Basel 3 = Basel 1.8? And is this a bad thing?

The proposed and partly ratified changes imposed on the Basel II accord have certainly exercised the minds of bankers (and a surprising number of others) over the last year. But are they really a major change? Do they reflect any change of philosophy? Or are they actually a step backwards away from some of the basic assumptions of Basel II. I believe that these widely touted Basel 3 requirements are better understood as a partial rollback of the original accord.

The basic concept of the Basel accord is the better alignment of capital with institutional risk as measured by extreme percentiles of the distribution of portfolio value. A couple of points come out of this:

• Banks should operate on a consistent global playing field.

• Market values are good measures of asset values

• More sophisticated approaches to risk measurement should be rewarded with lower capital

• Avoid double counting of Risk and incorporate where robust correlation effects

• Limit the extent of ad hoc regulatory supervision.

• Quantitative measures are better than qualitative ones


In some ways the new adjustments are consistent with that philosophy. For example, the introduction of an Incremental risk capital calculation to capture credit risk in the trading book. This is very much in line with the concepts of IRB and IMM, indeed is almost an integration of them both – which incidentally is why it will be difficult to implement. Similarly, macroprudential risk is an extension of scope of the Basel II accord to consider the entire system rather than one element within the system. So too the changes to the definitions of capital – the removal of T3 capital, the more precise use of equity in T1.



But I believe the bulk of the modifications run counter to the underlying philosophy of Basel. For example, the double counting of risk under Stress VaR and the general VaR calculations, the double counting of IRC and the specific market risk capital models. The use of simple Leverage and liquidity ratios as an additional constraint on banks to reign in lending may be more binding on many banks than the capital requirement. The use of liquidity adjustments to valuation clearly notes the limitations of market prices as measures of asset value. The introduction of a range of additional liquidity metrics that will be incorporated into regulatory judgments on appropriate bank liquidity levels.



Is this a bad thing? Should we be concerned that Basel III is moving away from the original philosophy of Basel. Yes and No.

Yes, in so far as the original philosophy was valid, no in so far as it was not. It seems to me that we definitely should be concerned about double counting and the introduction of ad hoc rules that leave much to the judgment of individual regulators – this definitely casts doubt on the Basel project – the imposition of a consistent playing field.

No – we should not be concerned about these amendments in that they reflect true weaknesses of the original accord – the lack of attention they gave to liquidity risk, downplaying of counterparty credit risk in the trading book (which to be fair was less of a concern when the accord was drafted), the inevitable procyclicality of any risk based capital measure. It is indeed the last of these that is probably the most important. Regulators like the rest of us, live in a real world, with banks that affect the real economy. Reality has a bad habit of forcing us to compromise theoretical ideals with the practical effects of those ideals. A major overhaul of Basel that dramatically increased capital requirements (as for example the imposition of countercyclical capital buffers) could jeopardize the very recovery it was design to forestall. And that would be far too big a price to pay for Basel III.

So after all is said and done, perhaps the new amendments do look less like Basel 3 and more like Basel 1.8?

What is Basel III?

The raft of documents produced by the regulators across the world has certainly added to the noise and confusion that the credit crisis has left in its wake. The Basel Committee on Banking Supervision (BCBS) has developed its recommendations to G20 institutions, realizing that radical changes in the regulatory regime could endanger the still fragile recovery after the crisis. So torn between a radical overhaul, and a fear of rocking the already rocky boat, they have produced three major documents:

BCBS 159: The first (BCBS 159) has been ratified by the G20 countries and will be implemented by the end of 2010 in most countries. BCBS 159 focuses on amending the internal models methods (IMM) associated with market risk in the trading book. It requires the introduction of Stress VaR capital calculations in addition to the existing general market var capital calculation. It also requires for international banks implementing internal models for specific risk the additional assignment of Incremental Risk Capital (IRC) – capturing default risk, credit migration risk, credit spread risk in the trading book using similar techniques to those found in the banking book (IRB) – for example, it uses a more conservative confidence interval (99.9%) and a longer time horizon (1 year)

BCBS 164: This has been proposed but not yet ratified. It imposes changes on capital (more focus on Tier 1 capital in general and equity in particular), yet more changes to counterparty credit risk capital in the trading book (above those required in BCBS 159), the imposition of countercyclical buffers and a general leverage ratio constraint. More interestingly it requires the development of macroprudential risk management that go beyond micro prudential risk management (focusing on the risks of particular institutions) and instead looks at the systemic risks of the entire network of institutions as part of a global economy.

