Mortgage Fallout Exposes
Holes in New Bank-Risk Rules
Looser Guidelines
Face a Backlash
As Losses Pile Up
By DAMIAN PALETTA and ALISTAIR MACDONALD
March 4, 2008; Page A1
Some of the world's top banking brains spent nearly a decade designing new rules to help
global financial institutions stay out of trouble.
What if much of their thinking was wrong?
CHANGING THE RULE BOOK
• New Scenario: The global turmoil stemming from the U.S. mortgage crunch
has banks and governments rethinking a set of risk-guidelines drafted a decade
ago.
• The Players: Banking regulators, who have hatched a new set of rules, known
as Basel II; bank executives, who are suddenly grappling with huge subprimemortgage-related write-downs.
• Lessons Learned: Fears that hedge funds would be the source of the next
crisis may have been off base, while confidence that banks knew how much risk
they were taking was overstated.
A version of their new guidelines -- known as "Basel II" for the Swiss city where they
were crafted -- was about to be phased in next month in the U.S. Their primary tenet:
Banks should be given more freedom to decide for themselves how much financial risk
they should take on, since they are in a better position than regulators to make that call.
But the global financial turmoil triggered by the popping of the American housing bubble
is upending fundamental assumptions about risk. Institutions world-wide have badly
misjudged the safety of investments ranging from subprime mortgages to complex
structured financial securities. This is especially true in Europe, where many banks are
already operating under the new Basel II risk standards.
In one early bad omen, Britain late last year suffered its first bank run since 1866, when
mortgage lender Northern Rock PLC was caught off guard when credit markets froze
around the world during the crises. Applying Basel II's tenets, Northern Rock a few
months earlier announced it would boost its shareholder dividend by 30% -- a move that
would cut into its capital even as regulators began worrying about the firm's condition.
Last month Northern Rock was nationalized by the British government.
Even in Switzerland, home to the new Basel rules, bankers have been burned on bad bets.
UBS AG wrote down $18 billion in losses due to flaws in the way the bank managed its
own risk. (The firm wasn't operating under Basel II-style rules until Jan 1.)
Today, in Washington, D.C., the Senate Banking Committee is expected to grill federal
regulators on what went wrong. Did banks know how much risk they were taking? Did
they know how much capital they needed to cushion them from sour loans? Did they
prepare themselves adequately for the evaporation of "liquidity," or their ability to easily
sell their securities or loans?
The answer to all three questions appears to be "no."
The recent financial blow-ups came largely not from hedge funds, whose lightly
regulated status has preoccupied Washington for years, but from banks watched over by
national governments. Citigroup Inc. in last year's fourth quarter had its worst-ever
quarterly loss and had to raise more than $20 billion in capital from outside investors to
revive its balance sheet, after bad investments in mortgage securities. Citigroup declined
to comment.
"I think it was surprising...that where we had some of the biggest issues in capital
markets were with the regulated financial institutions," said Treasury Secretary Henry
Paulson in an interview.
Lessons From the Turmoil
As regulators world-wide start looking for lessons in the tumult, the result is likely to
mean, at least temporarily, more government scrutiny and regulatory oversight of banks.
LESSONS LEARNED
U.S. and global reviews underway related to bank supervision:
Risk management
Who: Senior Supervisors Group (regulators from U.S., UK, France, Germany,
Switzerland).
What: An analysis of best practices at 11 of the world's biggest financial firms to
determine best and worst risk management practices.
***
Policy Responses to Credit Turmoil
Who: Presidents Working Group on Financial Markets (Treasury, Fed, SEC,
CFTC)
What: Expected to recommend bolstering risk management, improving market
discipline, and improving how credit ratings are used.
***
Regulatory structure
Who: Treasury Department
What: A blueprint that is expected to propose redrawing jurisdiction for both bank
regulation and consumer protection in the United States.
***
Liquidity risk
Who: The Basel Committee on Banking Supervision
What: Updated guidelines for how banks manage liquidity risk. The guidelines
are expected to increase focus on the contingency plans banks have for liquidity.
***
Capital
Who: U.S. and foreign regulators, possibly through the Basel Committee on
Banking Supervision.
