rules trigger markdowns of portfolios, even if there is no intention to sell them, which translates into losses and erodes the capital base of banks. Fair value rules in severe conditions made losses unavoidable. Moreover, leveraged banking firms tend to reduce their debt through fire sales of assets. When liquidity relies on fire sales of assets under adverse conditions, markdowns bite the capital base. Under stressed conditions, solvency and liquidity become intertwined. Whether illiquidity or solvency is the initial cause does not matter. Once the mechanism triggered, it operates both ways.
For borrowing, financial firms pledge their portfolios of securities to lenders. Such collateral-based financing is subject to loan-to-value ratios, whereby the value of pledged assets should be higher than the debt obligation. In a market downturn, complying with ratios imposes that additional collateral be posted for protecting lenders, or, alternatively, that debt be reduced. In a liquidity and credit crunch, cash is raised from the sales of assets for paying back the debt. Fire sales of assets for reducing debt and bringing back asset value in line with loan-to-value ratios add to the market turmoil.7
The mechanism is pro-cyclical. Fire sales of assets create a downward pressure on prices, which triggers a new round of collateral calls. This new round results in additional sales of assets and starts another cycle of market decline, and so on. An adverse feedback loop between asset prices and system liquidity develops as a result of such interactions. The mechanism is strongly pro-cyclical: if asset values move down, sales of assets amplify the downturn. In a highly leveraged system, the adverse dynamics develop until the system deleverages itself.
Unregulated funds tend to highly leverage their portfolios for enhancing the return to investors. In a favorable environment, asset values are up and extending collaterized credit to funds is easy. In a stressed environment, the deleveraging of funds puts pressure on the entire system.
Regulations are also pro-cyclical because they impose capital buffers that tend to increase in adverse conditions, while simultaneously the losses shrink the capital base. The process results in credit contraction precisely when credit is needed most by firms chasing funds in illiquid markets, and contributes to the contraction of the whole system.
Securitizations refer to the sales of pools of banking book assets to investors in the capital markets by issuing bonds backed by these assets. Securitizations were a key technique in the “originate and distribute” business model of banks, whereby the banks finance their loans in the markets and, simultaneously, free their capital from backing the risk of sold loans. Prior to the crisis, banks off-loaded and distributed massive amounts of their credit risk into the capital markets.8 The so-called “toxic assets”, such as subprime loans, were believed to have found their way into the pools sold in the markets and the risk was perceived as disseminated throughout the whole system.
Rating agencies recognized that they underestimated the risk of asset-backed bonds, many with the highest quality grade, and a wave of downgrades followed. Downgrades command a higher cost of funds, and a higher required return, which translate in a loss of value of the downgraded assets. Investors in asset-backed bonds of securitizations, originally of a high quality, incurred massive losses. The trust in the securitization mechanism disappeared, and with it a major source of funds for the banking system.
The frequency of downgrades by rating agencies increased abruptly by the end of 2007, as rating agencies seemed not to have anticipated the effect of the crisis and tried to catch up with bad news. Lagged downgrades were concentrated in time, instead of gradually measuring the actual credit standing of issues.
All entities were hit by rating downgrades. Among those are insurance companies, or monolines, acting as “credit enhancers”. These firms enhance the credit quality of assets by providing insurance against credit loss. But the “wrapped” instrument quality is as good as the quality of the insurer. Downgrades of credit enhancers have a leverage effect as any instrument “wrapped” in a guarantee by credit enhancers is also downgraded.
Because monolines extended so many guarantees to assets, they were highly exposed to the risk that erupted in a short period of time. It was not long before credit enhancers were downgraded. AIG, the biggest insurance company in the world, extended credit insurance by trading credit derivatives, and collapsed when lenders required the firm to post collateral against its numerous commitments.
2.4 The Responses of Regulators to the Financial Crisis
Following the 2008 financial crisis, the Basel regulators introduced a number of measures to make banks more resilient. A number of significant updates to the regulatory framework have been introduced, reshaping the regulations, after the Basel 2 Accord, into new Basel (2.5 or 3) rules. The main publications include: the global review of the regulatory framework was first published in December 2010, revised in June 2011, “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems” [24], a “Revision to the Basel 2 Market Risk Framework” is dated February 2011 [25]; the Consultative Document “Fundamental Review of the Trading Book: A Revised Market Risk Framework” [27] was submitted to the industry in October 2013 and covers the regulations for both credit risk and market risk, as of this date.
Figure 2.1 maps the approaches under Basel 2 and the sequential sets of new regulations. The shaded boxes refer to the Basel extensions beyond Basel 2.
Figure 2.1 Overview of Basel regulations
The Basel 2 blocks refer to the credit risk treatment for credit capital charges, with the risk-weighted assets according to banks' internal ratings. The current wave of regulations aims at reinforcing both the quality and the quantity of capital. The fraction of equity capital in total capital is reinforced and the capital ratio increases. The subsequent publications imposed new capital requirements, with a series of additions to the Basel 2 capital. The Basel 2 rules are expanded in Chapter 26 dedicated to credit regulations.
The market risk approaches include the VaR-based capital plus the standardized approach of market risk for firms who do not comply with requirements of internal models. A stressed VaR was introduced as an additional capital charge in 2011. An alternate VaR measure is currently proposed for market risk. All market risk approaches are presented in Chapter 17 in the market risk section.
The treatment of counterparty credit risk has been enhanced with the credit-value adjustment (CVA) that measures the impact of deteriorating credit standing on the value of derivative instruments. The CVA adjustment is introduced in Chapter 22 on counterparty credit risk.
The blocks referring to liquidity and funding ratios cover three ratios gradually introduced by Basel 3. The Liquidity Coverage Ratio (LCR) imposes a minimum level of liquid assets for facing market disruptions to banks' funding. The Net Stable Funding Ratio imposes a minimum level of long-term funding, depending on banks' assets. The leverage ratio caps the size of the balance sheet and of certain off-balance sheet commitments as a function of the capital base. The three ratios are presented in Chapter 3 on balance sheet compliance, where the calculations and the consequences for the balance sheet of banks are detailed through a simplified example.
3
BALANCE SHEET MANAGEMENT AND REGULATIONS
The purpose of asset-liability management (ALM) is to manage assets and liabilities in conjunction with, rather than independently of, the bank so as to finance the bank and control the liquidity risk
On so-called “liquidity spirals”, see Brunnermeier, M. K. (2009), Deciphering the liquidity and credit crunch 2007–2008, [39].
See Longstaff, F. A. (2010), The subprime credit crisis and contagion in financial markets, [94].
