February 29, 2008
Pillar 2 : The road less travelled
The supervisors have stepped in as a key actor in the Basel 2 drama that is unfolding in front of the financial community. The second act of the Basel 2 drama has thus just about commenced in the emerging world.
The much-neglected second pillar of the Basel 2 framework is getting greater attention in emerging markets. Regulators have become active by issuing guidelines on Pillar 2. Large banks, which were planning to put resources on advanced approaches in credit, market and operational risk ahead of pillar 2 are now paying attention to the formulation of bankwide capital assessment, stress testing and dealing with other risks such as reputational, strategic, liquidity and interest rate risk in the banking book.
Regulatory guidelines are , always, strong signals to the financial market. Guidelines put financial entities in alert mode. Guidelines with action plans and deadlines puts the markets into active mode. Pillar 2 guidelines are guidelines with some action plan as it promts the supervisor to step in and decide whether banks' calculation of economic capital is in line with its risk appetite , with the proviso that any misalignment between the two may call for supervisory action.
As the Banks in emerging markets have, to a reasonable extent, come to terms with the complexities of risk weights, external ratings and credit mitigants. Now the spotlight shifts to interest rate risk in the banking book, liquidity risk , stress testing and other risks. All of these risks have to be factored in Bank's overall capital assessment and management. The supervisor has the final say on the Bank's capital management process and can ask for corrective action or more capital.
What are the key takeaways from this exercise?
1. The signal from the regulator has put the Banks in an active mode in countries that have come out with guidelines in Pillar 2. That is an important gain in itself, as it propels the banks towards improved and holistic risk management and measurement framework.
2. This is good for the supervisors as they grapple to ensure financial stability in the midst of global financial turmoil.
the submission of ICAAP reports by the banks to the supervisors will give them a huge pool of knowledge on risk management systems and practices of the financial institutions adopting Pillar 2.
3.By forcing Banks to take a closer look at all material risks that they are exposed to, the bank's capital management policy will now be better aligned to its economic capital.
4. The ICAAP will be forward looking, as they will contain several stress tests on bank's financials and capital ratios.
5. Risk appetite will be closely monitored with a prompt corrective action strategy under ICAAP.
And the challanges....
While the process, as we can see, have significant direct and indirect benefits to banks, The transition to pillar 2 will bring its fair share of challanges. It will be an adventure into the road less travelled, and supervisors and market players have to surmount serious challanges.
It will be a journey into an unknown territory as methods for quantifying risks under pillar 2 are less well defined, though not less important. For instance, relating liquidity risks to an economic capital number will be difficult, given its known friendship with market and credit risk.
Risk aggregation will bring issues of diversification benefits and quantifying such risk aggregation benefits to capital strategy may be difficult.
The phase of negotiation with the supervisor will bring challanges of its own. Supervisory perception of banks have to find some common platform for all banks. Transparent supervisory guidance will be critical, so that banks are convinced that they have a fair and level playing field.
Supervisors will find difficulty in comparing various qualitative and quantitative information flowing from the banks and in ensuring consistency in their approaches.
Deciding on a minimum capital number for banks or slotting them in various CAR bands will be a challange that will force supervisors to have sleepless nights.
And finally, once the minimum ratios prescribed by the regulator will become public, the bank's business will be impacted by this small but power-packed additional piece of information.
With all these and more, the Pillar 2 promises to be full of action, drama, joys and tears - with all the essential ingradients of a great story!
Posted by sunandoroy at 09:01 AM
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February 23, 2008
New Directions in Liquidity Risk Management
The market turmoil of 2007 has once again highlighted the crucial importance of market liquidity to the banking sector.What started as weakness in the sub prime markets ( residential mortgage backed securities which were then mopped up by managers of CDOs and asset backed securities)led to Investor's loss of faith arising out of growing arrears in such structured products. This led to tightening of liquidity as banks wanted more liquidity to meet their obligations and a similar necessity for greater liquidity was also seen among asset managers to guard against increased redemption risks. It is now recognised that liquidity risk management is not as easy as earlier and financial institutions need to devise strategies to tackle liquidity shocks such as the one emanating from US sub-prime market.
In other words, the assuring assertions by the best of banks about their management of liquidity has been put to stern tests. The contraction of liquidity in certain structured product and interbank markets, as well as an increased probability of off-balance sheet commitments coming onto banks’ balance sheets, led to severe funding liquidity strains for some banks and central bank intervention in some cases.
Emerging lessons for liquidity risk management and supervision
1. It is now becoming clear that banks failed to foresee stresses of such magnitude and the subjective content of the stress led many banks to focus on firm-specific shocks when the combination of idiosyncratic and market-wide shocks was the order of the day. At the end of the day, the challenge of defining an appropriate level of stress remains a formidable one for both banks and supervisors.
2. The Central Bank's Role once again gains prominence and its e in financial stability becomes paramount. Appropriate liquidity facilities can help banks to ease out funding difficulties.
3. It is also clear that banks need to strengthen their Contingency plans. The existence of the plan is not enough, it has to be applied in practice. Many banks floundered when the banks needed to execute their contingency plans .
