basel iii news june 2011

8/6/2019 Basel III News June 2011

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Basel iii Compliance Professionals Association (BiiiCPA) www.basel-iii-association.com

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Basel iii Compliance Professionals Association (BiiiCPA)1200 G Street NW Suite 800 Washington, DC 20005-6705 USA

Tel: 202-449-9750 Web: www.basel-iii-association.com

Basel III News, June 2011Dear Member,

Deutsche Bank analyst Matt OConnor warned that forcing banks to holdtoo much capital could backfire, and:

1. Banks could charge more for loans, hurting consumers and smallbusinesses

2. Banks might take even bigger risks in order to generate more return,creating the possibility of an even bigger financial crisis.

Matt is right. But there are two other very important risks:

1. Much reduced lending capacity available - reduction in the supply of credit in order to return equity to shareholders.

Most banks are in the business of attracting shareholders, and mustgenerate return on equity (RoE) that is greater than cost of equity (CoE).

The Basel III changes will cause RoE to fall below CoE. As a result banksneed to change their business models.

2. Bank customers will look elsewhere for credit: To unregulated entities. This would increase the systemic risk.

Although at the November 2010 Seoul Summit, in view of the completionof the new capital standards for banks (Basel III), the G20 Leaders

recognized the potential for regulatory tightening to increase the


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incentives for business to migrate to the shadow banking system, we havenot seen any concrete measures yet.

Make no mistake, shadow banking is inherently complex as it mutatesover time and varies across jurisdiction.

We have a (June 2011) Basel III revision

Before we cover the new requirements, we will travel to the EuropeanUnions counterparty credit risk - frequently asked questions. It will helpus understand the Basel III amendment.

The financial crisis highlighted that banks massively underestimated the

level of counterparty credit risk associated with over-the-counter (OTC)derivatives.

This prompted G20 leaders at the September 2009 Pittsburgh summit tocall for more OTC derivatives to be cleared through a CentralCounterparty (CCP).

They also asked that OTC derivatives that could not be cleared centrallybe subjected to higher capital requirements in order to properly reflect thehigher risks associated with them.

Following the G20 leaders' call, the Basel Committee on BankingSupervision (BCBS) started to review the regulatory capital treatment forcounterparty credit risk.

The BCBS identified insufficiencies and that CCPs were not widely usedto clear derivatives trades.

As part of the Basel III reforms, the BCBS has changed the counterpartycredit risk regime substantially.


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The new regime will strengthen the capital requirements for counterpartycredit exposures arising from institutions derivatives, repo and securitie sfinancing activities.

It will create the right incentives for banks to use CCPs wherever practicable, thus helping reduce systemic risk across the financial system.

Specifically, the objective of these amendments will be:

1. Raise the amount of capital backing these exposures,

2. Reduce procyclicality, i.e. dampen the impact of economic fluctuationthroughout the cycle and provide additional incentives to move OTCderivative contracts to central counterparties;

In effect helping to reduce systemic risk across the financial system.

What are OTC derivatives?

A derivative is a financial contract linked to the future value or status of the underlying to which it refers (e.g. the development of interest rates orof a currency value, or the possible bankruptcy of a debtor).

Over-the-Counter (OTC) derivative contracts are not traded on anexchange (for example the London Stock Exchange) but instead privatelynegotiated between two counterparts (for example a bank and amanufacturer).

OTC derivatives account for almost 90% of the derivatives markets.

In mid 2010, the notional value of outstanding OTC derivatives wasaround $583 trillion or 476 trillion.

At the same point in time, the notional value of derivatives traded onexchanges was roughly $66 trillion or 54 trillion.


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The OTC derivatives market comprises a wide variety of product typesacross several asset classes (interest rates, credit, equity, foreignexchange (FX) and commodities) with widely differing characteristicsand levels of standardisation.

OTC derivatives are used in a variety of ways, including for purposes of hedging, investing, and speculating.

What are Central Counterparties (CCPs)?

A CCP is an entity that interposes itself between the two counterparties toa transaction, becoming the buyer to every seller and the seller to everybuyer.

A CCP's main purpose is to manage the risk that could arise if onecounterparty is not able to make the required payments when they aredue, i.e. defaults on the deal.

CCPs are commercial firms. There are currently about a dozen CCPs, allbut one located in Europe or the USA, clearing interest rates, credit,equity and commodities OTC derivatives.

What is capitalisation of bank exposures to centralcounterparties (CCPs)?

It is the amount of capital that banks will be required to hold against theirexposures to central counterparties.

According to the existing regulatory framework, banks do not have tohold capital for these exposures provided that certain conditions are met.

This will change with the upcoming legislative proposal in order to reflectthe fact that exposures to central counterparties are not risk free.


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The proposal will suggest applying different risk weights depending onthe type of the exposure the bank has vis--vis the central counterparty.

What is credit valuation adjustment?

Credit valuation adjustment (CVA) is an adjustment made by a bank tothe market value of an OTC derivative contract to take into account creditrisk of the counterparty, i.e. the risk that the credit quality of thecounterparty deteriorates or that the counterparty in question defaults.

Specifically, it can be defined as the difference between the 'hypothetical' value of the derivative transaction assuming a risk-free counterparty andthe true value of the derivative transaction that takes into account the

possibility of changes in creditworthiness of the counterparty (including

the possibility of the counterparty's default).

As such, in accounting terms, CVA is the "market value" of credit risk.

Why is CVA important?

The Basel Committee decided to introduce an explicit capitalrequirement for the CVA risk (i.e. a requirement for extra capital) after it

was revealed that nearly two-thirds of the losses stemming fromderivatives during the crisis were a direct consequence of thedeterioration of the credit quality of the counterparty, and not necessarilytriggered by the default of the counterparty, already covered by theexisting regulatory framework.

The calibration of the capital charge for CVA risk was published by Baselin December 2010.

