Unexpected deficiencies in bank capital after recent market turmoil has regulators rethinking aspects of Basel II and “value at risk.”
By Ed Blount, contributing editor and executive director, Center for the Study of Financial Market Evolution,
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, www.csfme.org
Market turmoil has thrown VaR, and Basel II, a curve
To central bankers, the implementation of the Basel II Capital Accord was planned as a stimulant to improve banks’ risk management practices, as well as to formulate appropriate, risk-sensitive capital levels for the global banking system.
Now, after building up very high expectations and investing enormous intellectual capital in the reformulation of Basel II, many bankers and regulators, not to mention bank investors, have fallen disappointed at the unexpected deficiencies in banking capital, especially for complex global financial institutions, that have been exposed by the recent market turmoil. Even the improved risk management systems of these large banks—as stimulated by Basel II—have become orphaned by their erstwhile supporters.
Consider that, for the past dozen years or so, the most popular risk paradigm has been VaR, or, value at risk. Central bankers seem to have concluded that banks that relied on VaR tended to operate in ways which exaggerated the banking systems’ natural “procyclicality.” That is, banks using VaR made too many loans into the credit boom economy, resulting in an overstimulation of the business cycle. VaR failed to prevent participants from building excess leverage, especially when market volatility was deceptively low. As a result, the VaR techniques “should be complemented by stress testing and by basic judgment and simple indicators,” the deputy general manager of the Bank for International Settlements, Herve Hannoun, told a group of central bankers meeting in Ottawa on May 8.
Among the “simple indicators” to be considered, Hannoun proposed maximum loan-to-value ratios for mortgage loans, capital charges on structured investment vehicles, leverage ratios, and dynamic provisioning. Each of these has a precedent in one or more national regulatory structures, he pointed out.
Three weeks later, his boss at BIS, general manager Malcolm Knight, told a meeting of international securities regulators in Paris on May 29 that “risk managers must rely on a wider range of tools to capture the multi-dimensionality of risk,” because “tail risk exposures—including the risk of illiquidity—are not well measured by simple tools such as value at risk.” Despite the relative rarity of losses out on the “tails” of a risk distribution, in some cases the bell-curve-shaped distribution is so flat that the actual value of losses can bankrupt banks and threaten financial markets. The bottom line on VaR is that it is so reliant on volatility as a measure of risk, that VaR adherents missed the entire accumulation of risky positions since there was very low volatility.
Knight recommended several corrective actions in order to reduce the risks in today’s market-dependent financial system. To begin, he emphasized the need for less complexity and more transparency in the securitization chain. He criticized mechanistic reliance on ratings agencies, explaining that their views should be supplemented with analyses of liquidity and of events that could trigger sudden ratings changes, especially for tranche-based instruments. Capital support should be boosted for certain products, he said, as well as for liquidity facilities associated with off-balance-sheet vehicles. Similarly, event risk in trading books should be framed more carefully in bank capital requirements. In summation, Knight advanced, as an overarching consideration, a new regulatory paradigm, by saying that, “The recent turmoil has highlighted the need for better coordination of financial regulation and supervision across institutions, markets, and jurisdictions.”
Indeed, BIS officials and their central bank members appear to have come to the conclusion that, despite the apparent success of the Federal Reserve in monetizing the systemic liquidity crisis and avoiding catastrophic fallout from the Bear Stearns crisis, the reality is that modern financial crises are simply too complex for any one country or central bank to solve alone. Therefore, the central banks, through their BIS consortium, are advocating the benefits of a paradigm called the “macroprudential,” or macro-financial regulatory approach.
Herve Hannoun posited that “it might be useful for the central banking community to consider developing a macro-financial stability framework in supervisory and monetary policymaking, as an alternative to the serial bubbles that we have experienced over the past ten years: the dot-com equity bubble, the housing bubble, the credit bubble and perhaps the latest one, the commodity price bubble.”
The justification for new paradigms is rooted in widespread disappointment in the VaR-based models. According to Hannoun: “economic capital and VaR techniques amount to transforming large nominal amounts into very small values at risk. This reduces the perceived order of magnitude of risk exposures and gives a false sense of comfort.” He added that the recent turmoil was a reminder that “nominal and notional amounts do matter when looking at risk exposures.”
The evolving BIS perspective is not only a backlash from the market turmoil, it is also a new call for evolving risk and regulatory benchmarks to support future reforms. The next generation of risk management systems for banks and capital adequacy systems for their regulators must operate in sync if the goal is to prevent the kind of unpleasant surprises that have recently undermined confidence in the global banking and credit markets.
Ultimately, these surprises seem also to have given bankers a reason to reconsider a situation in which years of their invested energies may give rise to a reformed capital regime which is still inadequate for the modern banking system. BJ
The electronic version of this article available at: http://lb.ec2.nxtbook.com/nxtbooks/sb/ababj0708/index.php?startid=6 
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