My view is that the Basel framework has traversed quite a bit in the past two decades, . The steps taken in the journey were important and Basel has made valuable contributions on its way.
The last two decades have also seen a dynamic world and an equally, if not more, agile financial market. The globalisation of financial world and the rise of financial engineering and innovative structuring, along with the mushrooming of various forms of shadow banking has intensified the economic cycles. the macroeconomic basis of finance has undergone a significant transformation. This complexity has posed critical challenges to both the micro- management at the institution level ( of which risk management is a part) and the regulatory framework. in the face of such dynamism, the speed of adjustment (the ability to respond in time to the evolutionary impulses) has not been able to keep pace with the need for change. I am of the view that Basel did make some valuable contributions such as putting in place a mechanism to measure risks in the bank's portfolio and to find a mechanism to relate it to capital. In other words, it did provide banks with the ability to relate the risks with his own contribution to venture. Indeed, that was valuable, but not enough.
The obvious question is, what is that enough? Now, thats a very difficult question and the answer lies in the future and can only be imagined. Here are some thoughts that I shared with the Conference delegates.
The Pillars must go
First, in my view, the pillars of BASEL act as a hindrance to the achievement of its full potential. Many countries implement Basel pillar after pillar , and each pillar is complied with after 2-3 years. For instance, if Pillar I gets over in 2007, pillar II gets over in 2009 and Pillar III thereafter. The unfortunate reality is that two years is a pretty long time,and lot can happen , as we have seen between 2007 and 2009. Now, if you stay in a house with three doors and close only a single door and get into a false sense of belief that you have protected yourself from risks that are outside, you are asking for trouble. This has precisely been the case with many banks who quantified their credit, market and operational risk ( pillar 1 risks), but failed to act upon liquidity, strategic and reputational risks ( Pillar II risks). Clearly, a more holistic implementation programme is required and this should be the first plank of the Basel III regime.
Why risk governance fails
Secondly, it has been very clear that the governance of risks within the banks were not up to the mark. The Board of Directors and Senoir management were either unaware of the risks and threats or demonstrated a rather irresponsible behaviour when sensitised about the risks by the CRO or the risk function. The CEOs did not find the CROs perceptions rather too restrictive and these guys were seen as clones of regulators inside the office only to stifle business. And, why shouldn't they? Most CROs did and could only talk about limits. not about integrating risk and rewards to give a solution towards long term growth. In other word, they failed to relate business strategy and risk management. My view is that unless the CROs are able to provide an unified view of risk and return, they will operate in the fringes. Basel III, therefor , should promote an unified view of risk and return to enable the risk function to gain prominence in the banks. Without such a holistic view, it is almost impossible for the CROs to make a lasting imprint on the Bank's evolution.
Overstressing the downside
This led me to my third point : the deficiency of the economic capital framework. The economic capital framework is of limited utility. it only tells us that the bank should measure all its risks through robust models and set aside capital for the bad days. Look at the emphasis on the downside that epitomises the risk management profession. You see it everywhere- the loss needs to be stopped by limits ( a lot of evidence being there in the market, including the Lehman Brothers event that those fast to react to stop loss were victims of market blips); the popular Value-at- Risk telling you about the maximum loss that a bank may sufffer for a given confidence level and over a certain time horizon. Any CEO confronted by such numbers will think that this is only a part of the story, about how to save face when in deep trouble. But why can't you also tell me the portfolio that is the ideal to keep me out of danger in the first place, saving me from troubled waters. There you go, value at risk plus portfolio optimisation as a key ingradient of Basel III, not value at risk and one more stressed VaR. The stressed VaR ( as suggested by a recent Basel II revision) will have no place in my imagined Basel III. It is overly restrictive, only talks about the bad days without telling you ways of not getting there in the first place.
Dump the Silo approach
Fourth, the silo mentality in risk quantification much change. We are living in a dynamic , integrated world, where risk factors move as vectors, not scalars. To think that risks may be captured by a series of partial equilibrium models, ceteris paribus ( assuming all other things remaining constant) is crazily oversimplified and clearly a lesson inherent in the recent turmoil. Take the case of liquidity, it is very clear that market ( and credit) risk models are not in a position to difference between risks in liquid and illiquid markets. Whatever little work has been done in the area ( including my paper published in the Reserve Bank of India Occasional Papers rbidocs.rbi.org.in/rdocs/PressRelease/DOCs/66978.doc ) show that you underestimate risks by around a whooping 30 percent if not more if you cannot measure the impact of illiquidity on the risk exposure of a portfolio. The dynamic interactions of risks must be captured with suitable mechanisms, which imples that the Basel III will continue to have a dimension embedded in rigorous empiricism.
Judicious Mix of Quantification and Qualitative Assessment
Those who entertain the view that Basel III will be a regime of qualitative risk management miss the point that models failed not because of the inherent deficiency of the approach, but they were far too simple in relation to the real world. Take Stress Tests for instance. In the absense of detailed guidance, what emerges is akin to a partial econometric modeling so unceremoniously brushed aside by attempts to model vector movements within the econometric models. The world needs modeling of risk vectors, it is an interconnected world, and serious efforts need to be dedicated to an effective user friendly approach.
finally, an inclusive approach
An inclusive approach is the ideal approach for Basel III. This means , amongmany things, Basel invites a lot of practitioners from around the globe to participate in their efforts, and regulation must emerge from such inclusive efforts. In other words, regulation is not just shaped by central bankers, the institutional process of regulation must be suppoted by an intensely communicative process among those in practice. The critical element here is to establish the linkages between the two within the structure of dual causality.
An inclusive approach also means greater participation of Board, internal Audit, Business Units and of course risk management department in the governance of a financial entity. Inclusion also means embedding risk analysis in strategic decisions and investment analysis and any kind of contingency planning. The It will play a key role in the inclusion efforts at all levels, enabling information to flow freely and enhancing its accessibility.
The above steps, I feel, are much needed. As members of risk management community, I think we have a special role in the communicative processes, in highlighting key issues to the regulator and the Senior Management . Not only our efforts contribute to the emergence of an effective Basel III framework, it will also take the risk profession to a level where it becomes an indispensible part of a Bank's strategic initiatives.
