Counterparty Risk Data Gathering Trumps Basel II September 7, 2006
Counterparty Risk Data Gathering Trumps Basel II
In the dog days of August, the House Committee
on Financial Services tentatively announced hearings
regarding the long-delayed implementation of the New Basel Capital Accord or Basel II. In a letter, some legislators asked that US bank regulators hold off on issuing a new rule for public comment regarding Basel II until after the hearings, but yesterday the FDIC board did the right thing and approved the proposal for public comment.
Fact is, regulators, legislators and even the
bankers feel an increasing sense of urgency regarding Basel II, if for no other
reason than there are so many other pressing issues requiring attention --
issues which the delay of Basel II implementation in the US has effectively
blocked. Important as Basel II may be to the industry and to the US
national interest, the approaching trough in the credit cycle is
stoking concerns about credit quality and collateral values. We hear
that top of the list for the financial services industry is the generic question
of how to get better counterparty risk data, especially for organizations
involved in Complex Structured Financial Transactions
(CSFT) and Over-the-Counter (OTC) derivatives.
For months
now, Washington's focus has quietly been shifting away from the
theoretical
constructs of Basel II and towards the very real risk issues of
counterparty credit risk and liquidity. One hint came over our transom when
a certain regulatory agency in DC called to ask about
applying structured data collection methods such
as XBRL to gathering counterparty risk data a la the suggestions made
by the Corrigan Group. XBRL is a machine readable language
for the communicating business and financial data which has been
adopted by the Federal Deposit Insurance Corporation for gathering bank call reports and is
being assessed by the Securities and Exchange Commission for enhancing
public company reporting.
It is remarkable and
encouraging to us that political
appointees are focused on gathering counterparty
risk data at this level of detail and at this time. Perhaps Moody's illustrated
the policy driver when it reported that sales of U.S.
collateralized debt obligations or CDOs soared to
a record $115.7 billion in the first half of
this year, a 72 percent increase from the same period
last year. Many CDO deals come with
credit derivative enhancements and ratings from
the major agencies of the overall riskiness of the
deal. These ratings, in turn, are used to justify
pricing. But does the sum of the parts analysis suport the yield to commission for the
CSFT dealer?
Fact is, a
growing number
of senior people in government are pondering
the use of XML-based technology solutions to address the issues
like those raised by the Corrigan Group (aka the "Counterparty Risk Management
Policy Group II" --http://www.crmpolicygroup.org/report), in particular the
issue of gathering sufficient financial statement data about hedge
funds and other lightly regulated entities to understand counterparty
risk. And the FDIC's use of XBRL for gathering bank data is only one
example.
Notice, for instance, that the Federal
Reserve Board has just added bank charge-off and delinquency rates to their
SDMX-ML data download series (http://www.federalreserve.gov/datadownload/). In
a matter
of months, most if not all of the public data gathered by the various bank regulators
will be available for free online, in "as filed" form and in an
industry standard format that you can easily import onto a spreadsheet or to
power a database analytics application.
By no coincidence, Michael Rasmussen at Forrester just asked us, on behalf of a client, whether
banks are using metadata to organize counterparty risk data for Basel II applications.
Specifically, the client described a "current focus around Basel
II" driven by interest "in a Metadata Repository (MDR)" and was said
to be interested in learning whether or not an MDR is being used by the
largest banks effectively to manage Basel II data
requirements.
Answer: Yes. Give us a
call, Michael.
And finally, last week the major
rating agencies announced a laudable new effort to draw up financial
criteria for rating hedge funds. Just as the rating agencies have been
the enablers of CSFTs, providing credit ratings of these unique asset structures
which have been absolutely crucial to acceptance on the Buy Side, now they purport
to be able to assess the credit risk worthiness of specific funds, a reflection of
just how important hedge funds have become to providing liquidity in the
global markets.
Part of the reason for
the rating agency initiative
regarding hedge funds is self interest (that is, a
fee), part
the insatiable desire of investors for designer assets, but most
risk pros we know still rely on collateral to "rate" fund counterparties. One
liquidity maven at a top bank trading desk in NY
tells an apocryphal tale of how a certain hedge fund went down because of a squabble between
two principals, ending in messy litigation and uncertainty for the fund's counterparties.
The funds financials, which were sterling, said nothing about the operation
risk embedded inside these individual members of the hedge fund maggotry.
