Kellys Formula: Fixing the Flaws in Basel IIIs Capital Buffers

2012-12-04 , by Ciby Joseph

Ciby Joseph (FCA, FRM) is currently a director at Crowe Horwath, UAE. A veteran credit and finance professional with more than 17 years of banking experience, his expertise includes credit risk analysis, credit risk management, Basel regulation, investment management, derivatives, feasibility studies and business valuations. He is the author of two books: Credit Risk Analysis (Tata McGraw-Hill, 2006) and Advanced Credit Risk Analysis & Management (John Wiley & Sons, April 2013). The main purpose of the Basel accords (I, II and III) is to ensure an adequately capitalized banking system that could survive difficult times. However, this is a tough task, because, as the 2008 credit crisis demonstrated how large and sudden significant changes in asset values can quickly eradicate bank capital. It is often pointed out that Basel II facilitated unbridled credit growth. This is primarily driven by Basel II's flexibility, which allowed banks and financial institutions to use either internal models or external agency ratings to determine their risk weights. Another criticism of Basel II is that it is pro-cyclical -- an anomaly that resulted in banks setting aside less capital at the top of the business cycle, effectively underestimating the riskiness, for example, of credit risk, which is the biggest risk underwritten by banks. Basel II has therefore been perceived as making banks less capitalized and more vulnerable to failure during a cyclical downturn. Basel III is the natural evolution to rectify the shortcomings of Basel II. The capital standards under Basel III prescribe tighter regulations that will require banks to hold both more capital and a higher quality of capital than under the current Basel II rules. The introduction of capital buffers in Basel III is one of the key steps to ensure that additional capital is available for banks that face a future crisis. Under Basel III, two forms of capital buffers are required: a capital conservation buffer and a counter-cyclical capital buffer. The capital conservation buffer is designed to encourage banks to hold more capital than the minimum stipulated by the accord or by the national regulator. This in turn will provide comfort to the banks during periods of stress or crisis, because the capital buffer can be drawn down as and when credit losses are incurred. Even if there are no immediate threats of a stressful period or crisis, banks ought to hold buffers of capital above the regulatory minimum. During the stressful period, if the capital buffers have been drawn down, the banks must immediately rebuild them. This can be done by either reducing risky assets, decreasing discretionary distributions of earnings (e.g., dividends, staff bonuses and share buy-backs) or raising new capital from the private sector. Basel III rules mandate a capital conservation buffer of 2.5%. One of the shortcomings of Basel II, as we mentioned earlier, was that it inadvertently resulted in pro-cyclicality in the regulatory framework. Hence, Basel III has given paramount importance to the steps necessary to reduce pro-cyclicality in the regulation and supervision of financial markets. http://www.garp.org/risk-news-and-resources/2012/december/fixing-the-flaws-in-basel-iii-capitalbuffers.aspx

The counter-cyclical capital buffer is expected to put the brakes on rapid credit growth, which was evident in the run-up to the 2008 credit crisis. Accordingly, Basel III stipulates that the national regulators, at their discretion, may include a provision requiring banks to employ an additional capital buffer (above and beyond the capital conservation buffer) in economic boom times. The recommended ratio for this buffer is 2.5% of the risk-weighted assets, although the final decision about the percentage belongs to national regulators, which have discretion based on the circumstances of each individual country's economy. To arrive at an appropriate ratio, regulators may consider factors such as the credit-to-GDP ratio. When you add up all of the numbers, Basel III stipulates that banks must hold at least 5% extra capital (over and above the normal capital adequacy ratio of 8%) to face bad times. However, the capital buffers under Basel III have the following limitations: 1. The capital buffer prescription in Basel III is too generic. The capital buffer prescription by Basel III seems to follows the "one size fits all" model, which is inappropriate. It paints all banks and financial institutions with the same brush, ignoring the fact that there are significant differences in risk appetite among individual institutions. In response to the 2008 crisis, governments and national regulators understandably sought to implement a broader systemic approach to financial regulation. This means that governments and regulators are now more interested in the stability of the banking system as a whole, rather than what constitutes prudent behavior from the point of view of any single institution The capital buffer, a core feature of Basel III, is one of the main tools the regulators are using to achieve the broader systemic financial regulation. However, it would be more useful if capital buffers were designed in such a manner that they take into account not only the macro-policy concerns but also the individual risk appetite of institutions. Even within the broader systemic approach, it is quite logical, for example, for the banks and financial institutions that are predisposed to take higher risks to have a higher capital buffer. For example, let's say ABC Bank has a large credit risk appetite and underwrites riskier credit assets as it focuses on business growth, while XYZ Bank follows ultra-conservative credit risk policies and prefers a slower growth. Logic would then dictate that ABC Bank, based on its higher credit risk, should require a higher capital buffer. The Basel III capital buffer rules, however, treat both banks equally. In our example, while XYZ Bank may do well without any capital buffer, ABC Bank would require much more than the capital buffer levels prescribed by Basel III to avoid a collapse under a severe crisis of the magnitude of 2008 crisis or the Great Depression. This article discusses a method to link the capital buffer to the individual risk appetite of banks and financial institutions. 2. The capital buffer may be insufficient. During a crisis similar to 2008 Financial Crisis or the Great Depression, is the 5% additional capital buffer sufficient? If we examine the banks and financial institutions that collapsed during 2008/2009, it is evident that the 5% buffer would not have been sufficient to prevent the collapse. http://www.garp.org/risk-news-and-resources/2012/december/fixing-the-flaws-in-basel-iii-capitalbuffers.aspx

