November 19, 2010
Can Basel III prevent Systemic Crises?
During an interaction in a risk management conference, the CEO of a Bahrain based Investment Bank asked me innocently whether the proposed Basel III regulations would prevent another systemic crisis that the financial world witnessed in 2008. In fact this CEO is not alone in this regard; many bankers carry the impression that Basel III is a kind of permanent fix (however costly it might be) and if diligently implemented the world will not see another crisis yet again.
Looking back, has Basel I, II mitigated systemic risks?
The answer is self evident.
The Basel accord began as an attempt to harmonise the capital base of internationally active banks and create a level playing field. For want of a better perspective on bank regulation, most countries adopted the Basel standard as this was the easiest way to convince banks to hold additional capital.
Inspite of this wide spread acceptance of Basel, the world has seen numerous crisis across all parts of the globe the S&L crisis in the United States, the banking crisis in Scandinavian countries, the failure of LTCM and the default by Russia. In fact crises have occurred at an alarmingly consistent rate, and going by the past trends, we should expect another crisis in the next 7-10 years!
So where does that leave Basel and systemic risks?
It would appear that Basel I, II have not really addressed this problem but for valid reasons. Systemic risks pose a challenge for several reasons. First, they are not easy to detect with confidence, and are even more difficult to prove. Second, going by the past history of financial crises, predicting the exact timing of a break point (when bubbles burst, markets lock up, and credit freezes) is well neigh impossible. Finally, crises are highly non-linear events, which mean that they occur without much warning.
Basel III is on the same lines: the definition of core capital has been strengthened considerably and new capital buffers introduced. This will, it is hoped, ensure that banks are better able to withstand periods of economic and financial stress and create a less procyclical banking system that is better able to support long-term economic growth.
So Basel I, II, III or IV or whatever is designed to limit each institution's risk seen in isolation; they are not sufficiently focused on systemic risk even though systemic risk is often the rationale provided for such regulation. As a result, while individual risks may be properly dealt with in normal times, the system itself remains fragile and vulnerable to large macroeconomic shocks.
Where Basel standards have failed is to recognise that one size fits all does not really help especially systemically important financial institutions (SIFI) that are so big, or interconnected, or unique that they pose a risk of taking down the entire financial system should they fail. If we can identify these institutions and why they are risky then mitigate those risks we might be able to prevent the next big financial meltdown.
The definition of SIFIs is changing as an IMF study suggests. Pre-crisis, the general consensus was that size posed the biggest risk for the systemic relevance of banks. Interconnectedness was ranked the second and third most important systemic risk factor for institutions. Other factors considered were concentration risk, leverage and the correlation of exposures.
Post-crisis, assessments of the factors contributing to the systemic importance of financial institutions have changed with interconnectedness, leverage or maturity mismatches to be the main risks. Size is considered to be less important factor.
The G20 Seoul Summit in November has endorsed the Financial Stability Boards (FSB) policy framework for regulating SIFIs in five areas:
Improvements in the resolution regimes to ensure that SIFI failure can be resolved without disruptions to the financial system.
SIFIs should have additional loss absorption capacity beyond the Basel III standards.
Intensive supervisory oversight of SIFIs.
Robust standards for core financial infrastructure to reduce contagion risks.
Peer review of the effectiveness and consistency of national policy measures for G-SIFIs.
It is hoped that the delivery of two key elements of regulatory reform viz., a materially strengthened global framework for bank capital and liquidity, and a comprehensive policy framework to address SIFIs will create a sounder financial system and reduce systemic risk globally.
For the more academically inclined, it is interesting to note the recent advancements in measurements of systemic risk. The RISK page of the Volatility Laboratory of NYU Stern presents a variety of risk measures for top US Financial Firms including systemic risk or SRISK. The Systemic Risk Contribution, SRISK%, is the percentage of all capital shortfall that would be experienced by a firm in the event of a crisis. Firms with a high percentage of capital shortfalls in a crisis are not only the biggest losers but also are the firms that create or extend the crisis.
Based on this methodology, NYU Stern has identified the 32 largest SIFIs in the United States. Guess what? many of them are already under Government protection!
Posted by aaaaaaa at 02:06 PM
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