The one outstanding issue is what to do in the event that a bank creates a valuation adjustment/provision for CVA risk (i.e. writes down some

capital to take account of the risk) (i.e. "incurs CVA"), and how torecognise it in the respective capital treatment, i.e. how does the amount


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of the created valuation adjustment/written-off capital count towards theoverall capital requirements to reflect the fact that this amount cannot belost twice. Addressing this issue requires assessing how much creditbanks should get for creating provisions for the CVA risk.

Important parts from the paper:Basel III: A global regulatory framework for more resilientbanks and banking systems, December 2010 (rev June 2011)

Enhancing risk coverage

One of the key lessons of the crisis has been the need to strengthen therisk coverage of the capital framework.

Failure to capture major on- and off-balance sheet risks, as well asderivative related exposures, was a key destabilising factor during thecrisis.

In response to these shortcomings, the Committee in July 2009 completeda number of critical reforms to the Basel II framework.

These reforms will raise capital requirements for the trading book and

complex securitisation exposures, a major source of losses for manyinternationally active banks.

The enhanced treatment introduces a stressed value-at-risk (VaR) capitalrequirement based on a continuous 12-month period of significantfinancial stress.

In addition, the Committee has introduced higher capital requirementsfor so-called resecuritisations in both the banking and the trading book.

The reforms also raise the standards of the Pillar 2 supervisory review

process and strengthen Pillar 3 disclosures.


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The Pillar 1 and Pillar 3 enhancements must be implemented by the endof 2011; the Pillar 2 standards became effective when they were introducedin July 2009.

The Committee is also conducting a fundamental review of the tradingbook. The work on the fundamental review of the trading book is targetedfor completion by year-end 2011.

This document also introduces measures to strengthen the capitalrequirements for counterparty credit exposures arising from banksderivatives, repo and securities financing activities.

These reforms will raise the capital buffers backing these exposures,reduce procyclicality and provide additional incentives to move OTC

derivative contracts to central counterparties, thus helping reducesystemic risk across the financial system.

They also provide incentives to strengthen the risk management of counterparty credit exposures.

To this end, the Committee is introducing the following reforms:

(a) Going forward, banks must determine their capital requirement forcounterparty credit risk using stressed inputs.

This will address concerns about capital charges becoming too low during periods of compressed market volatility and help address

procyclicality.

The approach, which is similar to what has been introduced for marketrisk, will also promote more integrated management of market andcounterparty credit risk.


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(b) Banks will be subject to a capital charge for potential mark-to-marketlosses (ie credit valuation adjustment CVA risk) associated with adeterioration in the credit worthiness of a counterparty.

While the Basel II standard covers the risk of a counterparty default, itdoes not address such CVA risk, which during the financial crisis was agreater source of losses than those arising from outright defaults.

(c) The Committee is strengthening standards for collateral management and initial margining.

Banks with large and illiquid derivative exposures to a counterparty willhave to apply longer margining periods as a basis for determining theregulatory capital requirement.

Additional standards have been adopted to strengthen collateral risk management practices.

(d) To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets,the Committee is supporting the efforts of the Committee on Paymentsand Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish strong standards forfinancial market infrastructures, including central counterparties.

The capitalisation of bank exposures to central counterparties (CCPs) will be based in part on the compliance of the CCP with such standards,and will be finalised after a consultative process in 2011.

A banks collateral and mark -to-market exposures to CCPs meeting theseenhanced principles will be subject to a low risk weight, proposed at 2%;and default fund exposures to CCPs will be subject to risk-sensitivecapital requirements.


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These criteria, together with strengthened capital requirements forbilateral OTC derivative exposures, will create strong incentives for banksto move exposures to such CCPs.

Moreover, to address systemic risk within the financial sector, theCommittee also is raising the risk weights on exposures to financialinstitutions relative to the non-financial corporate sector, as financialexposures are more highly correlated than non-financial ones.

(e) The Committee is raising counterparty credit risk managementstandards in a number of areas, including for the treatment of so-called

wrong-way risk, ie cases where the exposure increases when the creditquality of the counterparty deteriorates.

It also issued final additional guidance for the sound backtesting of counterparty credit exposures.

Finally, the Committee assessed a number of measures to mitigate thereliance on external ratings of the Basel II framework.

The measures include requirements for banks to perform their owninternal assessments of externally rated securitisation exposures, theelimination of certain cliff effects associated with credit risk mitigation

practices, and the incorporation of key elements of the IOSCO Code of

Conduct Fundamentals for Credit Rating Agencies into the Committeeseligibility criteria for the use of external ratings in the capital framework.

The Committee also is conducting a more fundamental review of thesecuritisation framework, including its reliance on external ratings.

Addressing systemic risk and interconnectedness

While procyclicality amplified shocks over the time dimension, excessiveinterconnectedness among systemically important banks also transmittedshocks across the financial system and economy.


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Systemically important banks should have loss absorbing capacitybeyond the minimum standards and the work on this issue is ongoing.

The Basel Committee and the Financial Stability Board are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingentcapital and bail-in debt.

As part of this effort, the Committee is developing a proposal on amethodology comprising both quantitative and qualitative indicators toassess the systemic importance of financial institutions at a global level.

The Committee is also conducting a study of the magnitude of additionalloss absorbency that globally systemic financial institutions should have,

along with an assessment of the extent of going concern loss absorbency which could be provided by the various proposed instruments.

The Committees analysis has also covered further measures to mitigatethe risks or externalities associated with systemic banks, includingliquidity surcharges, tighter large exposure restrictions and enhancedsupervision.

It will continue its work on these issues in the first half of 2011 inaccordance with the processes and timelines set out in the FSB

recommendations.

Several of the capital requirements introduced by the Committee tomitigate the risks arising from firm-level exposures among globalfinancial institutions will also help to address systemic risk andinterconnectedness.

These include:

1. Capital incentives for banks to use central counterparties forover-the-counter derivatives;


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2. Higher capital requirements for trading and derivative activities, as well as complex securitisations and off-balance sheet exposures (egstructured investment vehicles);

3. Higher capital requirements for inter-financial sector exposures; and

4. The introduction of liquidity requirements that penalise excessivereliance on short term, interbank funding to support longer dated assets.

