Basel II: back to the drawing board?

Two crucial inputs into Pillar 1 (Minimum Capital Requirements) of the proposed Basel II Framework for the International Convergence of Capital Measurement and Capital Standards have, if not gone belly-up, at least been severely compromised by the recent financial markets turmoil. They are the reliance on credit ratings provided by the internationally recognised rating agencies (currently Moody’s, Standard & Poor’s and Fitch) and the crucial role assigned to internal models in everything from stress-testing to marking-to-model illiquid assets.

It is clear that, as regard rating complex structured products, the three internationally recognised rating agencies have done a terrible job. That is in part because rating complex structured products is very difficult. There is more to the ratings performance however. There appears to be a systematic bias in the ratings. If rating were merely difficult, you would expect as many over-ratings as under-ratings. What we see instead, is a persistent bias: ratings seem to systematically over-estimate the creditworthiness of the rated instrument or structure. The reason for this must be the distorted incentive structure faced by the rating agencies. They are inherently and deeply conflicted.

• First, almost unique in any appraisal process, the appraiser in the rating process is paid by the seller rather than the buyer.

• Second, the rating agencies provide (remunerated) technical assistance/advice on how to design structures that will attract the best possible rating to the very issuers whose structures they will subsequently rate.

• Third, rating agencies increasingly provide other financial services and products than ratings (or ratings advice). As with auditors, there is the risk that the rating (audit) service may be subverted in the pursuit of remunerative sales of these other products.

I am not asserting that the rating process of complex financial instrument is unavoidably utterly corrupt and useless, although some of it probably is. Clearly, reputational considerations mitigate the conflict of interest faced by the rating agencies. The rating agencies have, for a long time, done a passable job of rating sovereign debt instruments and corporate entities. However, the principal-agent chain linking an individual or team working for some rating agency to the buyer of the security they rate is lengthy and opaque. The bottom line is that no-one any longer trusts the rating agencies’ judgement of the creditworthiness of complex structured instruments. That puts a huge hole in Pillar 1.

The recent financial turmoil has led to a demystification of quants and other high-tech builders and maintainers of mathematical-statistical models and algorithms. We have had a powerful reminder of the ‘garbage in – garbage out’ theorem. On many occasions marking to model has turned out to be marking-to-make belief or marking-to-myth. Wishful thinking dressed up in advanced mathematics remains wishful thinking. The incentives faced by the designers, maintainers and users of these models, and of those who calibrate their inputs have not been taken into account. Again conflict of interest is pervasive and inescapable.

With so many illiquid, non-traded instruments on their books (and in off-balance-sheet vehicles that may have to be brought on balance sheet again soon), many banks are confronted with the fact that ‘fair value’, when it cannot be measured objectively by a market price, is unlikely to be calculated fairly by techie employees of the bank whose activities are not understood by the bank’s risk managers or top management, and whose pay and prospects depend in a pretty obvious way on the numbers their models crank out. Again reputational considerations will mitigate the incentive to distort, but will not eliminate it. Turnover of quants, risk-managers and even top managers is so high that the restraining influence of reputational concerns is often weak at best.

What is Pillar 1 of Basel II without reliable and trusted rating agencies and without reliable and trusted methods for marking to model the illiquid assets of the banks? Not something I would use as a rule book for capital measurement and capital standards for banks. So whither now with Basel II?

Forcing the rating agencies to clean up their act is one necessary condition for Basel II to get back on track. This would require rating agencies to forsake all activities other than providing ratings. It also requires the end of the payment for the rating by the issuer of the security being rated. The only workable model would be payment out of a fund raised by a levy on the entire universe of securities-issuing and investing industries that rely on ratings.

As regards internal models and marking-to-model, I can see no way the cripling conflict of interest can ever be resolved for anything other than the simplest structured products - those for which even the CEO can understand the principles underlying the model and the numbers going in and coming out. This would mean that banks would not be allowed to hold on their balance sheets, or to be exposed to through off-balance sheet connections, complex structures whose valuation cannot be verified easily by third parties. This is tough and will be unpopular with the industry, but necessary for financial stability.

In any case, if a financial product is too complex for its valuation to be understood by the average Joe, it probably contributes negative marginal social value. Such complex products tend to be motivated by regulatory avoidance and tax avoidance considerations, and should be discouraged by regulatory design. True risk trading and risk sharing require simple, transparent instruments, designed for specific contingencies (states of nature), rather like elementary Arrow-Debreu securities. They don’t require convoluted bundles of heterogeneous opaque contingent claims.