My 2010 basel accord controversy

The Basel Controversy!

Guilty or Not Guilty?

Prepared and Presented by: Mohammad I. FheiliOrganizational Planning & development Specialist

M I Fheili & [email protected] & [email protected]

Mobile: +961 3 337175 & +961 71585660

Mohammad Fheili < [email protected] > < Mobile: 00961 3 337175 >

Mohammad Fheili “Over 30 years of Experience in Banking. [email protected] (961) 3 337175

Risk & Capacity Building Specialist. Trainer in Risk, Compliance, and Capacity

Building. University Lecturer: Economics, Risk, and

Banking Operations Currently serves in the capacity of an

Executive (AGM) at JTB Bank in Lebanon. Served as:

• Senior Manager & Chief Risk Officer atGroup Fransabank

• Senior Manager at BankMed• Talent Development Advisor at ABL• Economist at the Association of Banks

in Lebanon [ABL] Mohammad received his college education

(undergraduate & graduate) at LouisianaState University (LSU), and has been teachingEconomics and Finance for over 25continuous years at reputable universities inthe USA (LSU) and Lebanon (LAU).

Finally, Mohammad published over 25articles, of those many are in refereedJournals (e.g., Journal of Money Laundering& Control; Journal of Operational Risk;Journal of Law & Economics; etc.) andBulletins.”



Who is to Blame?

Lenders: for their predatory lending practices focused on sub-Prime mortgage candidates

Rating Agencies: Overrate the MBS and other derivatives withunderlying securities of little value with full knowledge.

Mortgage brokers: for steering borrowers to unaffordable loans Appraisers: for inflating housing values Wall Street investors: for backing sub-Prime mortgage loans

without first verifying the security of the portfolio Borrowers: for overstating income levels on loan applications

and entering into loan agreements they could not afford Government: for lack of oversight


Ongoing Effects:

Sub-Prime mortgage industry collapses, thousands of jobsare lost

Surge of foreclosure activity Housing prices and sales are both down Interest rates rise across the board as the effects of the

collapse of the sub-Prime mortgage industry seep into thenear-prime and prime mortgage markets

Investors lost billions of dollars in securities tied to the sub-Prime mortgage industry, resulting in upheavals throughoutthe global financial market


Measures Taken By . . .

United States: $700BN BAIL OUT PLAN; Fed cut key interest rate to 1%United Kingdom:Govt injected cash of £37bn into 3 major banksBank of England cuts interest rate to 4.5%Germany:€500bn financial rescueJapan:Bank of Japan cuts interest rate to 0.3%1.8trillion yen stimulus plan

Brazil:Abandons its tax on foreign investment.Plans to sell $50bn in dollar swap futures contracts to defend currency.Russia:950bn Rouble long term funding to Banks1.3trillion Rouble to State-run Vnesheconombank to service Russian Banks’ foreign loansChinaAbandons its tax on foreign investmentPlans to sell $50bn in dollar swap futures contracts to defend currency


Lessons in the process being learnt

Development of speculative real estate markets and lax standardsof credit appraisal are the surest routes to economic disaster

Rating instrumentality is no substitute to independent duediligence

Higher capital allocation with or without Basel II or prospectiveBasel III is no insurance for bank failures triggered by systemic,people and process failures

Sophisticated mathematical models, notwithstanding back testing,stress testing and the like hardly forebode collapses.

GAAP is not enough Macro prudential analysis (MPA) requires revisit High degree of flexibility is required in the choice of benchmarks Appetite for mergers and acquisitions move in a new direction Injecting liquidity through equity is a better route than a bail-out

package Regulators to keep watch on leverage ratios more than the capital.


The Swiss-Cheese Model

The Steel Model


Justifying Government Intervention Sudden changes in asset quality and value can quicklywipe out bank capital. Where short-term wholesaleliabilities fund longer-ion and investment term assets,failure to roll over short-term financial paper, or ‘run’ ondeposits, can force de-leveraging and asset sales.Banking crisis associated with such changes are oftensystemic in nature, arising from the interconnectednessof financial arrangements: banks between themselves,with derivative counterparties and with direct links toconsumption and investment decisions.

It is for this reason that policy makers regulate theamount of capital that banks are required to hold, andrequire high standards of corporate governance,including liquidity management, accounting, audit andlending practices.

If you were to Summarize Risk Management in Three Words, what would they be?

IdentifyAssess

Mitigate


1

3

You were askedby a Zoo Keeperto pick Oneanimal to takecare of, for a day,inside a 25m2

room; and alone?Feel free: To ask any

question. I’mthe AnimalKeeper!

To do whatyou deemnecessary tosucceed.

2

4


It’s About Making Risk Choices

Identification Assessment Mitigation

KeyRisks

Identified Risks

Non-Identified Risks ? ?

AcceptableRisks

Un-Acceptable

Risks

?

Control

Transfer

Avoid!

Finance

Risk Takers in line w

ith existing policies

Is Risk Management A Destination?

Is Risk Management a Destination?

If your approach to riskmanagement is that it is adestination by itself, . . .

. . . Then “Compliance” is your“cup of tea”, and you haveeffectively transferred theburden of decision-making tothe hands of the supervisors

If your approach to riskmanagement is that it is aprocess leading to . . . AnEnd

Then, you have takenmatters into your ownhands!

Bank’s Objective Function

MAXIMIZE PROFIT subject to:RISK Constraints

RISK . . . Default Liquidity Maturity Other Types of Risks

Uses of Funds

Sources of Funds

Reserves Loans Securities Other

Investments Fixed Assets . . .

All Types of Deposits

Borrowings

Other Sources

Equity Capital

. . .

. . . and Off-Balance Sheet . . .


Nature of Risk Has Changed . . . !

Return

Ris

k

Return

Ris

k

Speculative RiskManaging Revenue

Hazard + OthersManaging Costs

Credit R

isk

Market R

isk

Reputation &

O

ther Risks

Operational

Risk

Best Practices in Risk Management: Risk = Speculative + Hazards

Risk is Here to Stay . . .



Increasing Understanding of OutcomesIn

crea

sing

Evi

denc

e on

Pro

babi

lity Risk

Uncertainty

Ambiguity

Ignorance

Consequences are increasingly uncertain

Likelihood is Increasingly Uncertain

But Managing RISK is not a guessing game, it is a DATA-RICH Process


Collect them all!

