Triggers for PCA

1
Triggers for PCA

• Financial Regulation Seminar
• June 9, 2008

Thorvald Grung Moe Norges Bank (Central Bank of
Norway)
The views presented are mine and should not be
associated with Norges Bank
2
Outline

• Background
• Key features of PCA
• PCA in Europe?
• Design of PCA triggers
• Policy issues
• Way forward

3
Background
4
Definitions

• PCA Prompt Corrective Action
• Rule-based intervention framework based on
  specific levels of bank capital
• FDICIA Federal Deposit Insurance Corporation
  Improvement Act of 1991
• SEIR Structured Early Intervention and
  resolution (Benston and Kaufman, 1988)
• Mandatory regulatory responses based on
  predetermined capital assets ratios that trigger
  structured actions by supervisors

5
Trigger event

• How can we avoid another run?
• Strengthen the financial system
• Reducing likelihood of banks failing
• Reducing the impact of failing banks

6
Renewed interest in PCA

• The Treasury Committee
• see great merit in the prompt corrective
  action approach adopted in the US and in other
  countries.
• We recommend that the judgment of the relevant
  authority, supplemented by a set of quantitative
  triggers, be used to identify whether a bank is
  either failing, at risk or failing, or is just
  an outlier in the industry.

7
Tripartite report more reserved

• the interventions and powers available to the
  FSA are already wide-ranging
• there may be cases in which there are practical
  problems with implementing (intervention) OIVOP
  powers ()
• the authorities judges that the FSA requires a
  small number of additional powers

() Own Initiative Variation Of Permission
8
IMF support PCA type policy

• the regime of remedial measures to be applied
  against weak institutions crossing various
  thresholds established by the FSA could be
  further elaborated. Although the existing powers
  of the FSA to take action against weak
  institutions suffice, increasing clarity on the
  outcomes sought by regulators will lead to
  reduced ambiguity and would encourage early
  voluntary actions by weak financial institutions,
  for instance by reducing dividends and augmenting
  capital.
• IMF Article IV Concluding Statement May 23,
  2008

9
Should FSA have spotted the crisis?

• there were a number of indicators emerging that
  could have prompted the supervisory team to
  re-assess its view of Northern Rocks business
  risk much earlier (p. 42)

• A number of signals were apparent that
  individually (and in aggregate) should have
  provided a trigger for a review of the structure
  of the balance sheet and the appropriateness of
  controls, (p. 39)

10
FSA Internal Audit Report (March 2008)

• Inadequate FSA resources
• Lack of management attention
• Last ARROW in march 2006
• Letter to NR board Risk to FSA LOW
• No Risk Mitigation Process (RMP)
• Supervisory period extended to 3 y
• Weak Close Continuous process
• Liquidity review April 2007
• No material weakness

11
PCA Workshop in Norges Bank March 2008

• Issues for discussion
• DO YOU THINK PCA REGULATION COULD BE USEFUL IN
  EUROPE?
• HOW SHOULD PCA TRIGGERS BE DESIGNED AND USED?
• WHICH REGULATORY ACTIONS SHOULD BE TRIGGERED -
  AND HOW FIXED SHOULD THE LINK BE BETWEEN TRIGGERS
  AND MANDATORY ACTIONS?
• ANY OTHER RELEVANT ISSUES RELATED TO PCA TRIGGER
  IMPLEMENTATION IN EUROPE?

12
ConclusionNorges Bank workshop on PCA triggers,
March 2008

• PCA legislation is no panacea, but if
  implemented in a flexible and pragmatic manner,
  it could be a useful supplement to current EU
  regulations

13
PCA in context related themes

• Rules versus authority (Simons 1936)
• Why prevention is better than cure (Goodhart
  2007)
• Banking regulation and PCA (Freixas and Pragi
  2007)
• Disclosure, volatility and transparency (Baumann
  2004)
• Formulas or supervision? (Estrella 1998)
• The credit crisis and what it means (Soros 2008)

14
Key features of PCA
15
FDICIA -Subtitle D, Section 38

• Mandates that each appropriate Federal banking
  agency to take prompt corrective action to
  resolve the problems of insured depository
  institutions by prescribing or rescinding, as
  appropriate, specified capitalization measures
  established according to statutory guidelines
  (including capital restoration plan requirements)

16
FDICIA (1991) Bank classification and related
capital levels
17
Graduated supervisory response depending on
capital category

• Key provisions are Sections 38 (d)(i)
• No institution can pay dividends that will lead
  it to be undercapitalized
• Undercapitalized institutions will be monitored
  and have to provide a capital restoration plan
  asset growth can also be restricted
• Significantly undercapitalized institutions will
  (obviously) be subject to further restrictions
• Critically undercapitalized institutions will be
  taken into receivership within 90 days