Stress testing

Banks must have a comprehensive stress testing program forcounterparty credit risk.

The stress testing program must include the following elements:

1. Banks must ensure complete trade capture and exposure aggregationacross all forms of counterparty credit risk (not just OTC derivatives) atthe counterparty-specific level in a sufficient time frame to conductregular stress testing.

2. For all counterparties, banks should produce, at least monthly,exposure stress testing of principal market risk factors (eg interest rates,FX, equities, credit spreads, and commodity prices) in order to

proactively identify, and when necessary, reduce outsized concentrationsto specific directional sensitivities.

3. Banks should apply multifactor stress testing scenarios and assessmaterial non-directional risks (ie yield curve exposure, basis risks, etc) atleast quarterly.

Multiple-factor stress tests should, at a minimum, aim to addressscenarios in which

a) Severe economic or market events have occurred;


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b) Broad market liquidity has decreased significantly; and

c) The market impact of liquidating positions of a large financialintermediary.

These stress tests may be part of bank-wide stress testing.

4. Stressed market movements have an impact not only on counterpartyexposures, but also on the credit quality of counterparties.

At least quarterly, banks should conduct stress testing applying stressedconditions to the joint movement of exposures and counterpartycreditworthiness.

5. Exposure stress testing (including single factor, multifactor andmaterial non-directional risks) and joint stressing of exposure andcreditworthiness should be performed at the counterparty-specific,counterparty group (eg industry and region), and aggregate bank-wideCCR levels.

6. Stress tests results should be integrated into regular reporting to seniormanagement.

The analysis should capture the largest counterparty-level impacts across

the portfolio, material concentrations within segments of the portfolio(within the same industry or region), and relevant portfolio andcounterparty specific trends.

7. The severity of factor shocks should be consistent with the purpose of the stress test.

When evaluating solvency under stress, factor shocks should be severeenough to capture historical extreme market environments and/orextreme but plausible stressed market conditions.


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The impact of such shocks on capital resources should be evaluated, as well as the impact on capital requirements and earnings.

For the purpose of day-to-day portfolio monitoring, hedging, andmanagement of concentrations, banks should also consider scenarios of lesser severity and higher probability.

8. Banks should consider reverse stress tests to identify extreme, but plausible, scenarios that could result in significant adverse outcomes.

9. Senior management must take a lead role in the integration of stresstesting into the risk management framework and risk culture of the bank and ensure that the results are meaningful and proactively used tomanage counterparty credit risk.

At a minimum, the results of stress testing for significant exposuresshould be compared to guidelines that express the banks risk appetiteand elevated for discussion and action when excessive or concentratedrisks are present.


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Remarks from Herv Hannoun, Deputy General Manager, Bank forInternational Settlements2011 Research Conference: Financial crises: the role of depositinsurance International Association of Deposit Insurers, Basel, 8 June2011

Reducing the default probability of systemically important financialinstitutions by increasing their loss absorption capacity

Although substantial progress is being made in strengthening nationalresolution regimes and improving coordination on cross border issues, weneed to be realistic about the feasibility of a global resolution regime thatcan cope with the failure of a global SIFI.

It is therefore critical to reduce the probability of SIFI failures byincreasing the loss absorption capacity of such institutions.

At the G20 Seoul Summit in November 2010, the leaders reiterated theimportance of the work on SIFIs.

Global SIFIs were defined as institutions of such size, marketimportance, complexity and global interconnectedness that their distressor failure would cause significant dislocation in the global financial

system and adverse economic consequences across a range of countries.

It was also agreed that global SIFIs should have loss absorption capacitybeyond the minimum Basel III standards.

Indeed, additional capital requirements for global SIFIs find theirrationale in externalities that Basel III does not fully address.

To deal with the externalities of global SIFIs, the FSB and the BaselCommittee are currently developing an assessment methodology forsystemic importance that will identify global SIFIs.


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Based on their systemic importance, global SIFIs will be required tobolster their loss absorbency by holding a systemic capital surcharge oradding contingent capital.

I would like to underline that the Basel III capital requirements (the 7%common equity ratio, comprising the 4.5% minimum plus a 2.5% capitalconservation buffer) should be seen as setting a minimum requirement;they are not a maximum.

This is a fundamental point, which is the subject of an important debateat the moment in the European Union.

It is important in our view to allow national authorities to set highercapital requirements than the Basel III minima.

It is equally important to recognise the ability of supervisors, within eachjurisdiction, to require additional loss absorbency for SIFIs in the form of common equity beyond the 7% common equity ratio established by BaselIII. To conclude, in the absence of a global resolution framework for thetime being, the only reasonable course of action is to make SIFI failuresless likely by imposing systemic capital surcharges.


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The Japanese earthquake and tsunami6 June 2011 (Extract from pages 4-5 of BIS Quarterly Review, June 2011)

The destruction and human tragedy following the earthquake andtsunami in Japan have been huge.

There was an immediate drop in economic activity due to damage tofacilities, disruptions to supply lines and power shortages.

Recent data releases show that household spending and production have plunged.

Damage to the nuclear power plant in Fukushima and ensuing radiationleaks have added to the challenges.

The possible implications of these events for the Japanese economy as well as the global economic outlook and financial markets are manifold,and uncertainties associated with these effects continue.

Initial assessments by the Japanese Cabinet Office put the damage to theeconomy's capital stock at around $240 billion, which is more than doublethe damage following the Kobe earthquake in 1995.

GDP declined by 0.9% on the previous quarter in the first three months of 2011.

For the year, GDP growth is expected to be about 1 percentage pointlower than earlier estimates.

Financial markets reacted very strongly in the immediate aftermath of thedisaster (Graph A).

The Tokyo stock market plummeted by almost 20% in the first twobusiness days after the earthquake, and Japanese sovereign CDS spreads


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jumped by 30 basis points, probably reflecting concerns about the extrafiscal burden implied by reconstruction.

The foreign exchange market was also very volatile, with the Japanese yenappreciating sharply against the US dollar, reaching a high of 76.3 on 17March.