Data

Data

DataData

Data

Data

Data

Data

Data

Collect All The Data . . . To Improve Upon Your Ability To Make

Good Decisions


This is NOT Data Warehousing


How Do You Approach Data Collection? Look At A Typical Banking Organization

LOGISTICS Information

Technology Human Resources Administration Others

RISK & CONTROL Risk Management Internal Audit Internal Controls Inspections Others

BANKING Retail Banking Corporate Banking Treasury Private Banking Others

Support Functions (Cost Centers)

Business Generators (Speculative Behavior)

Board of Directors

With well defined sets of duties & responsibilities

With well defined sets of duties & responsibilities

Typical Transaction: Start . . . . (goes through the entire banking organization) . . . EndBefore . . . During . . . After . . .

How do you Identify, Measure, and Manage Risk in a Typical Banking Transaction?

e.g., Banking Transaction: Credit Facility Approval Process


Dissect the Process, and Collect Data at Every Step. E.g., Credit Approval Process

Acquisition/ Credit

Specific Customer Service

Collect And Review

Data

CreditReview

Assess Collateral And Risk

Document Approval

Sales: Bank-Client Interface Risk Analysis: Pricing the Facility Processing

Establishing Contact

Evaluate first customer info

Customer Meetings

Debriefing

Request documents

Obtain data & information

Completeness/ plausibility review

Follow up

Review document

Follow up with Loan Officer / Account Manager

Standardized Credit Rating

Document on other credit related factors

Inspect Object

Determine Loan-to-value

Evaluate Exposure

Data is Sufficient

Complete Loan Application

Prepare Credit rate

Handover Credit File

Follow Up

Data is Complete

Approval by Decision Makers

Check Compliance with Authority Structure

Prepare Contracts

Get Signatures

Provide Security

Disbursement Review

Disbursement

Plan Monitor & Report

Resolution

Correlations & Loan Portfolio Considerations

Loan/Asset Life Cycle

Credit Approval Process

Implement On the Credit

Decision


Credit Committees . . . Decision-Making Process !Credit Authority by Total Exposure

SmallExposure

MediumExposure

LargeExposure

Very LargeExposure

InvestmentExposure

Sales

Risk

Analysis

Corporate B

oard

Sales Locations

Sales Manager

Risk Analysis

Head of Risk Analysis

Executives

Supervisory Board

Credit Committee

- Account Manager

- Group Leader

- Risk Analyst

- Group Leader

+ + + + +

+ +

First Vote Assessment Assessment Assessment Assessment

Opinion Opinion

First Vote

First Vote

Second Vote

Second Vote

Analysis Analysis Analysis Analysis

Second Vote Opinion Opinion

First Vote

Second Vote

First Vote

Second Vote

- - - -

-- -

- - -

-

--

-

--

-

--

-Second Vote


• INADEQUATE Risk Management• Inadequate Supervision• LAX Governance• ABSENCE of Required Competencies• Inadequate Enforcement of Internal Policies and Procedures• LACK of Transparency• Inadequate Disclosure

Why Banks Fail?

Banking weaknesses in most failures wereunrecognized in due time because they wereCAMOUFLAGED with the hope that none shallever be discovered!

By the time “BANKFAILURES” were discovered,it was impossible to do awaywith drastic measures toresolve them!

If Bankers Have Been Doing Their Jobs Right, Bank Failures wouldNot Reach A Catastrophic Proportions. . .


Why not Blame Banking Innovations: Have Taken Place At A RateFaster than Employees Have Been Able to Digest . . . RiskyBusiness

New products Product sophistications New distribution channels New markets New technology Complexity (IT-

Interdependencies, data structures)

E-commerce Processing speed Business volume

Globalization Shareholder and other

stakeholder pressure Mergers & Acquisitions Re-Organizations Staff turnover Cultural diversity of staff and

clients Faster ageing of know-how Rating Agencies Insurance Companies Capital Markets Others . . . .

Trust between the Financial Supervisory Authorities andBanks/Bankers have come under serious questions . . . !

History Testifies Against Basel . . .

. . . But, equally Important, it does notfree Bankers from potential guilt. . .


Pre-Basel

Credit Risk Credit + Market Risks Credit + Market + Operational Risks(Pillars 1, 2, and 3)

Present and Beyond

1988

1996

1998

2001

2004

2008

2009

2013

Market Risk

Basel II Consultation

Starts

Finalization of Revised

FrameworkBasel III

Proposals

Basel I Basel II Basel III?

Jul. Jan. Jan.Dec.

__The Basel Committee of Banking Supervision was established in 1974 at the Bank for International Settlements (BIS)> > > each member is represented by its Central Bank and the authority responsible for domestic banking supervision.The Original Mandate was to deal with the regulatory challenge posed by the increasing internationalization of bankingin the 1970s.

__The collapse of the German Herstatt Bank and the New York-based Franklin National Bank in 1974 showed thatfinancial crises were no longer confined to one country, and that coordinated international action was needed toprevent future crises from spilling over borders.__The Committee’s first proposal, the 1975 Basel Concordat, established rules determining the responsibilities ofhome and host country regulators vis-à-vis cross-border banks.


Pre-Basel


Present and Beyond

1988

1996

1998

2001

2004

2008

2009

2013

Market Risk


Starts


FrameworkBasel III

Proposals


Jul. Jan. Jan.Dec.

__The Committee’s focus expanded in 1980s as American regulators looked for a way to share the regulatory burdenimposed on its banks after the Latin American Debt Crisis of 1982. In response, American regulators seized on theBasel Committee to establish a common framework for the capital regulation of internationally active banks, the 1988Accord on Capital Adequacy (Basel I).

__The 1988 Accord set minimum capital requirements based on a ratio of capital to risk-weighted assets of 8%. Assetswere risk-weighted according to the identity of the borrower.

__Whose job was to secure compliance with Basel I? The Financial Control Division of the banking organization (NotRisk Management; most likely because risk management did not exist in the org structure of the bank then.


Pre-Basel


Present and Beyond

1988

1996

1998

2001

2004

2008

2009

2013

Market Risk


Starts


FrameworkBasel III

Proposals


Jul. Jan. Jan.Dec.Basel I: Minimum Capital, Basic Risk Weighting

Basel II: Changes to Risk Weights, Second andThird Pillars not implemented in full (Practically)

Basel III: Changes to Risk Weights, Changes todefinition of Capital, New (experimental) measures,Accounting Complications

Pre-Basel


Present and Beyond

According to the BaselCommittee, the Accord havethe following objectives:

To promote safety andsoundness in the financialsystem

To enhance competitiveequality

To constitute a morecomprehensive approach toaddressing risk.

Basel I Basel II Basel III


MAXIMIZE PROFIT subject to:RISK, REGULATORY, Compliance, Reporting, Etc. Constraints

RISK . . .

Default

Liquidity

Maturity

Others . . .