BCBS 165: Like BCBS 164, this has yet to be ratified but focuses on the need to implement specific metrics for liquidity risk, a short term 30 day minimum liquidity coverage ratio to handle a major stress scenario, a long term 1 year net stable funding ratio to define a minimum stable funding requirement and finally a set of standard liquidity metrics that all regulators will take into account when evaluating the health of a banking institution.

Hegel and Risk Management

What has Hegel got to do with risk management? Everything actually. Hegel classically argued that change was the continuous dialectic of revolutionary forces and counterrevolutionary forces. The revolution poses a thesis, while the counterrevolution seeks to protect its antithesis. Out of the clash comes a synthesis through which progress slowly appears. What we call risk is often our micro view of a piece of these macro forces causing change. What looks random at one level of analysis, is anything but at a higher level of analysis. When a system's innate contradictions (whether that system be capitalism - See a chap called Marx, or an asset bubble) slowly develops the forces that cause that system to fail or end. Another way of saying this is that something that cannot go on for ever, certainly won't. A painful lesson for all concerned in the wake of the property bubble of the 2008-9. Or for the demographic bubble of the late 60s and 70s. Or the buildup in US armaments in the 80s and 90s. Or the defense spending in the former USSR over the same time. Bubbles build on a short sighted focus on momentum, rather that absolute values. This time its different goes the refrain. No one wants to be one left holding the baby when the music stops.
The risk is not apparent when the music is playing - our experience of the immediate past is too positive and discourages asking awkward and unpopular questions. When the music stops (as stop it must) the risk becomes an event, an event that brings down the house, and we ask ourselves - how could we have been so foolish...

The Future of Risk Management - the role of Integrity

I think if there is a common theme to the future of risk management, it’s probably the notion of systems integrity. What does integrity mean – I think it means consistency between parts and the whole. In the context of the future of risk management, this notion of integrity has specific meanings:

• Integrity of front office and middle office systems
• Integrity between management, traders and middle office
• Integrity of returns and risk
• Integrity of remuneration and risk adjusted returns
• Integrity across risk types especially market and credit
• Integrity across tail and non tail risks
• Integrity between economic measures of risk and regulatory measures
• Integrity between the network of capital and resource providers and the organization

Middle vs Front office - people and systems

Most institutions have quite separate systems for front office (basically functions like valuation, trading and clearing) to their systems for middle office (limit setting, portfolio monitoring, risk analysis, var calculations etc). We often find situations where banks have multiple valuation and risk systems in the same organization for the same portfolio. This encourages game playing and prevents executives have a single view of value or risk at an operational level of trades, positions, counterparties, businesses etc that they need in order to make decisions. Middle office has long been thought of as the poor relation of the financial institution. They have long been viewed as a cost centre that will always lose in any standoff between front office traders wanting to put on one more transaction, and risk managers pushing against limit breaches. This cannot continue. Traditional management accounting structures (P&L center, cost center etc) fail to capture the reality and instead discourage integration, and ignore the reality (certainly in buy side institutions and increasingly on the sell side) that middle office is a value added activity. Of course, management’s role in defining the culture as well as the incentives, is crucial in affecting the integrity between front and middle office.

On Risk Adjusted Returns

The notion of risk adjusted returns or economic value added has long been held as the economic correct way to evaluate opportunities in any business. While the details may be complex and hard to implement in practice, the effort to develop measurement systems that cut across risk (usually in the form of capital) and return (expected or historical) is essential to preventing the near sighted herd mentality that has pushed many financial institutions in the west to the brink. The whole fiasco of high levels of remuneration in institutions which have required extensive government funding, could have largely been avoided (at least ameliorated) if remuneration had been tied to long term risk adjusted returns, not simply to absolute profits.

The Curse of Silo based risk management

Most institutions measure their risks in distinct silos. Indeed the discipline of risk management has been cursed (?) by the proliferation of specialists focusing on risks narrowly defined. The reality is that anything that can cause a change in value is a risk, and our traditional buckets, say market risk, or counterparty credit, or operational risk, are purely human conventions, and our institutions and our systems need to rise above them and think holistically about how these risks interact, particularly in times of stress.

Reconciling Tail Risks and Non Tail Risks ...Or Not.

