Measuring and mitigating capital procyclicality in South African banks

Abstract

The regulatory market risk metric – Value at Risk (VaR) – has remained virtually unchanged since its introduction by JP Morgan in 1996. Many prominent examples of market risk underestimation have undermined the credibility of VaR, prompting the search for better, more robust measures. Expected shortfall and countercyclical capital buffers have been proposed by regulatory authorities, but neither is without problems. Bubble VaR (buVaR) – a coherent measure which avoids many of the pitfalls to which other measures have succumbed – was designed to be both forward-looking and countercyclical. Although tested on other markets, here it was applied to various South African instruments and the results compared with both international observations and other market risk measures. buVaR is found to perform consistently and reliably under all market conditions. Tradeable credit assets are vulnerable to two varieties of credit risk: default risk (which manifests itself as a binary outcome) and spread risk (which arises as spreads change continuously). Current (2017) regulatory credit risk rules require banks to hold capital for both these risks. It is a non-trivial exercise to aggregate these capital amounts as different approaches and models are required for each type. The buVaR approach was proposed by Wong (2011) to overcome the risk aggregation problem, and account for both diversification and procyclicality. The buVaR methodology operates by inflating the positive side of the underlying return distribution in direct proportion to prevailing credit spread levels (usually liquid credit default swap (CDS) spreads). Wong's (2011) framework required the calibration of some input parameters: this was undertaken for several markets, but South Africa was not among them. The model is calibrated – and tested – using South African data. The results exposed some unique features of the South African milieu and found considerable differences compared with other markets. Procyclicality plays a pivotal role in finance in both thriving and crisis periods. This influence stems not only from the way market participants behave, but also from risk metrics used and regulatory capital amassed and released during bust and boom periods respectively. The introduction of the regulatory Countercyclical Capital Buffer (CCB) aims to thwart procyclicality by accumulating (releasing) capital in upswings (downswings), subsequently reducing the amplitude of the financial cycle and promoting macroprudential stability. The timing of the accumulation and release of buffer capital is critical so identifying accurate indicators is important. Indicators must be established for all jurisdictions: the standard metric suggested by the Basel Committee on Banking Supervision (BCBS) has been questioned. For South Africa, studies suggest alternatives such as residential property indices since research has demonstrated that the BCBS proposal is procyclical rather than countercyclical. A superior method used to estimate the buffer has not yet been established. A Kalman filter was applied to South African data and the procyclicality of the BCBS proposal confirmed. Results suggest that buffer signals are dependent upon the filter employed.