REGULATORY . . . Basel I Basel II Basel III Basel IV (In the making)

TLAC Requirements Sanctions Rules USA_FATCA Requirements OECD_CRS (1st Reporting

2017) IFRS9 AML, Etc. . . .

Uses of Funds Sources of Funds

Reserves

Loans

Securities

Other Investments

Fixed Assets

. . .

All Types of Deposits

Borrowings

Other Sources

Capital

. . .

Off-Balance Sheet

Legal Issues . . .

From Originate-To-hold To

Originate-To-Distribute

(Decompose & Redistribute)

CRS: Common Reporting Standards, essentially inspired by FATCA, is a framework between governments to exchange informationobtained from local financial institutions to combat tax evasions.TLAC: The Proposed Minimum Total Loss Absorbing capacity requirements for Globally Systemically Important Banks (G-Sibs). It aims toboost G-Sibs’ capital and leverage ratios, ensuring these banks are equipped to continue critical functions without threatening financialmarket stability or requiring taxpayer support.

Instead of to Off-Balance Sheet;

now to Unregulated Shadow Banking

with less concerns over loan

monitoring & Follow up.

Used as a Cushion with loss-absorbing capacity or as a Source of Funding!

The Banking Model … Complex


By the late 1990s, theAccord had come to beseen as a blunt instrumentthat was “Useless forRegulators and Costly forBanks”.

. . . Banks succeeded inexploiting the differencebetween economic riskand regulatory risk toreduce capital levelswithout reducingexposure to risk.

Banks arbitraged Basel I’sCapital requirements in twoways:

They moved toward the riskierassets within a given risk weightcategory, which have a higheryield.

They shifted assets off thebalance sheet, typicallysecuritizing them. These assets weretreated as true sales for regulatorypurposes, even though the bank oftenretained much of the underlying riskthrough credit enhancements.

Pre-Basel


Present and Beyond



The Revised Frameworkbegins with a coreconcept: A Distinctionbetween “Expected” and“Unexpected” losses.

Expected losses in anygiven year can and shouldbe managed by “Pricing”or through “provisioning”.

But Supervisors want abuffer in the form ofCapital to be held forUnexpected, or occasionalpeak, losses.

This Capital Buffer will serveto:

Limit Insolvencies Absorb losses that could

activate explicit or implicitgovernment guarantees.

Ensure confidence in thefinancial system.

. . . Need to establish balancebetween the costs and benefitsof holding capital.

Pre-Basel


Present and Beyond



e.g., The Credit Risk Function

Quantitative Evaluation

Qualitative Evaluation

Internal Rating

Financial Data MitigationMatrix

Probability ofDefault - PD

Loss GivenDefault - LGD

Exposure AtDefault - EAD

Correlation

Risk Components

CalculationOf Credit

RiskAmount

(MeasurementModel of

Credit Risk)

Stress Testing

ExpectedLoss (EL)

UnexpectedLoss (UL)(Single Asset

AndPortfolio)

< Internal Rating Systems >

< Quantification of Credit Risk >

Reporting toThe Board

PortfolioMonitoring

Provisioning

Pricing

ProfitManagement

CapitalAllocation

< Internal Use >


Process of Internal Ratings

123456789

10

123456789

10

123456789

10

Borrower’sFinancial

Data

QuantitativeRatingModel

Borrower’sQualitativeInformation

Default

Probability of Default Per

Rating G

rade

Assessing Ratings Estimation of PD

Quantitative Evaluation Qualitative Evaluation

Initial Evaluation (tentative)

Final Rating

Rating Mitigation (Later)

-------

Normal

Bankrupt

Needs attention

How to set the time horizon ofassessing the creditworthinessof borrowers in assigningratings: Point-In-Time (PIT) andThrough-The-Cycle (TTC)

Two-Tier Rating System: Obligorand Facility Ratings


Pre-Basel


Present and Beyond

1988

1996

1998

2001

2004

2008

2009

2013

Market Risk


Starts


FrameworkBasel III

Proposals


Jul. Jan. Jan.Dec.

Basel II is no longer in the embryonic tube


Basel II: Born with Serious Defects

Pillar I: Minimum Capital Adequacy Ratios

Calculation Of Exposure

Calculation of PD/LGD

Calculationof RWA

Adjustments forCollateral Valuation

Adjustments forCredit Mitigants

Netting Balance Sheet Items

CalculationsOf Risk WeightsBased on PD/LGD

Supervisory RiskWeights and LGD

Standardized Approach IRB (Foundation) IRB (Advance)

Value at RiskStandardizedMeasurementMethods

Interest Rate Risk

Equity Position Risk

Forex Risk

Commodities Risk

Treatment of Options

Support for allThree Approaches

Basic Indicator Approach:Capital is calculated as apercentage of Gross IncomeStandardized Approach: lineof Business Based ExposureIndicatorsAdvanced MeasurementApproach: CapitalComputations as per LDA

Credit Risk Traded Market Risk Operational Risk

External/InternalRating

Systems

Pillar II: Supervisory Oversight Pillar III: Market DisciplineUsage of Metadata whichEnables transparency Capital for other Risks

Rules-Based Engines Risk Assessment Reports

Capital Adequacy Reporting

Flexible Reporting

Quantitative Reporting-IFRS 7

Qualitative Reporting-IFRS 7

The Revised Framework: Basel II . . . Geared toward strict compliance

The bulk of the revised framework is devoted to derivingthe various formulas and parameters needed to calculateminimum capital requirements under Pillar 1. It:

Defines “total risk-weighted assets” on the basis of acomplex system of risk-weighting that applies to threetypes of risks: Credit, Market, and Operational.

Defines “regulatory capital” Requires that the ratio of regulatory capital to risk-

weighted assets be no lower than 8%.

. . . The risk-weights have been at the heart of the problem.

Risk Weights

Credit Risk Under Standardized Approach

Regulatory Capital =

Risk Exposure

Risk Weights 8%X X

0% 20% 50% 100% 150%

Loans, Bonds,

Etc.

Regulatory Capital

Off-Balance Sheet Items

Liabilities Against

Customers

ASSETS LIABILITIES

CreditConversion

Factors

Type of ObligorGovernment within OECD

Banks within OECD

e.g., mortgages under certain

conditions

Corporates, Inc, Insurance

Companies

Risk Weights

PD

LGD

EAD

Correlations

StandardizedApproach

IRB FoundationApproach

IRB AdvancedApproach

Credit RiskModels

6

Supervisor

Supervisor

Supervisor

No

More

Bank

Supervisor

Supervisor

No

More

Bank

Bank

Bank

No

More

Bank

Bank

Bank

No

Self RegulationsStrict Compliance

Risk Weights . . . Direct Claims on-balancesheet

All Approaches to definingrisk-weights generate widevariation in weights whichdepend on the classificationof the credit. The largedifferences in these riskweights create strongopportunities for a form ofregulatory arbitrage: Bankscan “free up capital” byshifting portfolio exposurefrom high risk-weightedassets to lower risk-weightedassets.