Reportedly, this was driven by market speculation that Japaneseinsurance companies would repatriate US dollar funds to meet

yen-denominated claims.

The Bank of Japan responded swiftly.

To ensure ample liquidity, it offered funding of 82.4 trillion in the first

week after the earthquake, of which 57.8 trillion was actually provided tothe market.

The Bank also increased the amount of its asset purchase programme by 5 trillion, to prevent a deterioration in risk sentiment from adverselyaffecting output.

In response to the yen's sharp appreciation, the Ministry of Finance andthe central bank, together with other G7 countries, embarked on aconcerted intervention in the foreign exchange market.

On 6-7 April, the Bank of Japan unveiled a 1 trillion special lendingfacility to channel funds to banks for lending to distressed businesses inthe affected areas, and broadened the range of eligible collateral assets formoney market operations.

In addition, the government announced a supplementary budget of 4trillion for reconstruction purposes on 22 April.

These measures supported market functioning despite the severity of theshock.


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Markets calmed quickly after their initial reaction: the stock marketrecovered somewhat; the yen retreated to trade in the range of 82-83against the US dollar; and Japan's CDS spread declined.

Outside Japan, the impact on financial markets was limited, and largelyconfined to sectors seen as being most directly affected by supply chaindisruptions or direct loss exposures.

A primary concern in financial markets has been that an extended period

of power shortages in Japan might adversely affect industrial productionthrough global supply chains, given that Japan is a major producer of components for the semiconductor and automotive industries.

Thus, while broad equity market indices have shown signs of resilience(Graph B, left-hand panel), certain sectoral indices fell sharply followingthe news of the disaster, and have subsequently recouped only part of their initial losses (Graph B, right-hand panel).


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Monetary policy in a world with macroprudential policyRemarks by Mr Jaime Caruana, General Manager of the BIS, at theSAARCFINANCE Governors' Symposium 2011, Kerala, 11 June 2011.

We need proper governance arrangements: independence, clarity andaccountability.

Regardless of the specific type of cooperation mechanisms put in place,financial stability requires governance arrangements that incorporate the

principles of independence, clarity and accountability.

Independence from political cycles is needed for macroprudential policyno less than for monetary policy.

A common problem for both policies is the need to intervene during theupswing, when things are going well and the public might be sceptical

that problems loom down the road.


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Operational independence will be needed to shield unpopular policydecisions.

Strong accountability and clarity of communication will bolster publicsupport for the independence of macroprudential policy and hence itscredibility and effectiveness.

Clarity about mandates, responsibilities and powers is important for theeffectiveness and timeliness of actions and for managing the difficulttrade-offs.

Sufficient powers imply control over relevant instruments and appropriatesafeguards.

For example, access to micro supervisory data is important. At the same time, our limited technical knowledge means thatmacroprudential frameworks need room to adapt and grow withexperience.

Very specific and inflexible mandates raise the risk that the specifiedtargets are, or quickly become, poorly matched to the economy's andfinancial system's needs.

As a result, the policymaker's ability to respond to unexpectedcircumstances could be severely constrained.

Accountability is critical. That said, since financial stability objectives aredifficult to quantify or define precisely, accountability is harder to achievethan, say, for price stability objectives in monetary policy.

A clear and transparently communicated strategy that sets out the centralbank's intentions can serve as the basis for accountability.


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Regardless of the specific governance and cooperation arrangements, theemerging reality is that central banks have a key role to play.

This role requires mandates and governance structures that are consistent with their primary monetary policy function.

In some cases, central banks' duties and powers to promote financialstability are being enhanced.

More active financial stability roles will raise issues of reputational risk that central banks will need to manage carefully, especially if their viewson specific decisions are not shared by other agencies involved in the

process.

Central banks will also face additional challenges. They will face an added burden to be very clear about what policy actionsare being taken and for what reason.

They will need to be careful not to undermine price stability mandatesand hard-won credibility.

And they will need to preserve their operational autonomy, includingfinancial independence.

In turn, this requires control over their balance sheet and ex-ante clearmechanisms to transfer losses to the Treasury.

A forthcoming Central Bank Governance Forum report describes thecurrent range of practice across central banks and analyses the issues

posed by various choices.


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The European Systemic Risk Board (ESRB)

Mission, objectives and tasks

According to the ESRB Regulation: The ESRB shall be responsible forthe macro-prudential oversight of the financial system within the Unionin order to contribute to the prevention or mitigation of systemic risks tofinancial stability in the Union that arise from developments within thefinancial system and taking into account macro-economic developments,so as to avoid periods of widespread financial distress.

It shall contribute to the smooth functioning of the internal market andthereby ensure a sustainable contribution of the financial sector toeconomic growth.

For this purpose, the ESRB shall carry out the following tasks:

1. Determining and/or collecting and analysing all the relevant andnecessary information;

2. Identifying and prioritising systemic risks;

3. Issuing warnings where such systemic risks are deemed to besignificant and, where appropriate, make those warnings public;

4. Issuing r ecommendations for remedial action in response to the risksidentified and, where appropriate, making those recommendations

public;

5. When the ESRB determines that an emergency situation may ariseissuing a confidential warning addressed to the Council and providing theCouncil with an assessment of the situation, in order to enable theCouncil to adopt a decision addressed to the European Supervisory

Authorities (ESAs) determining the existence of an emergency situation;monitoring the follow-up to warnings and recommendations;


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cooperating closely with all the other parties to the European System of Financial Supervision (ESFS); where appropriate, providing the ESAs

with the information on systemic risks required for the performance of their tasks; and, in particular, in collaboration with the ESAs, developinga common set of quantitative and qualitative indicators (risk dashboard)to identify and measure systemic risk;

6. Participating, where appropriate, in the Joint Committee of the ESAs;coordinating its actions with those of international financial organisations,

particularly the International Monetary Fund (IMF) and the FinancialStability Board (FSB) as well as the relevant bodies in third countries onmatters related to macro-prudential oversight;

7. Carrying out other related tasks as specified in Union legislation.


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Intellectual challenges to financial stability analysis in the era of macroprudential oversight

Jean-Claude Trichet, President of the European Central Bank, Chairmanof the European Systemic Risk Board

This article discusses the main intellectual challenges related to theconceptual foundations, analytical models and regulatory assessmenttools in the field of financial stability analysis.