Recently a study has been conducted by Bundesbank (See "Basel III and Beyond: Regulating and Supervising Banks in the Post-Crisis Era," by Simon Varotto (2011)) on the new bank capital requirements under Basel III. Amongst others, the study examines the ability of banks to stay afloat amidst Great Depression style losses. The study notes that such losses would extend well beyond the capital buffers that have been proposed in Basel III, putting a significant dent in the regulatory capital held by banks. This suggests that, if such a severe stress scenario were to reoccur, government intervention is still unavoidable. That is why, rather than relying on existing static ratios, regulators and banks should consider adopting a more dynamic methodology for calculating and managing capital buffers. This dynamic tool must act as a warning sign to regulators and to the management of banks regarding whether the capital buffer of 5% is sufficient for an individual bank/financial institution. After all, the stability of the financial system is the sum of the soundness of all of the individual institutions in the system. The Capital Buffer and Kelly's Formula While a capital buffer is as efficient idea, to be effective it must be linked to the individual risk appetite of banks in such a manner that it can act also as a "sense check" to understand whether the capital buffer -- 5% of the risk-weighted assets (RWA) -- is adequate. The "sense check" must be able to alert regulators to situations where the losses will likely go beyond the buffers prescribed under Basel III, in which case the management of the bank and the regulator can act in unison to avoid undesirable consequences.;; In order to arrive at a meaningful capital buffer for each individual bank or financial institution in the system, we believe it useful to supplement the existing Basel III capital buffers with Kelly's formula: a methodology that provides us with an idea about how much capital should be risked in a credit portfolio, after taking into account the overall risk environment (be it internal or external). John Kelly, who created the formula in 1956, was a scientist at Bell Labs. His formula is a corollary to a Bell Lab application for information theory. The genius of Kelly is that he understood that in addition to being used for information theory, the formula could also be applied to solve the uncertainty element of risk taking. The Kelly formula shows how much capital to put at risk in order to avoid ruin if, for example, you have an edge in a probabilistic outcome. In the remainder of this article, we will discuss application of the formula for credit risk capital allocation and buffer calculation. The largest risk borne by the banks is credit risk, which also relies on probabilistic outcome aka, the probability of default (PD). The bank risks capital to build up a credit portfolio of acceptable PD where the bank believes it has an edge -- i.e., a credit portfolio comprising of obligors who will repay the principle amount and the interest on time, in such a manner that the loss-given default (LGD) is minimized.

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Just like any other methodology used in the business world, Kelly's formula has faced some criticisms. (Paul Samuelson, for instance, criticized the wealth maximization aspect of the formula. The focus of this article is not wealth maximization, but rather the preservation of capital.) However, many businesses today (including several hedge funds that modified the formula to suit their requirements) are using it for capital allocation. Mathematician and investor Dr. Ed Thorp, who has used Kelly's formula since the 1960s, is one of its strongest advocates. Thorp is the founder of Princeton-Newport Partners, which recently delivered 20% CAGR over a 20-year span via various investment strategies. As a consequence of growing up during the post-Great Depression era, Thorp was extremely risk averse, and he used Kelly's formula to help design effective investment strategies. (Thorp, a Ph.D. in mathematics, developed an option valuation formula in 1967 that was similar to Black Sholes Merton (BSM) model; however, he kept this model proprietary, to the benefit of his hedge fund. He is also known as the founder of first market-neutral fund, and was allegedly the first person to implement statistical arbitrage.) In his book, The Mathematics of Gambling, Thorp explains the attractive features of Kelly's system. The most important is that Kelly's formula ensures that the chance of ruin is "small." Using Kelly's formula, in fact, it is theoretically impossible (assuming money is infinitely divisible) for a bank to lose all of its capital. Since a complete capital wipeout during a stressful scenario or crisis is one of the major concerns of banks, any formula that minimizes this threat is welcome. Wherever a capital allocation decision is involved, the main issue that needs to be addressed is how to best use the limited amount of capital if the probability of risk/reward is acceptable. To manage capital allocated towards the credit risk, we can apply the adapted Kelly formula, as follows: Capital to be committed = (1-PD) - (PD / edge ratio) Where PD = probability of default at portfolio level; and edge ratio = the ratio between the net income to the maximum possible credit loss. In the above formula, the importance of the edge ratio, which links the risks and rewards of capital allocation, needs to be stressed. It shows the net income to the bank (from a credit portfolio) vs. the maximum credit loss, after recoveries (from the credit portfolio). As you can see, the calculation of the "capital to be committed" is connected to the underlying credit risk through the PD, which is linked to the edge ratio. A credit portfolio comprises several individual credit assets or obligors. All credit assets are selected through strict criteria based on credit risk due diligence. After such assessment, PD & LGD are assigned to each obligor. If we know the PDs and LGD of all constituents in a credit portfolio, we can arrive at the "portfolio-level PD & LGD." Once we know these variables, we can calculate the maximum capital to be committed, which minimizes the risk of ruin. Let us elucidate with an example.