The shift from Basel I to BaselII will “free up capital”,notably as regards residentialmortgages and retail lendingsince the risk-weights mostlycome down.

The IRB approach allowsgreater sensitivity to theprobability of default (PD) forany given type of loan but itdoes not mitigate the widedifferences in risk-weightsacross loan characteristicsobserved with Basel I andeither version of thestandardized approach. . . IRBprovides great scope for usinglower risk weights.


Risk Weights . . . Off-balance sheet Items

Basel II aims to createmore neutral incentivesas regards off-balancesheet exposures, whichare converted to balancesheet equivalents by“credit conversionfactors (CCFs)”.

The CCFs are very varied,depending on the type ofexposure, and createarbitrage opportunities.

Structured ProductsTreatment depends on a number ofparameters:

Where banks use IRB approach for thetype of underlying exposures beingsecuritized, risk weights depend onexternal ratings where these are available(7% - 100%)

Standardized approach, exposures B+ andbelow must be deducted totally fromcapital

Originating banks may exclude securitizedexposures where the risk is fullytransferred.

Exposures which are in effect off-balancesheet require a CCF . . .


ORM Under Pillar IBasic Approaches

Advanced Approaches

CRUDE generatinghigh capital charge

SOPHISTICATED generatinglow capital charge

Standardised Approaches

Pillar 1 -incentives

Subject to qualitative entry criteria

Pillar 2 -sound practices

Subject to qualitative entry criteria


Capital Charge for Operational Risk

Gross Income is definedas the sum of net interestincome and net non-interest income

BIA: When the grossincome is negative in anyof the three years it isexcluded from thecalculations

Income from loans and other interest bearingassets

Less: cost of deposits and other interestbearing liabilities

Plus: Fees & commissions Plus: Net income from other trading activities

Basic Indicator Approach

The Entire Business

Organization

Financial Indicator is a Proxy for

Operational Risk Scaling factor

Total CapitalCharge

3-year Avg. Gross income

* 15% =

* =


Standardised Approach

Corporate FinanceTrading & SalesRetail Banking

Commercial BankingPayment SettlementsAsset ManagementAgency ServicesRetail Brokerage

12345678

BL1 Gross incomeBL2 Gross incomeBL3 Gross incomeBL4 Gross incomeBL5 Gross incomeBL6 Gross income BL7 Gross incomeBL8 Gross income

* 18% =* 18% =* 12% =* 15% =* 18% =* 12% =* 15% =* 12% =

Financial Indicator is a Proxy for

Operational Risk Scaling factor

Total CapitalCharge* =

Capital Charge for Operational Risk

Gross Income (same as in BIA)represents the income from“normal” banking activities & shouldnot include:

Any provision Any operating expenses Profits/losses from the sale of

securities in the banking book Extraordinary or irregular items

SA: It is always a 3-year average grossincome (negative values for aggregate GrossIncome are replaced with zero)

SA and BIA assume that the level ofoperational risk a bank runs is directlyproportional to the size of its gross income

The use of gross income as risk exposureindicator is far simple than the use of risk-weighted assets


ORM Advanced Measurement Approach - AMA

Operational Risk [Reporting] is broken down into event types as they cut across business lines

Internalfraud

Externalfraud

Employment Practices

andWorkplace

Safety

Clients, Products & Business Practices

Damage to Physical Assets

Business Disruption

and systems failures

Execution, Delivery & Process

Management

Corporate Finance

Trading & Sales

Retail Banking

Commercial Banking

Payment and

Settlements

Agency Services

Asset Management

Retail Brokerage

loss data loss data loss data loss data loss data loss data loss data








QIS: Quantitative Impact Study


Total capital

Credit risk + MARKET RISK + Operational risk= CAR ≥ 8%

Market risk element ofthe denominator is themarket riskrequirement relating toTrading Book and Partof Banking Book.

Rules were introducedin the 1996 Market Riskamendment to Basel Iand largely unchangedunder Basel II

Credit risk Market Risk Operational risk

Minimum Capital Requirements forMarket Risk


Market Risk

Interest Rate Risk(Trading)

Equity Position Risk

FX Risk

Commodity Risk

Specific Risk Interest Rate Risk (Banking)

Liquidity RiskMarket Risk

TradedMarket

Risk

TreasuryRisk

On and Off-Balance Sheetpositions arising from movementin market prices

Loss of value of theinvestments (Continuallybuying and selling financialinstruments)

The business the bankconducts with its customers(Lending and Deposit Takingactivities)

The Role Played By Basel II In The Financial Crisis

The average level of capital required by the newdiscipline is inadequate and this is one of thereasons of the recent collapse of many banks.

The new Capital Accord, interacting with fair-valueaccounting, has caused remarkable losses in theportfolios of intermediaries.

Capital requirements based on the Basel IIregulations are cyclical and therefore tend toreinforce business cycle fluctuations.

In the Basel II framework, the assessment of creditrisk is delegated to non-banking institutions, suchas rating agencies, subject to possible conflicts ofinterest.

The Role Played By Basel II In The Financial Crisis

The key assumption that bank’s internal models formeasuring risk exposures are superior than anyother has proved wrong.

The new framework provides incentives tointermediaries to deconsolidate from their balancesheets some very risky exposures

The interaction between minimum capitalrequirements, a supervisory review process andmarket discipline is the way to pursue thesoundness of banks as well as the stability of theentire financial system. This interaction waslacking!

The Revised Framework: As It Should Have Been, But . . .

Capital Requirementsfor Credit Risk

Standardized Approach Foundation IRB Approach Advanced IRB Approach

Traded Market Risk Standardized Approach Internal VaR Models

Operational Risk Basic Indicator Approach (Alternative) Standardized

Approach Advanced Measurement

Approach

Regulatory Frameworkfor Banks

Internal Capital AdequacyAssessment Process(ICAAP)

Risk ManagementSupervisory Framework

Evaluation of InternalSystems of Banks

Assessment of Risk Profile Review of Compliance with

all Regulations Supervisory Measures

DisclosureRequirements of Banks

Transparency for marketparticipants concerningthe Bank’s Risk Position(Scope of Application, RiskManagement, DetailedInformation on own funds,etc.)