18
Mandatory Discretionaryprovisions for
undercapitalized banks

• Restrict dividends
• No management fees
• Capital restoration
• Restrict asset growth
• Prior approvals for branching etc.
• No brokered deposits

• Require new capital
• Restrict affiliate transactions
• Restrict rates on new deposits
• Restrict activities
• Replace management
• Require divestiture

19
Arguments in favour of a rule based approach to
intervention

• Increased credibility of supervisor
• Reduce scope for regulatory forbearance
• Reduce danger of undue political interference
• Beneficial impact on bank behavior
• Reduce probability of future insolvency
• Llewellyn Mayes (2004)

20
Preconditions for PCA in Europe()
() See Nieto and Wall (2007) for details
21
Philosophy of SEIR/PCA

• Minimize deposit insurance loss
• Forbearance should be limited
• Banks should be closed at positive capital levels

22
Institutional preconditions

• Supervisory independence and accountability
• Adequate authority
• Adequate resolution procedures
• Adequate and timely financial information

23
Discussion

• CRD (and B II) have PCA elements
• Supervisory architecture different
• Supervisors prefer broader approach
• Elements of discretion even in FDICIA
• Discretion due to uncertain information
• gt Reluctance to embrace rule based
  intervention, but emerging support for early
  resolution features of PCA

24
CRD/B II have PCA elements

• B II/Principle 4 Supervisors should seek to
  intervene at an early stage to prevent capital
  from falling below the minimum levels required to
  support the risk characteristics of a particular
  bank and should require rapid remedial action if
  capital is not maintained or restored.
• CRD/Article 136 Competent authorities shall
  require any credit institution that does not meet
  the requirement of this Directive to take the
  necessary actions or steps at an early stage to
  address the situation.

25
Different supervisory architecture
Systemic concern
Safety and soundness
Least cost resolution
Europe
NCB incl. supervision
DGS Pay box
26
Supervisors prefer modified PCA approach

• Canadas FSA (OSFI)
• FDICIA was influential in shaping OSFIs approach
  to intervention, but there was no direct
  importation.
• Rather, the framework was rejected in its
  existing form.
• Hard financial indicators were argued to be
  trailing rather than leading indicators of the
  financial health of an institution.
• Black (2004)

• US Federal Reserve
• Regulators imposed formal action on banks long
  before their capital became undercapitalized.
• PCA legislation may fill a few gaps, but may have
  been oversold.
• Peek and Rosengren (1996)

27
OSFI Soft indicators

• The Guides to Intervention therefore incorporate
  soft indicators, such as the strength of
  internal controls, internal policies on risk
  management and whether or not these were being
  followed, as well as figures on business growth
  in assessing financial health.

28
Broader supervisory approaches
FSA The ARROW risk model
FED CAMELS
Capital Asset Quality Management Earnings Liquidit
y Sensitivity to market risk
ARROW Advanced, Risk-Responsive Operating
Frame-Work
29
Even some discretion in FDICIA

• Section 38 (g)
• If an insured depository institution is in an
  unsafe or unsound condition, the agency may
• Reclassify the institution (downgrade)
• Require the institution to comply with (certain)
  provisions related to that capital category

30
Uncertain information gt discretion

• PCA encourage, but is not reliant on market value
  accounting
• Paradox PCA rely on effectiveness of
  supervisory examinations (Wall and Nieto 2007)
• PCA ratings are lagging indicators of bank health
  (Peek and Rosengren 1996)
• Interaction between accounting practices and
  financial crisis (Goodhart 2006)
• Greater volatility gt Stronger buffers

31
Emerging support for early closure

• Special Resolution Regime (SRR)
• to ensure that a range of tools are available
  to take greater control of a failing bank
• Special Resolution Regime (SRR)
• should be based on regulatory triggers, in line
  with principles in EU law governing the
  reorganization and winding-up of banks (!)
• based on regulatory judgment by the FSA after
  consultation with BoE and HMT

32
IMF support for SRR

• We support the aim of early intervention of
  distressed institutions in the proposed SRR.
• It is not possible to identify in advance all
  circumstances under which an institution should
  be put into the SRR process, but a definition of
  the circumstances likely to give rise to such a
  judgment would support this aim.
• An approach whereby the regime is presumed to be
  triggered when a bank meets this definition
  strikes an appropriate balance between regulatory
  forbearance and unnecessary actions.
• As thresholds for liquidity are hard to identify,
  discretion remains essential in this context.
• IMF Article IV Concluding Statement May 23,
  2008

33
The problem of signal error

• Banking crisis do not appear out of the blue
• A high proportion were anticipated by our best
  leading indicators
• There is a problem, however, of too many false
  alarms
• one false for every 2-5 true signals
• Goldstein (2000) Early warning system for
  financial crisis

34
Design of PCA triggers
35
Design of PCA triggers

• 10, 8, 3 or 0 ?
• Alternative triggers?
• Liquidity triggers?
• Link to Early Warning Systems
• Can we predict banking crises?