What: A review that could lead to significant changes to pending capital
requirements, potentially requiring firms to hold more capital against assets that
previously were thought to contain little risk.
***
Charlie McCreevy, commissioner for internal markets at the European Commission, says
that reassessment needs to examine whether banks are the best managers of risk. "There
should be no taboos," he says.
The Basel rules have their roots in the 1980s, when bank regulations varied dramatically
from country to country, making it tough for banks to compete across borders. The
world's central bankers huddled in Switzerland to hammer out basic standards, which
were unveiled in 1988.
A second round of talks, Basel II, focused on expanding those rules -- in particular, on
seeking ways to defend the financial system against the complex new investment
products becoming increasingly common at banks. The rules went into effect in European
countries last year. Next month's limited phase-in in the U.S. is likely to be delayed.
In the banking business, there are few things more core than the capital held by an
institution to cushion against losses. At its essence, it is what prevents a bank from
failing.
Under pre-Basel II rules, setting the level of this financial cushion is a relatively
straightforward process: Banks must hold a specific amount of capital, which is
calculated based on the types of assets they hold. For example, mortgage-related assets
don't require much capital because they have long been considered extremely safe.
The new rules would change that, letting banks calculate their need for capital reserves
based in part on their own assessments of risk and the opinion of credit-rating agencies.
Basel II has plenty of support. Federal Reserve officials have argued that its standards
give banks incentives to bolster their risk management.
In addition, Basel II requires institutions to maintain a safety net of capital to protect
against trouble in "off balance sheet" holdings they may have, an issue that had largely
escaped prior regulatory oversight. U.S. Comptroller of the Currency John Dugan says
the credit-market turmoil will strengthen Basel II by giving banks valuable new data to
factor into their models.
Each country implementing Basel II has wiggle room to tinker. In the U.S., regulators
wanted to tighten the rules. For them, the 1980s savings-and-loan crisis -- when more
than 1,000 banks failed amid
unforeseen risks related to
interest rates and real estate -remained a fresh memory.
Big banks including
Citigroup lobbied
aggressively in Washington
for looser, European-style
rules. They argued that tighter rules would make it tougher for them to compete globally,
since more of their money would be tied up in the capital cushion.
In June 2006, two Citigroup lobbyists joined Jim Garnett, the bank's head of risk
architecture, in a meeting in Washington with seven officials from the White House's
Office of Management and Budget, according to an official record. At the time, Citigroup
held $80 billion in core capital on its balance sheet to protect against its $1.1 trillion in
assets, according to the Federal Deposit Insurance Corp.
In early 2007, Citigroup teamed up with other banking giants, including J.P. Morgan
Chase & Co., Wachovia Corp. and Washington Mutual Inc., to meet with the White
House's National Economic Council and argue their case again. In a February 2007 letter
to regulators, the banks wrote: "To help ensure U.S. banking institutions remain strong
and competitive, the federal banking agencies should avoid imposing domestic capital
regulation that provides an advantage to non-U.S. banks."
In July, the Federal Reserve and regulators handed a victory to the banks, letting them
follow rules similar to those in Europe. That ruling potentially could enable American
banks to hold leaner, European-style capital cushions.
By then, cracks in the global financial system were already spreading rapidly. Citigroup
alone had a record loss of $9.83 billion in the fourth quarter, mostly because of bad bets
on what officials believed were extremely safe assets. Many other banks made similar
mistakes.
In the second half of 2007, Citigroup wrote down about $20 billion. Those losses ate into
the company's capital. Citigroup has had to raise more than $20 billion from investors,
including foreign-government investment funds, to build up its capital. Yesterday,
Citigroup's stock price closed at $23.09, near a 52-week low.
Regulators both in the U.S. and overseas say they are looking now to make changes to
Basel II -- which will likely require holding a higher level of capital against assets that
were previously thought to be safe.
The Basel rules are being questioned as much for what they didn't do as for what they
did. Despite requests from some regulators, they contained few provisions for monitoring
a bank's liquidity -- in other words, its ability to readily sell assets, or borrow affordably,
to cover obligations.