Picture
Perfect
Suffice to say that we
perceive that the twin
issues of counterparty risk and collateral valuation are rising to
the top of the proverbial hops kettle in Washington. These inputs, added to contacts
in the channel, suggest to us that modeling future capital needs for
the purpose of Basel II has lost some priority compared to estimating
the present day capital needs of banks and other obligors. It also
confirms our suspicion that the new rule on Shared National Credits
(SNC), including enhanced disclosure by hedge funds and other
counterparties of CSFTs, is going to move soon, probably with a new comment
period to update the December
2004 request.
Why do we
believe that "Snick," as SNC is pronounced inside the beltway, is about to
finally move after almost two years of torpor and long after the
various regulatory agencies requested comment? Because the mounting
threat of a serious systemic event in the opaque marketplace for custom built
assets -- or, more specifically, the lack thereof -- has begun to
really worry some people in the world of risk analysis.
Consider by way of
example the profile of a notional institution whose financial performance has been "enhanced" via
the use of OTC derivatives and CSFTs. Our subject is a good
sized regional
bank, an institution which has grown more sophisticated in terms of the
use of the trading book and more willing to purchase as well as
go short OTC products for both interest rate and credit risk management. The bank was
once a mediocre performer, but now has above average asset and equity returns. Over
the past five years, our subject also progressively improved default experience.
It's so good, in fact, that the bank is now in the bottom quartile of the peer
group in terms of charge offs. Volumes in purchased funds and
derivatives have increased over the period, but the bank's earnings are more stable than its
peer, picture perfect in fact. Almost too good to be true.
The worst
nightmare of the regulatory community today is not the visible threat looming on
the horizon, but rather the eerily tranquil scene in the marketplace for
everything from loans to credit derivative swaps. Despite the
growing list of anecdotal horror stories we hear from the Buy Side about
sharply discounted secondary market valuations for CSFTs, structures, mind
you, which often carry investment grade ratings from the
major credit rating agencies, the data for loan defaults and
related losses at banks remain well-below historical norms. As
the FDIC just reported, in Q2 levels of non-current commercial &
industrial loans were still near 16-year lows, albeit up now two quarters in a
row.
Are we looking at the
bend in the hockey stick?
As we've noted before, part of the
reason for the calm picture still visible in the credit markets is
the Fed's generosity between 2000 and 2003. Easy monetary policy covers a
lot of economic and political sins. John Dizard writes in the Financial Times
: "If the founding
Austrians had Marxists and Keynesians as their opposition theorists, the
present-day Austrians have Alan Greenspan and Ben Bernanke and their enablers in
the US political system."
To us, the chief obstacles
preventing regulators and risk managers from understanding the nature of
the next systemic tsunamis are 1) over-reliance on statistical modeling methods and
2) the use of derivatives to shift and multiply
risk. Of note, continued reliance on VaR models and Monte Carlo simulations
is enshrined in the Basel II proposal, the pending rule revision on CSFTs and the SNC
proposal. All share an explicit and common reliance on statistical methods
for estimating the probability of a default
or P(D), for example. These ratings, in turn, depend heavily
upon stability in the assumptions about the
likely size and frequency of risk events. None of these proposed
rules focus great attention or resources on assessing specific obligor behavior.
Thus the
urgency in some corners of Washington regarding revisions
to SNC, including a quarterly reporting schedule and enhanced disclosure
of counterparty financial data. Remember that one of the goals of the SNC enhancements is to
gather private obligor P(D) ratings by banks and to aggregate same to build a
composite rating system for regulators to use to assess counterparty risk.
That is, the creation of a privileged data
rating matrix which could be used to assess the
efficacy of both bank internal ratings and third party agency P(D) ratings alike. More
on this and the effect of derivatives on
visible bank loan default rates in a future
comment.
Bankers, after
all, are not very good at understanding future
risks, no matter how
many ERM consultants they hire, default risk software implementations
they direct, or meetings they attend at the Federal Reserve Bank of New
York. Even making accurate observations about the present
day risk events seems to be a challenge. Witness the fact that
commercial bankers as a group managed to
direct more than $2 out of every $3 in political contributions this year to Republican
members of Congress, even as the GOP looks ready to lose
control over the House and perhaps even the Senate. When Barney Frank (D-MA) is
Chairman of the House Committee on Financial Services, perhaps the
industry will take notice of this operational risk event and adjust accordingly.
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