Traditional measures of risk, most obviously sensitivities like the greeks and percentile measures like VaR, capture only selected dimensions of risk. As Nassim Taleb has memorably pointed out, they fail to capture the extreme losses (tail risks) that could derail the organization. Ironically protecting against these major losses is the whole point of risk capital. For example, both credit (Internal Ratings Based approaches) and market risk (Internal Models Approaches) and operational risk (Advanced Measurement Approaches) use the VaR concept as the definition of minimum regulatory capital. Even worse than this, is the fact that careless use of such VaR measures actually makes tail risks more likely, as traders go long exposures in the tail that have little effect on VaR, but potentially subject the institution to devastating downside. Tail risk measures such as conditional VaR and expected shortfall, do help in this regard, but the truth is, no single measure ever completely captures a complete distribution. So the only solution here is more management understanding of what distributions are about – and this means a more sophisticated management audience for risk results.

Systemic Risk - Only Connect

Systemic Risk always reminds me of one of those Rube Goldberg inventions. Take a look at this video and see what i mean...
http://www.youtube.com/watch?v=qybUFnY7Y8w&feature=youtu.be&a

On Basel III and the difficulty of self regulation

With the so-called Basel III regulations, the G20 central banks are looking to upgrade the Basel II accord in the light of the crisis of the last two years. One of the biggest outstanding issues, is the risk weights assigned to sovereign debt, which remains more or less as before. The risk weights for sovereign debt denominated in foreign currency is based on the sovereign credit rating: AAA to AA (0 per cent risk weight), A+ to A- (20 per cent risk weight), BBB+ to BBB- (50 per cent risk weight); and BB+ to B- (100 per cent risk weight).


Now given that

1) credit ratings are no longer the touchstone of fiscal probity they once were and

2) the central banks are themselves looking to raise capital in the global markets, so lower risk weights make that debt more attractive, and

3) it looks like the world will soon be faced with an impending sovereign debt crisis as government deficits become less and less sustainable.

Does this really make sense that Basel III facilitates the governments funding quite so (L)iberally?

Volatility Time and Risk Clock Speed

I have always felt that one of the best ways to manage personal risks is to simply sample less frequently. That’s why I read one news journal just once a week (the economist btw!). Risk managers need to understand what they are trying to manage, and it seems to me that this has multiple levels (like Kondratief cycles) First technology, demographics, geopolitics all these things are changing slowly over time say over years. Then real economics, business cycles, demand, supply are changing over say months or quarters. Market prices are changing almost instantaneously. When a risk manager manages in response to price changes, is he concerned with the price change in itself, or as a reflection of some more fundamental change. My concern with the concept of volatility time is that most of the moves in the market are merely noise carrying no real additional information. If our need is to respond to market changes in themselves then volatility time makes some sense. However if our focus is the information provided in those market moves then faster sampling really adds no value, particularly given the time and costs of processing the information to make an informed decision. I am sure there’s a great paper in this somewhere!

The Limits of Continuous Finance, Network Risk and the Prisoners’ Dilemma

Modern notions of Market Risk are based on the notion of stochastic calculus which is essentially atheoretical about the nature of the shocks that cause changes in asset prices. For example the whole notion of derivatives pricing using techniques such Ito’s Lemma is based on essentially continuous or discrete random changes in asset prices. Enter the Crisis of 2008/2009. The limitations of such models is made clear as the structural relationships between banks comes to the fore in deciding market trading. We are bank A – do we trade with Bank B? We may have exposure to subprime assets through CDOs and other securitized assets. We don’t know how big that exposure is. Bank B may have exposure to subprime assets. B may have exposures to Banks C and D…None of them know what their exposure is. If we transact with Bank B, we take on counterparty risk, which may be much increased by this unknown exposure (credit ratings don’t help much here). Better is to take government money and not take that exposure. Hence interbank funding dries up, and credit spreads rise dramatically. Transaction/Partnering with other members of your network simply becomes too expensive and too risky. This is much like the classic “Prisoners Dilemma” problem where risk aversion and ignorance about others actions produce a suboptimal solution.
What was consequence of this dilemma? High counterparty exposures allow defaults to propagate through the network of counterparties, one by one, the effects increasing as too big/interconnected to fail (TBTF) institutions’ failure are amplified into a failure of the network as a system. Not surprisingly the regulatory response is one of “macroprudential and systemic risk management” and of course call for break up of institutions whose individual failure could cause system wide problems (e.g., the Volcker Rule etc). But let’s go back, it follows that truly understanding systemic effects requires transparency of the underlying exposures (much like having the prisoners in the prisoners’ dilemma be able to communicate). This is one reason (another is reduced settlement risks) for the rise of centralized clearing (CCP), where one entity has transparency into the network and is able to interject using margin requirements, capital injections when the network looks vulnerable. Suddenly risk management for CCPs becomes critical to managing systemic risk for the entire network.