The 'Liquidity' Problem
A lack of liquidity has been a key feature of the financial turmoil sweeping global
markets. On Sept. 13, John McFall, a member of the United Kingdom Parliament, was
watching television at his Dumbarton, Scotland, home when he saw on the news that
Northern Rock had turned to the Bank of England for emergency financing.
"My immediate thought was: 'This was the financial equivalent of the last rites,'" said Mr.
McFall, who would later lead a government inquiry into Northern Rock.
Aggressive expansion had turned Newcastle-based Northern Rock from a regional lender
to the U.K.'s fifth-biggest mortgage provider. To finance this, the company began to
borrow heavily in global financial markets, rather than relying as much on traditional
customer bank deposits.
In fact, deposits had fallen as a proportion of the lender's total liabilities and equity from
63% at the end of 1997 to 22% at the end of 2006, less than half the level of its peers.
This meant Northern Rock had little in the way of internal cash on hand when its own
liquidity dried up after the firm's outside lenders decided to stop financing its growth.
Adam Applegarth, Northern Rock's CEO at the time of the crisis, defended the firm's
boosting of its dividend before a parliamentary inquiry on the bank run. He argued that
because of the high credit quality of its loans under terms of Basel II, the firm could opt
to hold less capital to cover potential losses.
Still, Northern Rock's troubles would have been "picked up" by regulators had there been
a proper system of liquidity controls in place, Mervyn King, the governor of the Bank of
England, told Mr. McFall's inquiry.
The Financial Services Authority, the U.K. banking regulatory arm, concedes it should
have been more aggressive in following Northern Rock's problems. Hector Sants, the
regulator's chief executive, says it will be conducting "more rigorous" liquidity reviews.
Last month, the Basel Committee said it plans to update its "core principals" for liquidity
risk to "reflect recent experience."
Even in Switzerland, where Basel II was hatched, financial supervisors are questioning
the rules. Yesterday, Philipp Hildebrand, a member of the Swiss central bank's board,
told a conference in London that the "idea is to further refine and strengthen liquidity and
capital-adequacy regulations" in light of "developments in the financial system."
One key principle behind the Basel rules is that banks are the best judge of the risks
they're taking. In many cases, banks have slipped up.
In July, Dominique Biedermann was eating breakfast at his Geneva home when he heard
over the radio that Switzerland's largest bank, UBS, had ousted its chief executive. At his
office one hour later, Mr. Biedermann -- an executive director at Ethos, an association of
funds that acts as an activist investor on their behalf -- phoned UBS to ask what triggered
the ouster.
"Everyone was saying the same thing. 'We aren't sure what is happening,'" recalls Mr.
Biedermann.
Later, in a letter to the board, Ethos charged that the people at UBS responsible for
controlling how much risk the bank should take were the same people responsible for
taking it.
"You can't control yourself, this is the problem," said Mr. Biedermann.
In response to that charge, a person familiar with the matter says UBS is confident it
properly separated risk management from risk control. UBS's various business groups
also have a built-in, independent risk-control process, this person says.
Risky Assets
Last year, UBS wrote down more than $18 billion due to its exposure to subprime
mortgages and other risky assets. In December, UBS disclosed plans to boost its capital
with a $12.1 billion injection from the Government of Singapore Investment Corp. and an
unidentified Middle Eastern investor.
The Swiss regulator, the Swiss Federal Banking Commission, in January sent its own list
of questions to UBS ahead of what a spokesman says is a "probable" investigation.
According to UBS, many questions center on risk management, valuation of "subprime
instruments" and internal controls.
"Of course we want to know from UBS, how could it come to this?" says Alain Bichsel,
the spokesman for the agency.
Mr. Bichsel says a regulator has a duty to monitor a bank's risk-taking and to check how
the bank monitors itself. But it's not a regulator's job to tell banks how much and what
sort of risk they can take. "Not every risk can be regulated," he says.
--Natasha Brereton contributed to this article.
Write to Damian Paletta at damian.paletta@dowjones.com1 and Alistair MacDonald at
alistair.macdonald@wsj.com2
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