36
When to intervene? At 10, 8, 3 or 0 risk
weighted capital?

• Markets will react negatively if banks even
  approach regulatory minimum
• Which type of crisis?
• Slow asset burn or sudden liquidity crunch?
• 90 days notice if critically under-capitalized
  realistic?

• weakness leading to failure are often evident
  and addressed well before the PCA capital
  triggers are met.
• Brunnmeir and Willardson (2006)

37
Perhaps not such a big issue?Very few banks are
actually undercapitalized
Distribution of US banks along PCA and CAMEL
categories
Source FDIC (2001)
38
Wider set of triggers?

• RBI will initiate structured action if banks
  break any of these triggers
• Capital to risk-weighted assets ratio (CRAR)
• Non-performing assets (NPA)
• Return on Equity (ROE)

Source Reserve Bank of India (2000)
39
Perhaps also liquidity triggers?

• FSA (2007) Liquidity is hard to predict!
• Liquidity risk can grow very rapidly
• One suggested liquidity trigger
• Request for emergency support facility
• Other suggestions
• Funding mismatch
• Short-duration liquidity shock
• Which corrective action to associate?
• Close link with central bank ELA

40
Link to Early Warning Systems

• New risk index estimated by Norges Bank gives
  strong and early signals of 1990-93 crisis banks
• The risk index includes six indicators
• The capital adequacy ratio
• Ratio of residential mortgages to gross lending
• An expected loss measure
• A concentration risk measure
• Return on assets
• Norges Banks liquidity indicator

41
Early Warning Systems Fantasy or Reality?

• ECOFIN (2008)
• Considerations should be given to the further
  development of early warning systems on
  individual (financial) institutions.
• FSF (2008)
• Authorities must do all they can to identify
  emerging problems so as to be able, if necessary,
  to take prompt appropriate action to mitigate
  them.

42
IMF Financial Soundness Indicators

• Core set
• RWC
• NPL
• Sector of loans
• ROA
• ROE
• Interest margin
• Cost ratio
• Liquid assets
• Net open FX position

• Encourage set -additional data on
• Deposit takers
• Other financial institutions
• Non-financial companies
• Households
• Market liquidity
• Real estate markets

43
Can we predict banking crises?

• There are two traditional views of banking panics
• Crisis is generated by random events (sunspots)gt
  bank run not due to any exogenous shock, or
• Crisis is generated by fluctuations in
  fundamentals of the economy
• Our theory makes firm predictions about the
  conditions under which crisis will
  occur Allen Gale (2002)

44
But Goodharts law would kick in

• It is highly unlikely that a set of indicators
  could be identified that could detect future
  crises sufficiently early and with a high degree
  of certainty, while not giving false signals.
• Indeed, if such indicators could be identified
  they would likely lose their usefulness because
  they would change behavior markets would take
  them into account and, by anticipating crises,
  precipitate them earlier, or policymakers would
  take actions to prevent crises from occurring.
  Consequently, the indicators would lose their
  ability to predict crises. IMF (1998)
  Economic Outlook

45
Something simple might do the trick The leverage
ratio

• it is essential that optimal risk-sensitive
  capital requirements be complemented by a capital
  floor that does not depend on the riskiness of
  banks activities.
• Bichsel Blum, April 2005

• Reducing the leverage ratio would undermine our
  whole system of prompt corrective action which is
  the foundation stone of our system of
  supervision
• Former Comptroller of the Currency John Hawke,
  April 2004

46
PCA policy issues
47
Current PCA policy issues in Norway

• Early intervention
• Write down share capital
• ELA conditions
• Early resolution
• Closing a bank and depositor payout
• Bridge bank solution

• 1996 Act on Guarantee Schemes for Banks and
  Public Administration etc.
• Chapter 3 Payment and capital adequacy
  difficulties
• Chapter 4 Public Administration

48
Triggers for SEIR in the 1996 Act
49
1) Write down triggers in the Act

• Write down possible according to the Act
• However, write down may come too late?
• Require new audited statement
• Could take some time
• How to protect shareholders right when time is
  short?
• Chapter 4 (PA) going concern may be better
  option?

