1.1 Background
The consultative documents entitled "Strengthening the Resilience of the Banking Sector" (henceforth referred to as 'Basel III') and "International Framework for Liquidity Risk Measurement, Standards and Monitoring" are a part of the Basel Committee's ongoing work in response to the crisis. This paper reviews the proposal, and asks whether they provide a basis for reform that will help to avoid crises in the future.
1.2 Liquidity
Typically, banks fail from the combination of substantial credit losses and limited or disappearing liquidity to adequately fund their assets during times of stress. Consequently, regulators have con-sidered access to adequate funding and liquidity levels crucial for the long-term stability of each bank. Hereto, international banking regulations did not have global liquidity standards, or con-sistent regulatory monitoring in cross-border supervisory oversight. The new short term Liquidity Cover Ratio, to be implemented starting 2015, focuses on the ability to maintain adequate liquidity coverage for extreme stress conditions of up to 30 days. This will be complemented by a longer-term structural Net Stable Funding Ratio, to be implemented by 2018, that relates the long-term and stable sources of funding to the liquidity characteristics of on- and o_-balance sheet.
1.3 Appropriately risk-weighted assets
The proposals raise capital requirements in the banking book. During the _nancial crisis expe-riences with resecuritization transactions, where a securitized instrument becomes the underlying asset of another securitized product, suggest that these sophisticated structures are particularly dependent on the availability of liquidity. To reect these experiences, the proposals increase the capital requirements by adjusting the risk weight of resecuritization exposures in relation to the securitization exposures, by harmonizing some credit conversion factors for speci_c liquidity facili-ties associated with securitization and market disruption lines, by demanding more rigorous credit analysis of externally rated securitization exposures, and by prohibiting the recognition of ratings that reect guarantees or other support provided by banks.
To provide further stability to the _nancial system, the proposals also call for enhanced counter- party credit risk practices, including higher Pillar 1 capital requirements determined by stress tests.
These capital charges account for the e_ects of deteriorating credit quality on transactions with counterparties. Further, the proposals emphasize the need for more robust collateral management practices, and increased capital requirements for exposures to large _nancial _rms. Importantly, the proposals also increase incentives to execute OTC-transactions through centralized clearinghouses.
The largest impact on the trading book comes from the introduction of the stressed market VaR requirement for banks that use the Internal Models Approach. Extending the market risk capi- tal requirement by calculating a stressed VaR, banks replicate VaR during periods of stress. By expanding market risk capital requirements to account for periods of stress, the procyclicality of market risk capital requirement is reduced. According to the Quantitative Impact Study, this change in capital requirement beyond the existing VaR estimate (using data from the most recent one-year period) and the stressed VaR for a one-year period of signi_cant stress is likely to increase the capital requirements 3 - 4 times. Moreover, an Incremental Risk Capital Charge (IRC) is in-troduced to complement the new VaR framework by incorporating the e_ects of credit migration, widening of credit spreads and loss of liquidity.
To improve market discipline through increased transparency, the Basel Committee also proposes the implementation of deeper and broader disclosure standards to ensure that market participants have an increased ability to better assess the risks other banks may pose. These proposals comple-ment and support changes in capital levels, capital requirements, and liquidity standards.
The problem we are pointing out is known and resurfaces after every crisis, as it did in January of 2009 when Basel Committee said: "Most risk management models, including stress tests, use historical statistical relationships to assess risk. They assume that risk is driven by a known and constant statistical process… Given a long period of stability, backward-looking historical information indicated benign conditions so that these models did not pick up the possibility of severe shocks or the buildup of vulnerabilities within the system".
Chapter 2
Literature Review
2.1 Modern Portfolio Theory
Modern Portfolio Theory (MPT) started with the work of Harry Markowitz and is based on a number of fairly elaborate assumptions regarding financial markets. MPT's dominance of the portfolio management and reporting resembles the use of Newtonian mechanics in building of the automobiles. Not surprisingly, MPT comes under detailed scrutiny every time a supposed once-in-a-lifetime event occurs in the financial markets.
2.2 Attempts at Fixing the Old Paradigm
2.2.1 Fat Tails
There have been numerous attempts to improve on the various aspects of MPT based risk modeling. One of those attempts that received most public attention is the use of the so-called 'fat tail' distributions. As famously argued by Nassim Nicholas Taleb (2007) in his best-selling "Black Swan: The Impact of Highly Improbable", normal distribution does not have enough room in its tails to accommodate extreme events. Taleb, following in the footsteps of the brilliant Benoit Mandelbrot, suggested using distributions in which the probability of the extreme event declines much slower as one gets away from the center of the distribution. There is a whole class of distributions called power law distributions which Taleb advocates in his intellectually stimulating book. For an in-depth treatment of many novel aspects of fat tail distributions, please also see Rachev et al (2005). Can fat tail distributions be the answer to the deficiencies of the old paradigm? As we have suggested above, they cannot, simply because the problem with the old paradigm lies mainly outside of its distributional assumptions. The issue is that under the existing framework low market volatility will ALWAYS produce a low risk forecast, no matter which distribution is applied to the data. In statistics this is known as the GIGO problem (garbage-in-garbage-out) and it is not solved by any level of mathematical wizardry, but only by a paradigm shift.
