potential outcomes. The only way to deal with that, as far as I can see, is to cut down on leveraging, witch Basel III does.
— rj · Sep 15, 10:42 AM · #