Based on large bank with Tier 18 and Tier
211,2
50
2) ELA policy issues (2004 2008)
2007
2008

• Current financial crisis has highlighted
• Classic LLR case again
• Illiquid, but solvent
• ELA despite RWC gt 10
• ELA only for systemic banks with collateral
• But, obvious need for CORRECTIVE ACTION
• Need to coordinate ELA conditions with FSA
• Strengthen capital position
• Engage shareholders

2004
ELA policy issues
2006
2005
51
3) Closing a bank and depositor payout
(highlights from recent report)

• A bank closure (public administration) today will
  be a challenge, even for small banks
• If a bank is put into public administration, it
  is unlikely to reopen again
• Public administration is (therefore) not a
  realistic resolution option for large banks
• Depositors should expect partial payment within
  two weeks the rest within 3 month

52
4) Bridge bank solution

• How to maintain critical payment services, and
  write down non-protected creditors?
• Policy dilemma
• Cannot be done under chapter 3
• But chapter 4 (PA) will close the bank
• Solutions
• Change law (US bridge bank/UK SRR) or
• Find creative solutions within current law
• How to handle TBTF banks?

53
Important PCA elements for EU

• Early resolution
• Provide incentive for market based crisis
  resolution
• Could ease burden sharing discussion
• Early intervention
• Fact finding How do supervisors react to
  breaches of regulatory capital today
• Common definition of solvency
• Convergence of supervisory reaction to declining
  capital levels

54
Guidance for policy reform

• PCA can be a very useful supplement
• Especially the ability to close early
• Better to prevent crisis, but harder
• Focus should be on resolution policies
• Write down, bridge bank, payout, etc.
• Resolute handling of liquidity problems
• Better information systems
• Tight policy coordination FSA NCB
• Enhanced role of owners

55
Way forward
56
Banking regulation at a crossroadNew
regulations or just new attitudes?

• Investors have lost confidence in banks
• Bank stocks now trades at a book multiple of 1
  which is lowest level in15 years.
• Changes to regulations are politically
  inevitable.
• It appears certain that those changes will dent
  banks profits.
• FT June 6, 2008

• I dont think we should lose sight of the fact
  that so much in regulation is not about
  structure, but about attitude and management the
  how of regulation the way it is done.
• Sir Andrew Large (1997)

57
Way forward

• No silver bullet
• Goal Resolve banking crises without taxpayers
  money
• Prime responsibility for crisis resolution with
  firm, owners and creditors
• Better higher buffers would help
• Plus self- co-insurance
• How to resolve maintain access to critical
  payment services
• Has to deal with TITF (too interconnected to
  fail)
• Changes in regulatory design?

58
Finding the right balance

• A balance need to be struck between rigid PCA
  regimes and general, less binding frameworks. One
  effective combination would include automatic
  rules for pre-agreed acceptable supervisory
  actions, plus room for flexibility in particular
  cases.
• BCBS (2002) Supervisory guidance on dealing
  with weak banks

• there is a need for a sensible balance to be
  stuck between an early corrective action
  framework, and avoiding an excessive intrusive
  regulatory approach and the development of
  excessively complex PCA triggers.
• G. Kaufman (2004)

59
Conclusion (repeat)Norges Bank workshop on PCA
triggers, March 2008

• PCA legislation is no panacea, but if
  implemented in a flexible and pragmatic manner,
  it could be a useful supplement to current EU
  regulations

60
Thank you for the attention
61
References

• F. Allen and D. Gale (2002). Financial fragility.
• U. Baumann (2004). Disclosure, volatility and
  transparency.
• J. Black. The development of risk based
  regulation in financial services Canada, the UK
  and Australia.
• J. Blum and U. Birchler. Capital regulation of
  banks Where do we stand and where are we going?
• Brunnmeir and Willardson (2006). Supervisory
  Enforcement Actions Since FIRREA and FDICIA.
• BCBS (2002) Supervisory guidance on dealing with
  weak banks
• A. Estrella (1998). Formulas or Supervision?
  Remarks on the future of regulatory capital.
• X. Freixas and B. Pragi (2007). Banking
  regulation and prompt corrective action.
• FSA (2008). The supervision of Northern Rock a
  lessons learned review.
• C. Goodhart (2006) Why prevention is better than
  cure.
• M. Goldstein (2000). Implications of early
  warning models of crisis.
• HMT (2008). Financial stability and depositor
  protection strengthening the framework.
• House of Commons, Treasury Committee (2008). The
  run on the Rock.
• FDIC (2001)Keeping the Promise Recommendations
  for Deposit Insurance Reform.
• IMF (1998). Economic Outlook.
• IMF (2008). IMF Article IV Concluding Statement
  May 23, 2008.
• G. Kaufman (2004). Musing on financial stability
  issues. Reserve Bank of New Zealand Bulletin.
• A. Large (1997). Regulation and reform.
• D. Llewellyn and D. Mayes (2004). The role of
  market discipline in handling problem banks.