The focus is on ways to detect and contain systemic risk.

The article also tries to point in directions that could be helpful inresolving these intellectual challenges.

The article starts with a discussion of the nature and origins of financialstability and systemic risk.

It then goes through four areas in which lessons from the present crisishave illustrated major analytical challenges in enhancing theunderstanding of financial stability and systemic risk.

The article concludes that

1) The understanding of the fundamental working of financial systemsand the risks they generate needs to be deepened, in particular in relationto financial innovation and the role of nonbank financial intermediaries

2) Better insights need to be developed about when and how financialsystems migrate from stability to instability,

3) Models need to be developed that capture the interactions between widespread financial instability and the performance of the economy atlarge (including the related amplification effects and nonlinearities), and


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4) Such models need to be further extended to be able to assess theeffectiveness and efficiency of macroprudential regulatory policies incontaining systemic risks.

Meeting this agenda will require reorienting signifi cant resources inacademia, central banks and supervisory authorities in these directions.

It will also require enriching the way of thinking in economics andfinance.

New approaches should be considered that do not necessarily rely only onthe notions of equilibrium, universal rationality and efficiency, but gobeyond those concepts.

Approaches that have been used successfully in other fields, such as thenatural sciences, may be a helpful source of inspiration.

My starting point is that we have recently entered a new era of financialstability policies, the era of macroprudential oversight.

The new supervisory bodies that have just been created in Europe suchas notably the European Systemic Risk Board (ESRB) in the EuropeanSystem of Financial Supervision (ESFS) would benefit significantly fromintellectual progress in those directions.

The article starts with a discussion of the nature and origins of financialstability and systemic risk, in particular how systemic risk can be definedand which factors can make financial instability widespread anddangerous.

It then goes through four areas in which lessons from the present crisishave illustrated major analytical challenges in enhancing ourunderstanding of financial stability and systemic risk.


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The first area concerns challenges at the very fundamental level of thefunctioning of financial systems, in particular how they change over timethrough innovation.

The second area relates to challenges with respect to our understandingof the transition from tranquil times to crisis times.

Third , it is extremely challenging to develop better tools assessing themacroeconomic implications of financial instabilities.

Fourth and last, we have very limited analytical tools and models (andexperiences) to assess how regulatory policy can be used to contain risksat the level of the financial system as a whole and the overall economy.

1| FINANCIAL CRISES, STABILITY AND SYSTEMIC RISK 1|1 The meaning of systemic risk and experiences with systemiccrises

The crisis that we have experienced over the last three years is anoverwhelming case of the materialisation of systemic risk.

Systemic financial risk can be defined as the risk that financial instabilitybecomes so widespread that it impairs the functioning of a financialsystem to the point where economic growth and welfare suffer materially.


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Chart 1 displays one indicator a Composite Indicator of Systemic Stress(CISS) that ECB staff developed to capture in real time how muchsystemic instability is present at a given point in time.

The chart clearly shows how systemic stress emerged in the EuropeanUnion in August 2007, how the situation degenerated to a full-blownsystemic crisis in September 2008 with, in particular, the bankruptcy of Lehman Brothers (when the indicator shoots up towards its maximum

value of 1) and how the process of relaxation was countered in May 2010,in particular due to the Greek debt crisis.

There were many financial crises in history and a share of them reachedsystemic dimensions.

Examples include in particular the worlds Great Depression in the 1930sand, at national levels, the Nordic and Japanese banking crises during the1990s.


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Every crisis possesses its own characteristics, and having learnt thelessons from the last crisis does not provide protection against future,necessarily different, crises.

Moreover, in a dynamic economic system, progress and growth can onlybe achieved in accepting risks, which could indeed include a tail risk of crises.

The experience of the last three years suggests that policy authorities inall advanced economies need to improve considerably their capacity todetect and contain systemic risks.

Financial supervision was too much focused on the microprudentialdimension of individual risks at the level of single intermediaries and

markets, rather than looking how risks could add up and compound eachother.

In order to become better in this regard, authorities need to considermore the deep underlying sources of systemic instability and, in

particular, how risks can reach the systemic dimension.

1|2 How financial instability can become systemic

Research suggests that there are, in particular, three broad ways through which financial instability can reach systemic dimensions.

The first is contagion.

The failure of one financial agent (or crash of one market) can lead tofailures of other financial agents (or crashes of other markets), even whenthe latter have not invested in (or are exposed to) the same risks and arenot subject to the same original shock as the former.

Second, widespread financial imbalances can build up over time and thenunwind abruptly.


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Hyman Minsky described how in good times consumption andinvestment increase, generating income, which fuels the financing of more consumption and investment but also the neglect of increasingrisks.

Even small events can then lead to a re-pricing of risk and an endogenousunravelling of the credit boom, which adversely affects many agents andmarkets at the same time.

Third, severe negative aggregate shocks can adversely affectintermediaries and markets simultaneously.

Historical research has shown that many banking crises were related tosevere economic downturns.

Note that the three mechanisms can happen independently, but that mostof the time they are mutually reinforcing.

There are a number of inherent features of financial systems that makethem particularly prone to these forms of systemic risk.

The first is externalities.

They particularly relate to the complex and dynamic network of

exposures among major intermediaries.

What in tranquil times is an efficient mechanism to share risk, can, intimes of stress, become a dangerous channel for transmitting instability.

Two contracting parties do not have an incentive to take account of theeffects of their risk-taking on third parties.

As a consequence, the risk at the level of the system may be higher thanthe sum of perceived individual risks.

The second feature is asymmetric information.


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Financial systems allocate funds from agents who have them but possessno specific knowledge about promising investment opportunities, toagents who have knowledge about the opportunities but not the funds toengage in them.

