the great leap forward from basel ii to basel iii dr. michael zerbs president and coo april 2011
TRANSCRIPT
The Great Leap Forward
From Basel II to Basel III
Dr. Michael ZerbsPresident and COOApril 2011
© 2010 Algorithmics Incorporated. All rights reserved. 2
The main point
What is the long term impact of Basel III on …?
Can be translated into …
What are the implications of outcome oriented supervision ascertaining the sustainability of
business models?
© 2010 Algorithmics Incorporated. All rights reserved. 3
2008 / 2009
Key challenges
• Banks’ capital in the US and Europe was critically eroded
Many actual losses were caused by events that were out of model scope
Systemic interdependencies were poorly understood Source: Bank of England, 2011
Trading Book Losses 2H 2007 – 1H 2009 compared to Regulatory Capital YE 2007
© 2010 Algorithmics Incorporated. All rights reserved. 4
2008 / 2009
Key challenges
• Banks’ capital in the US and Europe was critically eroded
• Many actual losses were caused by events that were out of model scope
• Systemic interdependencies were poorly understood
0
10
20
30
40
50
60 Implied losses for AAA tranches of sub-prime RMBS at March 2008
Perc
en
t o
f N
oti
on
al
Source: FSA, 2010
© 2010 Algorithmics Incorporated. All rights reserved. 5
In response
• Basel III
• Fundamental changes in supervisory approach (e.g. FSA)
• However – we need to watch for unintended consequences
Source: BIS, 2010
© 2010 Algorithmics Incorporated. All rights reserved. 6
Unintended consequences
The pervasive view that “this time is different” is precisely why it usually isn’t different, and
catastrophe eventually strikes again.
Reinhart and Rogoff (2008)
© 2010 Algorithmics Incorporated. All rights reserved. 7
Funding liquidity risk
Unintended consequences
• We may exchange known risks for new unknown risks or new tail risk
Potential future exposure (one scenario through time)
Potential future exposurewith daily collateral calls (one scenario through time)
Counterparty credit risk
© 2010 Algorithmics Incorporated. All rights reserved. 8
Unintended consequences
• We may exchange known risks for new unknown risks or new tail risks
• Intervention creates new risks and economic distortions
Foreign exchange reserves as a percentage of M2
Banks’ holdings of central bank and government paper expanded as a result
of sterilization measures
Source: BIS, 2010
© 2010 Algorithmics Incorporated. All rights reserved. 9
Unintended consequences
Over 1,000 pages and counting …
• We may exchange known risks for new unknown risks or new tail risks
• Intervention creates new risks and economic distortions
• Risk by a different name is still risk
© 2010 Algorithmics Incorporated. All rights reserved. 10
Unintended consequences
• We may exchange known risks for new unknown risks or new tail risks
• Intervention creates new risks and economic distortions
• Risk by a different name is still risk
• Crowded trades don’t make good hedges
© 2010 Algorithmics Incorporated. All rights reserved. 11
Unintended consequences
Lucas critique
We cannot predict the effect of a change in policy based on relationships observed historically
Therefore
Supervision requires an element of “predictable unpredictability”
Multi-step approach – e.g. “judgments on judgments”
© 2010 Algorithmics Incorporated. All rights reserved. 12
Mitigating unintended consequences
Imaginative stress testing is fundamental
Basel III, supervisors and banks share stress scenarios as the “Language of Risk:”
© 2010 Algorithmics Incorporated. All rights reserved. 13
What if …
• Resurgent capital inflows to emerging markets reverse, having obscured flaws in banks’ business models?
Imaginative stress testing
Source: IMF, 2010
© 2010 Algorithmics Incorporated. All rights reserved. 14
What if …
• Resurgent capital inflows to emerging markets reverse, having obscured flaws in banks’ business models?
• New asset price bubbles form and, eventually, are pricked or burst?
Imaginative stress testing
Source: IMF, 2010
© 2010 Algorithmics Incorporated. All rights reserved. 15
What if …
• Resurgent capital inflows to emerging markets reverse, having obscured flaws in banks’ business models?
• New asset price bubbles form and, eventually, are pricked or burst?
• Rising inflation causes a major shift in monetary policy?
Imaginative stress testing
Source: IMF, 2010
© 2010 Algorithmics Incorporated. All rights reserved. 16
Requires a comprehensive risk architecture that …
• Supports dialogue
• Provides coherence
• Differentiates among stakeholder
• Allows for unorthodox scenarios
• Stress tests business models
Stress Testing: Effective Implementation
Source: CEBS, 2010
© 2010 Algorithmics Incorporated. All rights reserved. 17
Requires a comprehensive risk architecture that …
• Supports dialogue
• Provides coherence
• Differentiates among stakeholder
• Allows for unorthodox scenarios
• Stress tests business models
Credit RiskMarket Risk
Liquidity Risk
Stress Testing: Effective Implementation
© 2010 Algorithmics Incorporated. All rights reserved. 18
Requires a comprehensive risk architecture that …
• Supports dialogue
• Provides coherence
• Differentiates among stakeholder
• Allows for unorthodox scenarios
• Stress tests business models
Source: IMF, 2010
Stress Testing: Effective Implementation
© 2010 Algorithmics Incorporated. All rights reserved. 19
Requires a comprehensive risk architecture that …
• Supports dialogue
• Provides coherence
• Differentiates among stakeholder
• Allows for unorthodox scenarios
• Stress tests business modelsSource: IMF, 2010
Stress Testing: Effective Implementation
© 2010 Algorithmics Incorporated. All rights reserved. 20
Conclusion
1. Basel III is a major step forward. It applies key “lessons learnt”
2. However, unintended consequences are a serious challenge
3. Supervision and banks’ own risk management both require an element of unpredictability to maintain their effectiveness
4. This makes imaginative stress testing a key part of Basel III and sound risk management practice
5. It can only be done within a comprehensive risk architecture