« Operational Risks from External Events |
Main
| Are Islamic Banks Riskier than Conventional Banks? »
April 16, 2008
Basel II Plus : Prescriptions for the current Market Turmoil
The month of April has seen prescriptions emanate from two influential quarters: the IMF which released the spring 2008 Global Financial Stability Report, and the Financial Stability Forum which finally released the recommendations on enhancing the resilience of markets and financial institutions. While the GFSR is issued every six months, the FSF report was prepared at the behest of the G 7 Finance Ministers and central bankers with the objective of coming up with recommendations on improving the resilience in the financial system in the light of the current market turmoil.
The IMF report is highly analytical and has some incisive analysis. The IMF says that the risks to global financial stability have increased sharply since the last report in October 2007, and estimates almost $1 trillion in losses and mark-to-market write downs. In terms of the blame game it has apportioned all stake holders: a collective failure to appreciate the extent of leverage taken on by a wide range of institutions. Private sector risk management was found wanting (always the case and especially so in times of turmoil, write downs and meltdowns), regulators have lagged behind financial sector innovation (where did GARP get the courage to award the European Central Bank as Financial Risk Manager of 2007?). Finally, disclosures have not helped in communicating risks, especially in the originate to distribute business model. Net result: disorderly unwinding - the stuff of the nightmares for central bankers - has crystallized into reality.
The FSF report is more prescriptive and provides guidance (as well as a timeline) on the regulatory areas which will receive attention in view of the shortcomings in Basel II. The crisis has helped regulators to test the efficacy of some of the Basel II regulations; it is indeed refreshing to read that BIS acknowledges the need to strengthen elements of Basel II when it is still getting off the ground in most countries! This is an implicit admission that supervision has lagged behind rapid innovation and the shifts in business models. Nevertheless, the FSF report still maintains that the starting point for improving the banks capital adequacy is the timely implementation of Basel II. Going forward, supervisors also need to rigorously assess banks compliance with the Basel II framework.
The IMF and the FSF reports both talk of the procyclicality effects of Basel II capital requirements and fair value accounting practices. It would appear that the presence of both these triggers has actually exacerbated the current downturn in the economy. Thus while the roots of the crisis lie in the US sub prime market; the spreading of the crisis much beyond could be attributed to the procyclicality effects. The FSF report says that BCBS has already put in place a data collection framework to monitor the impact of Basel II on the level and cyclicality of the capital requirements over time and will take further action as appropriate.
Some of the proposals of BCBS relating to capital requirements: the need to raise capital requirements for certain complex structured credit products, the need to capture default risk in the trading book (this is where most of the structured products are held for many banks and securities firms).
By far, the most eagerly awaited sound practice guidance is for the supervision of liquidity (due in July 2008). The FSF report highlights the need for effective liquidity risk management practices and the fact that high liquidity buffers play an important role in maintaining institutional and systemic resilience.
Both the FSF and IMF reports underscore the importance of the Pillar 2 mechanism. The IMF says that supervisors will need to better assess capital adequacy related to risks that may not be covered in Pillar 1; more attention could be paid to ensuring that banks have an appropriate risk management system and a strong internal governance structure. The FSF reports echoes a similar view: Supervisors should use Pillar 2 to strengthen risk management practices and to control tail risks and mitigate the build up excessive exposures and risk concentrations.
Indeed both the IMF & FSF reports suggest that national supervisors have their tasks cut out. Some actions points (1) More intense supervision and ensuring stricter implementation of Basel II (2) greater attention to applying fair value accounting results, (3) ensuring that risk management capital buffers and estimates of potential losses are appropriately forwarding looking taking into account the uncertainties associated with models valuations, concentration risks, and expected variations through the cycle.
Tail Piece: Modelling Financial Stability!
The sub prime crisis has provided IMF the impetus to expand the scope of research to quantitative financial stability modelling. Considering that financial stability as a term came into existence just about 12 years back when the Bank of England first used the term in 1996, this indeed is a major push for FS reporting. I particularly liked the work on the construction of a Banking Stability Index.
In a broad sense, evaluating financial stability in the banking system is nothing but evaluating the interdependencies between the individual banks. A large loss in a systemically important bank is more often likely to trigger losses in other banks in the system. The IMF has modelled this by evaluating the joint probability of default (JPoD) of a portfolio of banks, by taking the individual probability of default and modelling the interdependencies using non parametric copulas. The concept of joint default analysis is also used by Moodys to determine the impact of external support on banks ratings so in a way they are also modelling the interdependencies.
The JPoD represents the joint probability of default of all banks in the portfolio given that at least one bank has defaulted in the system and is thus a measure of the Banking Stability Index. The IMF has actually tested this on portfolio of 15 large systemically important banks in and has determined that the JPoD for this portfolio has risen almost 10 times from mid 2007 till the present!
Posted by aaaaaaa at April 16, 2008 08:33 PM
Post a comment