This creates an agency problem between the two parties, which may behandled more or less well through the underlying financial contracts.

If contracts are incomplete and negative news arrive on some of theinvestment projects, but information asymmetries do not allow lenders tojudge whether this also affects other investment projects, funding mayevaporate for all projects alike a phenomenon often referred to asadverse selection.

The special propensity of financial systems to systemic risk is not simplythe result of these two imperfections.

Externalities and information problems are also present in othereconomic sectors.

But there are some other features of financial systems, which render theirimplications much more severe and widespread.

First, illiquid assets, maturity mismatches between assets and liabilitiesand leverage amplify the force with which problems of one financialintermediary are pushed through the complex network of exposures.

Second, sizable amounts of debt relative to capital and short-termfunding have more dramatic effects in situations of stress.

These features in conjunction with the above imperfections lead to powerful feedback and amplification mechanisms, which may causesudden regime changes, driving the system from a state of relative


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tranquillity to a state of turmoil (see, for example, the soaring values of the CISS in August 2007 and September 2008 in Chart 1).

In the aggregate, one observes the abrupt nonlinear adjustments that areso characteristic of financial instability.

A well-developed analytical apparatus for supporting policies in this area would have to fully capture all these elements.

The following sections try to address some of the intellectual challengesin providing such an apparatus, using the experiences of the present and

previous crises.

2| ADVANCING THE ANALYTICAL APPARATUS FOR

FINANCIAL STABILITY AND SYSTEMIC RISK POLICIES2|1 The basic functioning of financial systems and the risks theyimply

The first set of intellectual challenges in advancing the analyticalapparatus for financial stability and systemic risk policies relates to thedeep functioning of financial systems.

The crisis has shown that financial systems are much less understood

than what was thought. While some important parts and implications of the DNA of financialsystems are known their main components, their main functions,indicators of their efficiency or which basic risks can emerge , there aredifficulties in grasping the essence of some major mutations ( financialinnovations) and in predicting how the overall body reacts to specificstresses; two elements that, on occasion, may be strongly related.


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The crisis has taught authorities (and market participants) that the earlyidentification of the build-up of vulnerabilities and widespreadimbalances has to become better.

The analytical apparatus supporting financial stability policy needs to provide authorities with the means to understand the efficiency and risksof both new financial instruments and new business models of financialintermediaries.

A second crisis lesson in this area is that not only models about thesystemic risks in banking are needed but also about how nonbank financial intermediaries can contribute to the transmission of instabilityat the system level.

Brunnermeier and Nagel (2004) found that, whilst hedge funds aretechnically among the most sophisticated investors, between 1998 and2000 they were heavily invested in technology stocks rather than acting asa price correcting force towards fundamental values.

More generally, the explosion of the industry of highly leveraged financial institutions over the last 20 years from around 100 billion USdollars capital under management in 1990 up to 3 trillion US dollars in2007 is not yet fully understood in its financial stability implications.

Also to be noted, the credit derivative activities of some insurancecompanies did play a significant role in the crisis.

The activities of so-called shadow banks, which were not subject to thesupervisory regime of banks, played themselves a decisive role in the runup to the subprime crisis, which has been the trigger of the globalfinancial crisis.

A third lesson suggests that the image of atomistic and highly efficientfinancial markets needs to be revised.


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As also a growing body of financial research suggests, asset valuations,corporate financing activities and intermediation processes are subject toa range of important imperfections to which greater attention is

warranted.

The two examples of externalities and asymmetric information havealready been mentioned.

Another example is oligopolistic structures in major wholesale financialmarkets. Many derivatives markets are dominated by a small number of highly sophisticated and complex financial intermediaries.

Their strategic behaviour is likely to have very different effects on thosemarkets than the benchmark of perfect and atomistic markets might

suggest.How this strategic, and maybe sometimes also predatory behaviour can

on occasion have destabilising effects needs to be understood muchbetter.

A more radical line of work responds to analytical challenges of the crisisat a more fundamental theoretical level.

It starts from the presumption that certain inherent features of the

standard economic paradigms, in particular in macroeconomics preventthem from capturing crucial features of exceptional situations like theones experienced in the last few years.

Notably, analytical models based on a strong tendency to convergetowards equilibrium, a high level of market efficiency and representativerational agents have great difficulties in generating the amplificationeffects, nonlinearities and crashes characteristic for systemic instability(see Section 1 and Chart 1).


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So-called agent-based models do not rely on strong equilibrium attractorsand incorporate heterogeneous agents whose direct interactions havesignificant influence on overall economic outcomes.

They are based on bottom-up simulations of individual behaviour ratherthan top-down maximisations.

They have been applied successfully to a wide range of problems indifferent sciences, including physics, biology, computer science, trafficsystems and mass panics, in particular to problems where amplification,intermittent changes and nonlinearities play a significant role.

2|2 The transition from tranquil times to crises

The second set of intellectual challenges for financial stability analysisrelates to the period in which the system moves from stability toinstability.

One distinguishing feature of this crisis relative to previous crises isspeed.

While the unfolding of the sovereign debt crises in the 1980s occurredover the course of years, the Asian financial crisis developed, at its peak,over months rather than years.

The major intensification of the present crisis, starting in mid-September2008 (see Chart 1), spread around the globe in the course of half-days.

In physics such phenomena are described as phase transitions. Whensome factors exceed a critical level, a system behaves qualitativelydifferently from a situation when the factors stay below this level.

Building on some fundamental physics research on crackling noise andself -organised criticality, Bouchaud (2009) describes how the randomfield Ising model originally developed to analyse how spins order within


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a disordered magnet can be applied to the persistence and breakdownsof financial bubbles.

Investors take their decisions based on slowly moving fundamental variables, such as interest rates, inflation, earnings forecasts etc.

At the same time, however, they are influenced by the majority opinion of other investors.

For that latter fact, the aggregate opinion can be subject to largediscontinuous changes, even though dramatic changes do not necessarilyhappen in the fundamentals.

Moreover, the physics analogy illustrates hysteresis in optimism.