Enhanced Comparabilityof Banks

Financial Stability

Pillar II: Minimum Capital Requirements

Pillar I: Supervisory Review Process

Pillar III: Market Disclosure & Discipline

Pillar I: Supervisory Review of Capital Adequacy

Pillar I is based on four Key Principles: Bank’s own assessment of capital adequacy (i.e., the

principle of Proportionality) irrespective of size and/orcomplexity.

Supervisory Review Process Capital Above Regulatory Minima Supervisory Intervention

ICAAP: Internal capital AdequacyProcess

Risks Analyzed: An identification of the major risks facedin each of the following categories:

Credit Risk Market Risk Operational Risk Liquidity Risk Insurance Risk Concentration Risk Residual Risk Securitization Risk Business Risk Interest Rate Risk Pension Obligation Risk Any other risks which have been identified

ICAAP Total Variations in a single Process

Un-Anticipated VariationsAnticipated

Variations(Provisions, Transfer, Etc)

Process Capability Study Discover And Eliminate Causes Of Un-Anticipated Variations

Compute Central Tendency And Variability

Natural Limits / Appetite for Risk/Tolerance for Risk

Risk Financing Catastrophic

1) Regulatory Arbitrage2) Insensitivity to Portfolio Diversification3) A Substitute for Management Judgment

4) Procyclicality 5) Capital for Subsidiaries versus Group

Level

Key Features in Basel II To Be Reconsidered

Regulatory Arbitrage Drives capital Out of the System

Large variations in riskweights (and CCFs)encourage regulatoryarbitrage whichreduces capitalrequirements asportfolios are weightedtoward favored assetclasses.

As total risk-weightedassets decline as ashare of actual totalassets, the leveragethat a given amount ofcapital can supportunder the regulationsrises.

Lending without additionalcapital backing

Return capital toshareholders

The end result: very lowlevels of equity backing forthe balance sheet.

Banks face very low risk-weights under Basel I so longas investment grade creditratings (BBB- or above) aremaintained; this continuedunder Basel II.

Incentives to Increase Leverage


Regulatory Arbitrage Drives capital Out of the System Residential mortgages, which have constituted the underlying

assets in many of the asset backed securities that have been atthe root of the crisis, have been strongly privileged under allversions of the Basel framework.

Banks originating securitizations have great scope to reducetheir risk-weighted exposures or to exclude them all together.

Under the IRB approach of Basel II senior trenches ofsecuritized claims rated BBB+ or above carry low risk weights(7 to 35%)

This system clearly provides incentives and great scope forchanneling credit to home mortgages, many of them funded inwholesale markets and eventually securitized, with very littleequity capital backing.

Insensitivity to Portfolio Diversification EncouragesExcessive Exposure to Favored Asset Classes.

The capitalrequired asbacking forany givenloan shouldonlydepend onthe risk ofthat loanand mustnot dependon theportfolio itis added to.

It reduces complexity by allowing the analysis to focus onthe specific loan or investment while avoiding the need totake account of portfolio composition or how it influencesthat composition.

It reduces the calculation of minimum regulatory capitalto a simple additive process once risk weights have beendetermined.

It allows the framework to apply to a wide range ofcountries and institutions, which facilitates agreement ina highly political context (Single Global Risk Factor)

It involves building a system for the calculation of capitalrequirements that systematically fails to reflect theimportance of diversification as an influence on portfoliorisk.

The minimum capital requirements associated with anytype of loan due to credit risk simply rise linearly with theholding of that asset type, regardless of the size of theexposure.

The Rules of Basel II Provide a Government Stamp ofApproval and Can Substitute for Management Judgment

Pillar 2 accords greatdiscretion and authority tosupervisors . . .

Supervisors are notauditors and are notparticipants in thebusiness environment.

Supervisors have theauthority to obtain anyinformation they need fromthe supervised institution,but they don’t know whatto ask for.

They are not well paid bythe standards of seniorbank executives andlimited in their access toresources.

Supervisors are poorly placed toquestion the judgment of bankmanagement so long as theobjective minimum standards aremet.

This makes it easy for explicitcapital requirements formulas ofthe first pillar to dominate thesupervisory judgment foreseenas part of the second pillar.

Senior Management of banks canbe tempted to delegateresponsibility for what should bemanagement judgment bytreating regulatory requirementsas satisfactory targets for whichsupervisors could be heldresponsible.

The Revised Framework is pro-cyclical and can Exaggerate Booms and Busts

Rising profits in the upswing usually generate increases inretained earnings and hence Tier 1 Capital, and prudent banks,ideally, should use these to build a cushion to see it through thedownswing which inevitably follows. More specific factors include:

If asset values do not accurately reflect future cash flows, pro-cyclicality results. Leverage ratios depend on current marketvalues (and are therefore high in good times and low in bad times).

Banks’ risk measurements tend to be point-in-time and not holisticmeasures over the whole cycle.

Counterparty credit policies are easy in good times and tough inbad,

Profit recognition and compensation schemes encourage short-term risk taking, but are not adjusted for risk over the businesscycle.

Capital Regulation under Basel did nothing to counter this pro-cyclicality.

Capital Requirements for Banking SubsidiariesMay not be Adequate at Group Level

Basel II is to be applied on a consolidated basis to internationallyactive banks to ensure that it captures the risk of the wholebanking group.It is not clear this works well since:

Wide scope exists for parent groups to maintain high levels ofcapital in depository subsidiaries by simply shifting funds withinthe group

Parent groups are often less well-capitalized than their subsidiarydepository institutions

Large balance sheet expansions have occurred at both bankingsubsidiary and parent group levels without requiring meaningfulincrease in capital at the parent group level.

Subjective Inputs

Risk inputs are subjective. Some prices are of the over-the-counter variety and are not

observable, nor do they have appropriate histories formodeling purposes. Banks can manipulate inputs to reducerequired capital.

Unclear and Inconsistent Definitions of Capital Regulatory adjustments for goodwill are not mandated to

apply to common equity, but are applied to Tier 1 and/or acombination of Tier 1 and Tier 2.

The regulatory adjustments are not applied uniformlyacross jurisdictions opening the way for further regulatoryarbitrage.

Banks do not provide clear and consistent data about theircapital.This means that in a crisis the ability of banks to absorblosses is compromised and different between countries –exactly as seen in the crisis.

Supervisors Have Not Been Known To Be Forward Looking.

Building capital buffers under Pillar 2 (Stress Testing, . . . )requires supervisors to be forward looking., that is, to keep upwith changes in market structure, practices and complexity.This is inherently difficult.

Supervisors may be even less likely to be able to predictfuture asset prices and volatility than private bankers.

Supervisors have smaller staff (per regulated entity). Supervisors are mostly less well paid. If supervisors practices lag the policy makers will be

ineffective in countering defects in Pillar 1. Pillar 2 is not likelyto be effective in a forward-looking way.

