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February 05, 2008
Pro-cyclicality (the flip side)
While Basel II is generally seen by industry practitioners as having been a positive contributor to the risk management of banks and the stabilty of financial systems (see PRMIA Survey), the nagging worry that most have had is that the use of market-sensitive credit models would lead to an exacerbation of credit cycles. This may be coming to fruition in terms of credit restrictions and some would argue that this is just the flip-side of the easy credit terms the same models allowed when volatility was low and stock prices were increasing.
As the Bloomberg headlines says today MBIA, Ambac Downgrades May Lead to Bank Rating Cuts, S&P Says. Changes in credit ratings or market prices that drive Merton-type credit models will no doubt be affecting factors like collateral and lines of credit and general liquidity to banks and other affected financial service firms.
See my previous posting on the Social Amplification of Risk to see how the human response to risk events can cause the same kind of impact.
Is this just the beginning of the regulation-based contribution? Could the economic downturn be exacerbated even further by the pro-cyclicality of Basel II? Does this kind of approach prohibit banks from making opportunistic lending when other credit providers do not face the same restrictions?
Please share your comments.
Posted by dkoenig at February 5, 2008 11:25 AM
An interesting prespective, that the Regulator, in an effort to make the system more sound, in fact exacerbates the problem. I don't think that is the goal of the Regulator, or an expected consequence - but it does present an interesting risk problem.
I think the social amplification of risk is a natural consequence of a material event - commonly thought of as the herd mentality. For example, take hurricane Katrina hitting New Orleans, followed by Rita and Houston. Yes, the "herd" evacuated the City, leaving a city that is above sea level - but also many companies implemented DR plans, a more rational response to pending power outages, etc.
Sub-prime, Ambac, Soc Gen, will all move the herd - and if the lighting strike is indeed very close, the herd will move, maybe even stampede.
So what stops the social amplification of risk? I would argue science, truth, and false evidence ceasing to appear real. FEAR is false evidence appearing real. The movie "Wall Street" had it wrong, greed makes people fat and lazy, fear on the on the other hand, makes people run!
For example, during the AIDs scare of the 80's and early 90's, the herd would not go to a public eateries, yet when Princess Di visited AIDS hospitals, shook hands and hugged AIDS patients, reality became clearer - the herd settled down.
So to it will be with Basel II, reality needs to become more clear. I think the contempory risk issues facing banking probably pertains more to an effort of sectioning off (because accounting standards permitted) rather than a inclusive push to add transparency -economically and operationally.
While these regulatory changes may indeed "amp" up an already spooky herd, good modeling, transparent approaches and risk analysis coupled with reasoning should make something opaque clear and with that provide competitive advantages.
The challenge isn't to stop the quest at the regulators requirement, as many stampeding herds have trampled strong fences - the "challege" and the opportunity for competitive advantage, is to point out to the internal stakeholders that what was thought of as cancer is in fact the common cold - this can only be done by a risk manager.
Posted by: frank hayden at February 8, 2008 05:55 AM
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