Much as supersaturated vapour refuses to turn into a liquid, optimism isself-consistently maintained (until a critical threshold is reached and anavalanche of opinion changes is launched).

This analogy from physics illustrates how imbalances that have built upendogenously over an extended period of time can suddenly unravel.

Another lesson in this area concerns the role of confidence.

Ultimately fi nancial transactions rely on promises about future payments.

If agents begin to doubt such promises, trust may vanish triggering sharpdrops in asset valuations.

Arguably, this is even more the case in a highly complex andinterconnected system, such as the one that decades of financialdeepening and sophistication have rendered.


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But the non-fundamental factors that also determine whether fi nancialagents have confidence in the payment promises embedded in such acomplex system are hard to characterise in quantitative models.

More generally in practice, it is challenging to assess how and whenconfidence abruptly evaporates at a very large scale, as it did for examplein September 2008 after the demise of Lehman Brothers (see Chart 1).

One direction is the analysis of asymmetric and imperfect information.

For example, recent research has illustrated which factors generateadverse selection phenomena, so that markets dry up and instability

propagates through contagion.

Another direction is a greater incorporation of psychological factors ineconomic analyses, as actually the field of behavioural finance is startingto do.

Whereas the former approach still relies on the assumption of fullyrational agents, the latter approach starts from empirical evidence thatcontradicts this assumption.

Akerlof and Shiller (2009) discuss a variety of psychological factors that played a role in the present crisis, and much more work would appear

beneficial.

The combination of complexity, interconnectedness, payment promisesin debt contracts, limits of information and basic human behaviour

animal spirits can lead to the violent feedback and amplificationmechanisms that are so typical for the transition from stability toinstability.

For all these reasons, enhanced and deep market intelligence shouldcontinue to play a very substantial role.


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2|3 Financial crises and the macroeconomy

The third area of intellectual challenges in financial stability analysisrelates to why authorities care so much about financial stability, namely

to which extent financial instability affects the overall economy, notablygrowth and consumer welfare, and why the transmission to the realeconomy may sometimes be so severe.

Chart 2 shows the range of GDP growth forecasts for the euro area acrossmajor forecasting institutions (dashed blue line) and the realised GDPgrowth rates (solid orange line) as policy makers saw them during thecritical years of 2008 and 2009, respectively.

By comparing the corridor of dashed lines and the solid orange linein panel a) of Chart 2 one can see that all forecasting institutionsconsistently over-estimated the growth rate for 2008, even until very latethe same year.


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Moving on to panel b) of Chart 2, it can be seen that the strongly negativegrowth rate of 4% in 2009 the free fall in economic activity wasdramatically missed until the end of 2008.

In this sense, left alone with unreliable forecasts policy-makers had to acton informal information, real-time data releases and their own wisdomand judgements on how the situation was evolving.

There can be many reasons for these sizable forecasting errors. One maysimply be that it is particularly difficult to look into the future inextraordinary circumstances.

It would, however, be too simple to just stop here.

Another reason for the errors may be that standard macroeconomicmodels, as they tend to be used as input in projections, do not have welldeveloped financial sectors and are mostly linear in nature.

Therefore, it is not all that surprising that they were not able to predict thedrastic effects of the financial meltdown on growth figures.

So, a tremendous intellectual challenge is to develop aggregate modelsthat

(i) Give the central role to financial systems that they actually play in theeconomy by channelling funds from firms, households and governments

with surpluses to the agents that need them to finance real investmentand smoothen consumption and

(ii) Incorporate states of widespread instability in these financial systemsthat feature the characteristics discussed before (bank defaults and othernonlinearities, feedback and amplification effects etc.).

Although a new literature of macroeconomic models with financialfrictions is emerging, we are presently still very far from a new


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generation of macroeconomic models that would fully meet the challengedescribed.

As this fundamental research field advances, such models could alsoenrich the toolkit for macroeconomic forecasts.

A related challenge can be identified in the very important field of macro-stress testing.

A traditional stress test starts from an extreme but plausiblemacroeconomic scenario and considers its one-off effect on banks.

Looking ahead, stress-testing frameworks could consider the two-wayrelationship between the financial system and the economy at large.

For example, severely weakened banks have less room for lending withnegative effects on consumption and investments.

Again, cumulative effects and amplifications can take place in practice, which would not be captured by the traditional approaches.

Therefore, the type of aggregate models described before could alsoenrich stress-testing toolkits.

2|4 The regulation of systemic risk

The fourth and last set of intellectual challenges addressed in this articledeals with regulatory policy.

How can we assess in advance whether regulatory measures have thedesired stabilizing effects at the level of the financial system as a whole?

This is a surprisingly new question. Most financial regulations in the past

have been assessed at the microprudential level, namely for their effect onindividual intermediaries or markets.


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Absent aggregate models with realistic characterizations of widespreadfinancial instability, how can we design new macroprudential regulatory

policy instruments and calibrate instruments known from themicroprudential arena for the desirable effects on systemic stability and

welfare?

Some results from the theory of complex systems might be read in a waythat those systems cannot be steered with precision.

As a consequence, the efficient solution could be to ensure that agents inthe system have sizable buffers in order to survive even extreme shocksrather than to try and remove or limit the risks directly.

Determining how high those buffers should be is a demanding question. The view embedded into the new Basel III capital and liquidityframework is that such buffers need to be higher than was previously thecase.

Although the new standards foresee a multitude of micro-basedregulatory measures, they also entail macroprudential elements.

These regulatory measures have been developed in response to the major

flaws identified during the crisis, namely the insufficient quantity andquality of the capital base of financial institutions, the underestimation of liquidity risk as well as the build-up of excessive leverage in the financialsystem (one of the imbalances referred to in sub-section 1|2).

In addition to meeting stricter regulatory requirements with regard to thequantity and quality of regulatory capital as well as liquidity cushions,banks will need to build up additional capital buffers in good times thatcould be drawn down in stress periods.


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A capital conservation buffer will ser ve as a backstop against excessivedistributions in the form of dividends and compensation payments ingood times.