Markets Just Aren’t Efficient Pillar 3 relies on disclosure and market discipline that will

punish banks with poor risk management practices.Underlying this is an efficient markets notion that marketswill act in a fully rational way.

At the level of markets, the bubble a the root of the sub-prime crisis, and crises before it, suggest the systematicabsence of informational efficiency.

Strengthen the Global Financial System by:1) Raising capital Requirements,

2) Increasing Capital Levels, 3) Improving Risk Management Practices,

and 4) Expanding Disclosure.

Basel III

Improving the Quality of Capital Equity is the best form of capital, as it can be used to write off losses. Goodwill. This can’t be used to write off losses. Minority Interest. That if a company takes over another with a majority

interest and consolidates it into the balance sheet, the net income ofthe 3rd party minorities can’t be retained by the parent as commonequity.

Deferred Tax Assets (net of liabilities). These should be deducted ifthey depend on the future realization of profit (not including tax pre-payments and the like that do not depend on future profitability)

Bank investments in its own shares Bank investments in other banks, financial institutions and insurance

companies. Provisioning shortfalls Other Deductions. Projected cash flow hedging not recognized on

balance sheet that distorts common equity; defined benefit pensionholdings of bank equity; some regulatory adjustments that arecurrently deducted 50% from Tier 1 and 50% from Tier 2 not addressedelsewhere.

The Proposed New Basel III Framework Minimum Common Equity: The highest form of loss-

absorbing capital, this threshold will be set at 4.5% of risk-weighted assets.

Tier 1 Capital Requirement will be set at 6%. Total Capital Requirement will be set at 8%. For each category, there will be a 2.5% Conservation Buffer

to absorb losses during periods of financial and economicstress. If an institution “uses up” the conservation bufferand approaches the minimums, it will become subject toprogressively more stringent constraints on dividends andexecutive compensation (. . . Until the buffer is replenished).

Minimums will be phased in between January 2013 andJanuary 2015, and the conservation buffer will be phased infrom January 2016 to December 2018.

Raise Min. Core Tier 1

to 4.5%+2.5% =

7%

The Proposed New Basel III Framework A Counter-Cyclical Buffer (0% to 2.5%) also could be imposed by

countries in order to address economies that are buildingexcessive risks as a result or experiencing rapid economic (i.e.,credit) growth. It must consists of fully loss-absorbing capital.

In addition to raising the capital requirements, Basel III imposesmore criteria in order for instruments to classify as commonequity and to count as Tier 1 capital. Instruments that no longerwill qualify as common equity will be excluded beginning inJanuary 2013.

There will be higher capital requirements for certain trading,derivatives and securitization activities. These will be introducedat the end of 2011.

A liquidity coverage ratio (Liquidity Coverage Ratio, Net StableFunding Ratio) will be introduced in 2015 and the net stablefunding ratio will be applied starting in 2018.

Basel III Minimum Capital Requirements

0

1

2

3

4

5

6

7

8

9

10

11

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

3.5%

4%

4.5%4.5%

5.5%

6%

8%

8.625%

9.25%

9.875%

10. 5%

Tier 1 Common Equity

Other Tier 1 Capital

Other Capital

Capital Conservation Buffer

% of RWA

Year


Equity Instruments that no-longer qualify as Tier 1 or Tier 2 Capital

0

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

Year (As of January 1st)

Allowable recognition of instruments (% of outstanding nominal amounts at 1/1/2013

Phase in of the required regulatory adjustments of certain items in calculating common equity (% of full adjustment that will ultimately apply)


Leverage and Liquidity Ratios

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

2022

Leverage Ratio

Net Stable Funding Ratio

Liquidity Coverage Ratio

Observation Period

Observation Period

Minimum Standards in Force

Minimum Standards in Force

Supervisory Monitoring

Parallel Run

Disclosure

Migrate to Pillar 1

The Proposed New Basel III Framework A non-risk-based leverage ratio will also be introduced in

2018. It is currently proposed that a minimum Tier 1 leverageratio of 3% be tested during a parallel run period and thensubjected to an appropriate review and calibration process,before migrating to Pillar 1 treatment.

Systematically Important Banks should have loss-absorbingcapacity beyond these minimum standards: A combinationof Capital Surcharges, Contingent Capital, and Bail-in-Debt.In addition to strengthening the loss-absorbency of non-common Tier 1 and Tier 2 Capital instruments.

Existed Way Before Basel Ever Did . . .

Bank Capital

Back to the ABC of Bank Capital: The Good Old Days!

It’s a Wonderful Life!

What is Bank Capital?

Is bank’s net worth, which equals the difference betweentotal assets and liabilities.

Is a cushion against a drop in the value of bank assets,which could force a bank into insolvency.

Helps prevent bank failure, a situation in which a bankcannot satisfy its obligations to pay its depositors andother creditors.

Helps lessen the chance that a bank will becomeinsolvent if its assets drop or devalue.

How Linear is the Relationship Between the various Typesof Assets, Liabilities, and Capital that a Bank is Allowed toCarry on Its Balance Sheet ?????? !!!!!!! WhateverHappen to Gap and Duration Analysis?


Internal . . .

Internal

The level of capital which the management of thebank thinks is appropriate, supported by aninternal assessment of the capital at risk;

Based on the capital level, the second step wouldbe setting of decent Return On Equity. Thishurdle return would be based on marketexpectation, exceeding the market expectationwill result in an increase in shareholder valuewhereas failing to meet those expectations willresult in a destruction of value.


External . . . External

The level of capital which the credit ratingagencies think is consistent with a given creditrating. No credit rating agencies will giveassurance of up-grading or maintaining currentrating solely based on capital adequacy, butindication can be obtained through discussion;

The regulatory capital. A margin of error needs tobe built as regulatory capital shortfall can havevery serious consequences.

It will change with experience.

Why is Bank Capital Important?

The amount of capital affects return on investment for the equityholders (owners) of the bank. Bank capital ends up costing the equity holders because

higher capital reserves generate lower return on equity for agiven return on assets.

The lower the bank capital, the higher the return for the equityholders of the bank.

Larger bank capital reserves benefit the equity owners of a bankbecause it makes their investment safer by reducing thelikelihood of bankruptcy.

How Do Banks Raise Capital?

Banks can raise capital by: issuing new equity (common stock), Issuing bonds that can be converted into equity, reducing the bank’s dividends to shareholders, which

increase the retained earnings that can be put intocapital accounts. Neither option is particularly appealing to existing

shareholders because issuance of new equity dilutestheir profits and reduction of dividends simplyreduces their return on investment.