2.2.2 The New Paradigm
To proceed further we must identify some theoretical framework that resembles reality to a greater degree than the abovementioned assumptions of a relatively stable "equilibrium" state. There are a number of economic approaches that can be helpful in this regard. De Long et al (1990) show a model of market bubbles in which rational traders who follow positive-feedback strategies are buying with rising prices and selling with falling prices, thus producing self-sustaining trends which ultimately end in a crash. The situation of demand rising with the price not infrequently encountered in financial markets upsets traditional supply-demand relationships and makes traditional equilibrium approaches incapable of dealing with the real world fluctuations. De Long's model formalizes a permanent theme in the literature on self-reinforcing bubbles which goes back as far as Bagehot (1872). Going further, Hyman Minsky (1992) identified the key features of the credit cycle which tend to drive large boom-bust sequences. According to the Financial Instability Hypothesis (FIH), fundamental relationships in the real economy and financial markets change with the change in the behavior of the participants and particularly with the change in the behavior of the financial intermediaries. For example, after a period of prosperity, an increase in the risk-taking activities takes place and rising leverage builds setting up the potential for a violent downturn. Some interruption will expose the unsustainability of leverage levels leading to a credit contraction and a potential collapse in the asset values.
Minsky (1992) summarized his insights in two theorems of the Financial Instability:
"The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system."
Soros (1987) extensively discusses his view of boom-bust sequences. His description, though less rigorous than Minsky's, gives a useful view into the mechanism of self-sustaining bubbles via the mechanism he calls "reflexivity". Economy can deviate very far from a theoretical equilibrium for long periods of time, because many so-called 'fundamentals' under certain conditions can become highly intertwined with prices, which are supposed to reflect them. The views of both Minsky and Soros explain how the risk gets built up to an extremely high level due to purely endogenous market forces. The stage is then set for a dramatic reversal. In an exceptionally lucid explanation of systemic risk, Danielsson and Shin (2003) write, "One of the implications of a highly leveraged market going into reversal is that a moderate fall in asset value is highly unlikely. Either the asset does not fall in value at all, or the value falls by a large amount."
As argued by Satchkov (2010), the risk forecast from a traditional model needs to be adjusted upward when:
a. Risk is mispriced for a period of time
b. The trend of worsening risk mispricing stops and shows signs of reversal
Risk mispricing can potentially be measured by a variety of more or less easily observed metrics. In this class of metrics we include junk credit spreads, housing price to rent ratios, sovereign spreads, price to earnings ratios, financial sector leverage, international debt and capital flow patterns and others. Let us consider some empirical examples of the performance of RiXtrema model relative to the old paradigm models. Exhibit 4 explores a familiar situation of a run up to the 2008 crash.
2.3 The Basel system historically
A 'revised framework' known as Basel II was released in June 2004 (BCBS, 2004) after many issues with Basel I, most notably that regulatory arbitrage was rampant (Jackson, 1999).
2.3.1 Portfolio invariance
The risk weighting formulas in the Basel capital regulations are based on a specific mathematical model, developed by the Basel Committee, which is subject to the restriction that it be 'portfolio invariant'; that is, the capital required to back loans should depend only on the risk of that loan, not on the portfolio to which it is added (Gordy, 2003).
2.3.2 Single global risk factor
For the mathematical model underlying the Basel approach (I or II), each exposure's contribution to value-at-risk (VaR) is portfolio invariant only if: (a) dependence across exposures is driven by a single systemic risk factor - a global risk factor, since it is supposed to apply to global banks operating across countries; and (b) each exposure is small (Gordy, 2003).
2.4 'Basel III' proposals for reform
Basel II, to all intents and purposes, never came properly into effect. In July 2009 the Basel Committee already adopted changes that would boost capital held for market risk in the trading book portfolio (see MR in equation 1 above) - in essence applying a multiplier of 3 to VaR specific risk and to stressed VaR risk in the calculation (BCBS, 2009a). The quantitative impact study has shown, oddly, that the average capital requirement for banks in the study would rise by 11.5%, but the median would only rise by 3.2% (BCBS, 2009b). More capital of course is to be welcomed. The consultative document issued by the Basel Committee in December 2009 aims to fix some of the problems noted above. This paper focuses on these new proposals on capital.
Bottomâ€ofâ€theâ€cycle calibration
Adjustments to Pillar I Risk Capital were first suggested to remedy the procyclicality of the capital requirement. FIs use hybrid risk rating philosophies in assigning probabilities of default (PDs) to their obligors, with varying degrees of Pointâ€inâ€Time (PIT)â€ness. This PIT (i.e. conditional) element1 makes the PDs procyclical which in turn makes the Pillar I Risk Capital procyclical. Gordy and Howells (2006) discussed alternative approaches - either by adjusting the inputs or output - to dampen this procyclicality.
Reference
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