The Great Leap Forward From Basel II to Basel III Dr. Michael Zerbs President and COO April 2011

The Great Leap Forward

From Basel II to Basel III

Dr. Michael ZerbsPresident and COOApril 2011

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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?


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


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


In response

• Basel III

• Fundamental changes in supervisory approach (e.g. FSA)

• However – we need to watch for unintended consequences

Source: BIS, 2010


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)


Funding liquidity risk


• 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



• 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



Over 1,000 pages and counting …



• Risk by a different name is still risk





• Risk by a different name is still risk

• Crowded trades don’t make good hedges



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”


Mitigating unintended consequences

Imaginative stress testing is fundamental

Basel III, supervisors and banks share stress scenarios as the “Language of Risk:”


What if …

• Resurgent capital inflows to emerging markets reverse, having obscured flaws in banks’ business models?

Imaginative stress testing

Source: IMF, 2010


What if …


• New asset price bubbles form and, eventually, are pricked or burst?


Source: IMF, 2010


What if …


• New asset price bubbles form and, eventually, are pricked or burst?

• Rising inflation causes a major shift in monetary policy?


Source: IMF, 2010


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








Credit RiskMarket Risk

Liquidity Risk









Source: IMF, 2010








• Stress tests business modelsSource: IMF, 2010



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

Documents

The Great Leap Forward From Basel II to Basel III Dr. Michael Zerbs President and COO April 2011