The Fed runs a fool’s errand on bank capital rules

The problem is that it’s extremely difficult to measure, much less anticipate. Unlike credit and market risk, it’s hard to distil governance and control practices into a quantitative framework. Regulators outlined a crude model tied to gross income but allowed banks to fashion their own models as an alternative.

JPMorgan deployed a fancy tool called a Loss Distribution Approach, which simulates the frequency and severity of future operational risk loss projections based on historical data to estimate an aggregate one-year loss at a 99.9 per cent confidence level. At the end of September, the model directed the group to allocate just over a quarter of its regulatory capital to operational risk, in addition to the 70 per cent being allocated to credit risk and 5 per cent to market risk.

Yet policymakers harbour reservations over internal models and new rules propose replacing them. “These models can present substantial uncertainty and volatility,” said Federal Reserve vice chairman for supervision Michael Barr in October. “In the agencies’ proposal, the operational risk capital requirements would be standardised rather than modelled.”

At a disadvantage

The standardised version resurrects the Basel Committee’s original crude approach. It scales the capital charge by revenue, so the bigger you are, the higher the charge. Which makes some sense – higher volumes tend to be associated with higher operational losses. Yet while the rules cap the charge linked to net interest revenue, no such cap is afforded to fee income. So banks, such as Morgan Stanley, that derive a substantial share of revenue from fees are at a disadvantage.

“It makes no sense. I mean, that’s the bottom line,” outgoing Morgan Stanley chief executive James Gorman said at a Senate Banking Committee hearing earlier this month. “I’ve been at this a long time, I was on the New York Fed board for years, I’ve seen a lot of rules, some that make sense and it’s a question of how far you turn the dial. This doesn’t make sense.”

Nor do the new rules take into account diversification benefits across revenue streams. “Operational risk is … asinine,” JPMorgan CEO Jamie Dimon said at an investor conference in September. “Do you like diversification? I think diversification is a wonderful thing, but … operational risk is anti-diversification. In operational risk, are all revenues equally bad? Really? Honestly, I look at that, I think, who did that? What person, in what ivory tower, thinks that that is a rational thing to do?”

JPMorgan estimates that the rules will impose an incremental $US30 billion capital surcharge on his bank. The industry-backed Bank Policy Institute estimates that overall, $US172 billion of additional capital will have to be put aside. It observes that even during the global financial crisis, when operational risk blew out, losses remained less than 30 per cent of the capital required under the new standardised approach.

US banks are especially hard hit not just because of their higher weighting to fee income, but because the Fed has gold-plated its rules. European bank ABN Amro recently migrated to the standardised approach and its operational risk capital requirement jumped by just 3 per cent. But in the US, the rules multiply the impact of a poor track record of operational-risk management without giving benefit for a good track record.

Not all policymakers agree that the shift makes sense. Dissenting from his colleagues, Fed governor Christopher Waller questions whether a separate bucket for operational losses is useful at all, arguing that, slower to manifest, they’re unlikely to emerge at the same time as credit and market losses. Indeed, this year’s Canadian bank penalties stem from failings that occurred in 2008 and 2009.

Bankers have until January 16 to comment on the Fed’s new approach, so they have the holiday period to sharpen their pencils. They will admit that operational risk is very real, but finding a model that captures potential embezzlement, consumer abuse and money laundering losses is no easy task.

Marc Rubinstein is a former hedge fund manager.

Bloomberg Opinion