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Example A financial system has two banks: (1) ABC Bank, which has a larger credit risk appetite and underwrites riskier credit assets; and (2) XYZ Bank, which follows ultraconservative credit risk policies. Let us assume that the RWAs are identical for both banks - i.e., $6 billion - but with differing risk and reward variables (see Table 1). Let's now elaborate on how Kelly's formula can act as a sense check on a capital buffer calculation. Solution As far as capital adequacy and the capital buffer are concerned, both banks will be treated the same - i.e., the capital adequacy of $480 million (or 8%, as prescribed by Basel III) and a 5% capital buffer of $300 million (5% of $ 6 billion). It is evident that ABC Bank underwrites more risky assets, and that its net income is correspondingly higher. Its net income or margin is 3.33% (or $200 million). However, while its Portfolio PD is higher, its LGD is also on the higher side. On the other hand, XYZ Bank is very cautious and willing to forego profitable opportunities that would have fit within the credit appetite of ABC Bank.;; In the case of ABC Bank, in the worst-case scenario, the credit loss at the portfolio level (the sum total of individual losses) would be 66.67%, as opposed to 33.33% at XYZ Bank. Under a normal scenario, ABC Bank would have a higher profitability on its credit portfolio -- i.e., the net income earned by ABC Bank would be $200 million vs. $150 million by XYZ Bank (or 3.33% and 2.5% of the credit portfolio of each bank, respectively). Interestingly, Kelly's methodology yields significantly different results for both banks in our example. Using the Kelly formula, the edge ratio is more favorable for XYZ Bank rather than ABC Bank, although the profitability of the latter is better. The edge ratio of both banks is calculated (employing Kelly's formula) below.

*The net income and max loss figures in the above table are in USD millions.

Based on the knowledge of the edge ratio and credit portfolio PDs of both banks, we can compute the percentage of capital to be committed by both banks by applying the following ratio: Capital to be committed = [(1-PD) - (PD / edge ratio)] http://www.garp.org/risk-news-and-resources/2012/december/fixing-the-flaws-in-basel-iii-capitalbuffers.aspx

Where PD = probability of default at portfolio level; and Edge ratio = the ratio between the net income to the maximum credit loss. The result is given in Table 3. Kelly's formula shows us that XYZ Bank can deploy 79% of its capital, while ABC Bank may deploy only 58% of its capital. The above findings can supplement the Basel III capital buffer concept. We know that the capital adequacy required for both banks is $480 million. Based on the Kelly formula, we can deduce that this must be 79% and 58% of the total capital required in the case of XYZ Bank and ABC Bank, respectively. Accordingly, we can also arrive at the Basel III capital buffer requirement. The result is given in the subsequent table. It is evident that the 5% capital buffer for ABC Bank is insufficient. If there is deterioration in portfolio PD or LGD, or a reduction in net income, the impact on the capital buffer would be apparent. Under the static ratios prescribed in Basel III, the capital buffer will remain identical, because it is RWA-driven. Kelly's formula, in contrast, provides more dynamism. The application of Kelly's formula is suggested not as a replacement of Basel III capital buffer rules, but as a supplement, just as successful hedge funds use it as a successful supplement to their investing or trading decisions.

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REFERENCES John Kelly. "A New Interpretation of Information Rate," The Bell System Technical Journal, July 1956. Luis I. Jcome and Erlend W. Nier. "Macroprudential Policy: Protecting the Whole," International Monetary Fund website, 2011. Leonard C. MacLean, Edward O. Thorp and William T. Ziemba. The Kelly Capital Growth Investment Criterion: Theory and Practice (World Scientific Publishing Company, 2011). Leonard C. MacLean, Edward O. Thorp and William T. Ziemba. "How does the Fortune's Formula-Kelly capital growth model perform?" Academic paper published in January 2011. William Poundstone. Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street (Hill & Wang, 2006). Jack D Schwager. Hedge Fund Wizards (John Wiley & Sons, 2012). Edward O. Thorp. The Mathematics of Gambling (Lyle Stuart, 1985).

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