Role of Bank Capital Requirements in theRecent CRISIS and How Higher Reserves CouldHave Averted Bank Failures Higher bank capital reserves

could have provided a meansof satisfying obligations topay off depositors andcreditors as assets were lostor devalued due to riskyinvestments

Capital is supposed to act asa first line of defense againstbank failures and their knock-on consequences forsystemic risk by providing acushion against losses.

Capital Serves One Economic Purpose: Absorb Potential Losses


The Basics: Types of Capital

DEBT CAPITAL What will be repaid if the bank go into liquidation Subordinated to the bank’s depositors & lendersEQUITY CAPITAL Fully paid ordinary shares Non-Cumulative perpetual preferred shares


Basel II Capital Structure, Ratios and Deductions

CAPITAL STRUCTURE Tier 1: Issued & fully paid

for Ordinary Shares +Non-Cumulative PerpetualPreferred Stock +Disclosed Reserves +Innovative Tier 1 capital

Tier 2: UndisclosedReserves + Asset Re-evaluation Reserves +general Provisions +general Loan LossReserves + Hybrid CapitalInstruments +Subordinated Debt

Tier 3: Subordinated Debtfor a minimum of twoyears (Used to supportMarket Risk)

RATIOS BETWEEN THETIERS OF CAPITAL

Tier 2 capital cannot exceed50% of the total equity

Innovative instruments arelimited to a maximum of15% of Tier 1 capital (afterdeductions)

Lower Tier 2 capital(Subordinated Debt issues)may only equal up to 50%of core capital

The use of Tier 3 capital islimited to 250% of theamount of Tier 1 capital thatis required to supportMarket Risk (28.5% ofMarket Risk should becovered by Tier 1)


( - ) Goodwill: Tier 1 capital of the newbank (acquired plus acquiring bank) is lessthan that which the banks independentlyhad before the acquisition.

( - ) Investments in Subsidiaries: when it isnot consolidated

( - ) Holding of Shares in Another Bank:discretion of local supervisors

Basel II Capital Structure, Ratios and Deductions

Components of CapitalComponents Minimum Requirements

Core Capital (Tier 1) Common stockholders’ equity Qualifying, noncumulative, perpetual preferred stock Minority interest in equity accounts of consolidated subsidiaries Less: goodwill and other intangible assets

Note: Tier 1 must represent at least 50 percent of qualifying total capital and equal or exceed 4 percent of risk-weighted assets.There is no limit on the amount of common shareholder's equity or preferred stock, although banks should avoid undue reliance on preferred stock in Tier 1. Banks should also avoid using minority interests to introduce elements not otherwise qualified for Tier 1 capital.

Supplementary Capital (Tier 2) Allowance for loan and lease lossesPerpetual preferred stock and related surplusHybrid capital instruments and mandatory convertible debt securities Term subordinated debt and intermediate-term preferred stock, including related surplus Revaluation reserves (equity and building) Unrealized holding gains on equity securities

Note: Total of Tier 2 is limited to 100 percent of Tier 1ALLL limited to 1.25 percent of risk-weighted assetsSubordinated debt, intermediate-term preferred stock and other restricted core capital elements are limited to 50 percent of Tier 1

Deductions (from sum of Tier 1 and Tier 2) Investments in unconsolidated subsidiaries Reciprocal holdings of banking organizations’ capital securitiesOther deductions (such as other subsidiaries or joint ventures) as determined by supervisory authority

Any assets deducted from capital are not included in risk-weighted assets in computing the risk-based capital ratio

Total Capital (Tier 1 + Tier 2 - Deductions) Must equal or exceed 8 percent of risk-weighted assets

New Basel Capital Requirements

Old Standards New StandardsAmount

Includable in Total Capital

Elements of Capital

No LimitTier 1

•Common shareholders’ equity•Non‐cumulative perpetual preferred•Minority interests in consolidated

subsidiaries

Includible Only Up to

Amount of Tier 1

Tier 2 Amount Includible In Tier 2 Capital

•Cumulative preferred (perpetual or long‐term)

•Long‐term preferred•Convertible preferred

No Limit

•Intermediate‐term preferred

•Subordinated debt•Debt‐equity hybrids, including perpetual

debt

Only Up to 50% of Tier 1

Amount Includable in Total Capital

Elements of Capital

No Limit Tier 1

•Common shareholders’ equity•Additional Going Concern Capital

(common shares and retained earnings)

No Limit Tier 2

•Minority interests in consolidated subsidiaries•Cumulative preferred (perpetual or long‐term)

•Long‐term preferred•Convertible preferred

• Intermediate‐term preferred•Subordinated debt

•Debt‐equity hybrids, including perpetual debt

The Million Dollar Question

Can Bank Capital Regulation

Prevent Future Financial Crises?

Bank Regulation: Proposed Changes to Corporate Governance

Introduction: Why Change Corporate Governance?

Proposed changes to the internal structure ofcorporations can be divided into three primarycategories:

1) Shareholder Empowerment2) Disclosure Requirements3) Executive Compensation

The latter two frequently appear as measures designedto empower shareholders

The Corporate Structure of a Bank

The corporate structure of banks is divided into threebranches: Shareholders, Directors, and Managers

Shareholders are the equity holders, or owners, of thecorporation, and can be divided into two types:

1) Diffuse shareholder: small, or minority shareholders Vote for directors Vote on matters including mergers and

acquisitions, or other fundamental changes inbusiness strategies (albeit indirectly throughboard member elections)

2) Concentrated shareholder: large, sometimesinstitutional, investors Occasionally elect their own representatives to the

board of directors, Can negotiate incentive packages to align

management interests with that of shareholders

The Corporate Structure of a Bank: Board of Directors

Board of Directors: besides making employment decisions andmonitoring management, directors in banking firms have furtherresponsibilities beyond mere fiduciary duties:

1) Ensure the bank’s activities are in the best interest of not onlythe shareholders, but depositors as well as the government(taxpayer)

2) Abide by laws and regulations reflecting the government'sinterest in maintaining safe and sound financial institutions

Other responsibilities of bank boards of directors include:1) Select competent management2) Supervise the bank’s affairs3) Adopt sound policies and goals under which management

must operate in the administration of the bank’s affairs4) Avoid self-serving practices5) To be informed of the banks position and management

policies6) Maintain reasonable capitalization7) To ensure the bank has a beneficial influence on the economy

and the community in which it rests The board also oversees the level and structure of top executive

compensation; this duty is perhaps the most critical in aligning theinterests of management with that of shareholders

The Corporate Structure of a Bank: Managers, (Focus on CEO)