4. When banks’ contingency plans were based on assumptions of limited cross-border movement of liquidity, the stress on Contingency plans were aggravated.
5. Stress tests also underestimated the off balance sheet effects on banks balance sheet.
6. There was a felt need for banks to take sufficient consideration of reputational risk and its implications for liquidity buffers.
7. ICAAP: Finally, the need for a good ICAAP with business line level risk adjusted measures ( RAROC) and appropriate funds transfer pricing has become important. Recent events highlighted the importance of close coordination between treasury functions and business lines to ensure a full appreciation of potential contingent liquidity risks. In many banks, treasury functions operate in isolation and are unaware of the contingent liquidity risk of new products or how evolving business practices could change the contingent liquidity risk of existing business lines.
( For recent initiatives of Basel Committee read bcbs136.pdf from www.bis.org released on Feb 21,2008)
This once again reaffirms that the journey of Basel 2 will continue as financial markets mature and become more complex. Upgrading skills in supervision is also of paramount importance to contain the adverse consequences of creative destruction that is inherent in market freedom and financial innovation.
Posted by sunandoroy at 04:00 AM
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February 22, 2008
Central Banking and Risk Management
The actions and signals of Central Bankers are gaining importance in the market driven economies of the 21st century. The 20th century saw the rise of the State in many emerging markets as they became free from colonial occupation. In three or four decades after the end of the second world war, the flaws of these command economies became apparent. In many economies, the gap between potential and actual growth trajectories diverged, owing to excessive controls and regulations. Then the emerging economies chose the path of liberalising markets and many economists and commentators started writing obituaries of the State. The initial euphoria with markets have now subsided and there is an acceptance that unrestricted markets can be as detrimental as the excessive regulation by the State. The regulators are thus back in the new role of facilitating markets in their potential to achieve higher growth paths.
As finance is the fuel for economic expansion, central bankers as the regulators of the financial world have resurfaced, and their faces are friendlier than ever before. They are back not just to regulate, but to facilitate , guide and protect the financial sector from a variety of shocks. With the onset of the 21st century, Central Banking has entered into a communicative mode where signals are stronger.
As the financial markets get integrated worldwide, the role of central banking has become important in addressing domestic as well as systemic risks. The tools in the hands of central bankers have seen many innovations in recent times. As capital flows freely among countries rapidly, liquidity management at a systemic level has led to growth of various instruments of sterilization. India, faced with huge captal inflows, leading to liquidity and inflationary pressures have resorted to the market stabilisation scheme ( detailed in one of my earlier blog) , quite successfully.
The objectives of monetary policy have also widened beyond the traditional concerns of growth and price stability. Many countries have explicitly added financial stability as the third objective of monetary policy . As a result. monetary policy announcements in many countries have , along with the guiding in interest rates and money supply devotes attention to issues of stability of financial sector and the risks faced by it in terms of excessive risk appetite in assets where the perceived risks are higher.
Central Banks, thus, are not just interested in the risks faced by the institution ( such as reputational risks arising from poor conduct of monetary policy or risks of exchange loss in their pool of forex reserves) . Their concern extends to controllong risks of financial institutions, which have become far more diversified and in many cases more speculative. Risks no longer increase with distance and the high correlation between domestic saving and domestic investment is breaking down. highly leveraged derivatives grew in size and complexity and as Alan Greenspan observed :
" Weshould recognise that if we choose to enjoy the advantages of a system of leveraged financial institutions, the burden of managing risks in the financial system will not lie with the private sector alone. Leveraging always carries with it a remote possibility of a chain reaction, a cascading sequence of defaults that will culminate in financial implosion if it proceeds unchecked. Only a central bank, with its unlimited power to create money, can thwart such a process before it becomes destructive."
The central banks, however, are not prepared to let the financial sector problems escalate to that intensity. That's why they stress financial stability , get worried with any signs of financial instability. A potential worry could be the real estate sector, which has seen more asset bubble bursts than even the stock markets in the last few decades. The central banks take a keen interest in the developments of such vulnerable sectors and asks banks to keep higher capital by assigning higher risk weights and provisioning requirements.
Indicators of capital adequacy, liquidity, solvency and asset quality have become important in that context. Central Banks as supervisors of the banking system keeps close watch on these ratios at aggregate level and also the outliers.
Being acutely aware of the linkages between the systemic risks and bank performance, the central banks today actively manage and monitor the risk appetite of Banks . Adoption of Basel 2 in many countries reinforces the role of central banks in ensuring financial stability.
Thankfully, such interventions have matured beyond just holding enough capital for bad days and now looks into people, systems and processes.
Unfettered competitive capitalism is thus by no means accepted as an optimal economic paradigm. Regulators, including central banks try to contain the unhealthy effects of competition and facilitates market growth in a healthy manner. The focus of this action is more on early detection of risks and preventing the damages caused by such risks through appropriate policy actions. The key issue here is in achieving this without adversely affacting the growth path and without discouraging innovations, two major sources of financial prosperity of future generations.
Posted by sunandoroy at 07:10 AM
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