# Presentation: 178684

## Basel II: A Contracting Perspective

- Edward J. Kane
- _Boston College_

- Federal Deposit Insurance Corporation
- September 13, 2006

## BASEL II IS RE-REGULATION

## 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.

## The basic concepts of Basel II 

- The basic concepts of Basel II

## CONTRACTING CONCEPTS

**CONTRACT**: Any commitment by** **two 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.

## 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

## 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

## First-Order Stake of U.S. Regulators Is Enhancing Financial Stability; First-Order Stake of EU Regulators is Enhancing Financial Integration. 

**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)

## 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-transfer* *techniques* 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*.

## 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

## 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.

## 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**.

## 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 private_ _communications_, 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

## 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.

## 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

##  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. 

-  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.

## National Options GrantedUnder 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)

## 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.

## 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)

## 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.

## 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 Fed** **are the engine driving the Basel II train.

## QIS4 showed that large-bank and FDIC+ predeal understandings about individual-bank and system capital could not be reconciled without intersectoral 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. 

- 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.

## 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.

## 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.

## Sometimes it is Better to Keep Negotiations Open than to Seal a Deal

- Post-Basel Contracting Forum

- Large Banks