Excessive distributions may have contributed to destabilising thefinancial sector as a whole in the recent past.

The capital conservation buffer will be complemented with acounter-cyclical element that explicitly considers the macrofinancialenvironment (e.g. excess aggregate credit growth ) in which financialintermediaries operate.

This capital buffer regime is expected to contribute to mitigating theinherent pro-cyclicality in the financial sector (potentially constituting

building-up and unraveling of widespread imbalances).Beyond pro-cyclicality refl ecting the build-up and unravelling of

widespread imbalances as one form of systemic risk, regulators areincreasingly concerned about the interconnectedness among systemicallyimportant financial institutions (SIFIs) and the sizable externalities thatthese financial intermediaries can exert on other intermediaries and thesystem as a whole (see Section 1).

Economists have suggested recently that these intermediaries should

hold higher capital or pay a tax or levy, respectively, in proportion to therisk of such externalities.

They argued that if the amount of capital or the size of the tax/levy wasdetermined by leverage, maturity mismatch and asset growth, then it

would discourage intermediaries to become the source of suchexternalities.

In practice, however, the sources and variants of such externalities aremultiple and diverse.


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Recent policy debates show how complex and challenging it is tointroduce such capital or liquidity surcharges in the present regulatorysetup, not the least because of the difficulty to precisely andcomprehensively measure all the externalities (systemic impact).

Regulatory initiatives at the international level revolve around thefollowing cornerstones:

(i) Reducing the probability of the failure of SIFIs;

(ii) Reducing the impact of their failure;

(iii) Enhancing their supervision and

(iv) Strengthening core financial infrastructures.

A broad consensus has arisen about the need for SIFIs to have higher lossabsorbency commensurate to their systemic importance compared tonon-systemic firms.

Key work is under way on the identification of SIFIs and the assessmentof the magnitude of additional loss absorbency, to be achieved via acombination of equity surcharges as well as other innovative instruments,

such as contingent capital and bail-in-able debt.

In parallel, major efforts are ongoing to improve the resolvabilityof SIFIs.

Prominent examples in this area are the establishment of effectiveresolution regimes, the development of recovery and resolution plans(living wills) and the creation of dedicated resolution funds.


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To address the issue of linkages and contagion, there is also a generaldrive towards directing trades to Central Clearing Counterparties (CCPs)

whenever possible.

This way counterparty risk can be managed more effi ciently and policieson haircuts can be more effective.

The growth of CCPs into highly systemic institutions, however, calls fortheir tight supervision.

Finally, the recognition that the quality, quantity and timeliness of information are crucial for a sound and stable financial system is drivingefforts to improve data collection, develop stress tests into a trulymacroprudential tool that fits into a policy framework aimed at advancing

the systems resilience, and work on the harmonisation of accountingstandards that reflect as closely as possible the economic value of contracts.

Another reminder of the present crisis is the danger of excessive debt andleverage.

For example, we know that the debt financing of a wide range of economic agents (from households to large and complex intermediaries)

without enough income, equity or collateral was a major cause of the

instability.

Since one locus of this problem was the heavy flow of credit into mortgagemarkets in a number of important countries, one should not neglect toolssuch as loan-to-value ratios and debt-to-income limits.

Some Asian emerging countries have some interesting experiences withthe use of such demand-side oriented macroprudential policyinstruments.


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We should reflect on whether the positive experiences of those countries with tightening limits would justify generalising them as fullycountercyclical instruments (also relaxing them in downturns).

And whether these experiences in emerging economies of relativelymoderate size would be fully valid for sizable industrial countries withhighly developed financial systems.

From an institutional perspective, Europe has pushed ahead with thecreation of the ESRB, a body responsible for the macroprudentialoversight of the financial system within the European Union.

The ESRB will monitor systemic risk and, when necessary, issue warnings and policy recommendations both about the current situation

and the medium-long term, starting with the toolbox described above and working on new instruments suited to industry developments.

The strength of this new institution comes from its membership, whichcomprises all the EU central banks and financial supervision authorities

plus the Commission and a representative of the Councils structures.

This should ensure that micro- and macroprudential concerns are tackledin a harmonised way and that its recommendations carry due weight.

The ESRB starts at a time that calls both for crisis management and for prevention.

It was the right time to put in place such a building block of a truly stableand efficient financial system.

The issue of adequate policy responses to emerging systemic risksbecomes even more challenging in the international arena.

Lately, global imbalances have been reconfirmed and could further widenin the future.


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While a detailed discussion of this specific issue is more the topic of other papers in this volume and goes beyond the scope of this article, we needto think more about how to make the international monetary system moreresilient to such imbalances and policy structures more flexible inaddressing them more effectively than the case in the past.

Identifying and mitigating systemic risk is the key challenge for policymakers in the era of macroprudential oversight, which has just started.

This requires analytical frameworks and tools to understand and counterit.

Authorities need to deepen their understanding of the fundamental working of financial systems and the risks they generate.

They need to develop a better assessment of when and how systemsmigrate from stability to instability.

They need to develop models that truly capture the interactions between widespread financial instability, aggregate consumption, investment andgrowth.

And, they need to further extend the latter to be able to assess theeffectiveness and efficiency of regulatory policies in containing systemic

risks.

Meeting this tall agenda will be challenging in the years ahead.

It will require reorienting significant resources in academia, central banksand supervisory authorities in these directions.

It will also require enriching the way of thinking in economics andfinance.


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New approaches should be considered that do not necessarily rely only onthe notions of equilibrium, universal rationality and efficiency, but gobeyond those concepts.

Approaches that have been used successfully in other fields, such as thenatural sciences, may be a helpful source of inspiration.

The ESCB has launched a large research effort in order to extend theanalytical apparatus available in our central banks.

We call it the MaRs, for Macroprudential Research network.

Many researchers from all EU central banks are contributing to it,following three work areas:

1) Macrofinancial models linking financial stability and the performanceof the economy;

2) Early warning systems and systemic risk indicators; and

3) Assessing contagion risks.

basel iii news june 2011

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