The CEO is responsible for running the bank on a dailybasis;” the CEO: hires, fires and leads the seniormanagement team, who “in turn, hires, fires and leadsthe other employees in the organization;” “Develops, along with the board of directors, the

bank vision and sets the strategic direction for thebank

“Establishes, more than any other individual, thecontrol culture for the organization

“Oversees the development of the bank's budget andthe establishment of the bank's system of internalcontrols”

Ultimately, the goal of management is to formulate abusiness plan that incorporates and oversees financial,administrative and risk functions in order to maximizethe firm’s value

Public responsibilities

Managers & Compensation Managers are paid a contracted salary, and frequently a

performance measured bonus; compensation can be either in theform of cash or stock options, though usually both

As mentioned before, top management salaries are structured bythe board of directors; however, some consideration include:

1) Capital structure2) Capital reserves

Compensation and risk: boards have the responsibility ofbalancing the firms ability to recruit and retain management talentwhile maintaining appropriate risk management systems Aligning executive compensation with the company’s long-

range objectives Certain business risks may present opportunities for

managers driven by short-term incentives (e.g. stock price orearnings per share)

These metrics can be manipulated, for example, bymanagement decisions related to revenue and expenserecognition or through stock buybacks at the end of theperiod

Failure within Corporate Governance

• The lingering financial problems with the 2007-08crisis stem from shaken investor confidence in themarkets, the result primarily of excessive risk-taking on the part of managers, enrichingthemselves via short-term bonuses whiledestroying the long-term value of their firms— Moral hazard— Consider also that in 2008, 70% of shares in

financial institutions were owned byinstitutional investors, thus, this was notmerely a matter of unsophisticated investorsbeing taken advantage of by large, complicatedbanking firms

• Shareholder disempowerment: firms have grown“director-centric”

Failure within Corporate Governance

Personal response: the failure of corporategovernance comes primarily from two sources:

1) Failure on the part of boards of directorsand managers of many financial institutionsto adequately manage or react to the risksurrounding the types of products thesefirms were selling to investors

2) Second, shareholders have becomedetached from the boards of firms in waysthat make monitoring and oversight, evenfor sophisticated investors, difficult

Corporate and Financial Institution Compensation Fairness Reform Finally, the Bill directs federal regulators to craft

regulation that requires financial institutions todisclose the structures of incentive basedcompensation sufficient to determine whether it is:

1) Aligned with sound risk management2) Structured to account for time horizon of risk3) Reduces incentives for employees to take

unreasonable risks The goal is to regulate compensation structures or

risk incentives that may:1) Threaten the safety and soundness of covered

financial institutions2) Present serious adverse effects on the economy

or financial stability

The Pros and Cons of Corporate Governance Reform Pros:

Moral hazard incentive problems Despite decreases in market capitalization between 2003-2008,

several top Wall Street firms paid out an aggregate $600 billion,giving the impression that compensation packages are not inline with the best interest of shareholders

Cons: Zingales: “While popular, actions directly aimed at curbing

managerial compensations would be completely useless if notcounterproductive, just as the 1992 Clinton initiative to curbmanagerial compensation had the opposite effect”; Rather, hecontinues, “[the] real issue is the lack of accountability ofmanagers to shareholders, centered in the way corporateboards are elected”

Micro-managing compensation Keeping talent Shareholders tend to be detached from the everyday

management of corporations

Credit Rating Agencies

Background 3 Biggies – Fitch, S&P and Moody’s

Others in US Basel’s list of internationals

History Generally good Last decade of criticism mounting Current attack Completely wrong on new securities (standards/duty) Conflicts of interest

What They Do Issue Rating

Once upon a time paid for by investors, now paid for byissuers of the securities

Used as a way to lower cost for investors Theoretically increase market efficiency Increase market information Increase liquidity for smaller size issuers/less well

known securities Rating reflect: Company’s ability to repay debts Structure of the instrument Subordination of the security

What They Do . . . Uses of Credit Ratings

Most issues of bonds need at least one rating inorder to increase their marketability Avoid under-subscription or low initial

purchase price Many lenders use credit ratings as covenants in

loans Defaults can be triggered by a drop in the

borrower’s credit rating

What They Do . . . Advisory Services

Advise issuers on how to structureinstruments in order to obtain the maximumyield Use of covenants and subordination Structured Financing - form trenches

using definitions in the transactiondocuments

Advise companies on formation of SpecialPurpose Vehicles to maximize their creditratings

What They Do . . . Advisory Services create lowest possible quality at

each rating level (regulatory arbitrage-type pattern)

• Obvious conflict of interest in rating issuancesand SPV’s which they

advised during formationoFeel an obligation to rate as promisedo Very few rating agencies have a policy ofnot rating projects they have advised on

Regulatory Reliance . . . Basel II – recognized ratings from External Credit

Assessment Institutions (ECAI’s) Allows regulators worldwide to use ratings from

ECAI’s in order to determine reserverequirements

Insurance Regulators – Use credit ratings toevaluate insurance companies’ reserves

Regulatory Structure

General Increase in Government Intervention

• Safety Nets• Bail outs• Deposit insurance• Discount windows

Decrease industry stability


• Regulations

• Heightened Supervisory Power

• Requires marketdiscipline

• Improves corporategovernance

• Improves bankfunction


• Increase market discipline

• Increase cost efficiency

• Increase profit efficiency

• Reduce asymmetric information

• Reduce transaction costs

• Decrease stability

• Economies of scale in compliance costs

• Discourage entry of new firms

• Consolidation into larger banks

• Reduction of competition


Increased Regulation requires increased informationdisclosures

Information disclosures are costly

Compliance is expensive

Thinking Beyond Basel III

Preparing For The Next Crisis

Basel III designed in Swiss style.

*A committee has been set up todiscuss the benefits of using a Markto “how you feel today” accounting.methodology” instead of Mark-to-market

Surrender monkey says: systemic risk

has a hole new flavor

9 years for implementation

No discussion of too big too fail

Counter cyclical buffers can be 0%No accounting

reform or harmonization*

The Rear View Mirror

• The past 3 years have been unprecedented: Failure of numerous large institutions across the globe Large-scale government support of the financial system Coordinated economic stimulus activity Record low interest rates Regulatory reforms

The above promotes the need to continually strengthen riskmanagement capability, however, it also highlights thepossible inadequacies historically

Learning from the past – ‘Rogue Trading’

During 2008, Societe Generale reported a loss of €4.9bn due to a number of unauthorized trades

In 1995 Barings collapsed after a Nick Leeson, a traderin Singapore generated losses of £900m through aseries of rogue trades, caused by serious controlfailures

And another And another

This did not stop the following…

Expecting the unexpected

The last few years have seen the demise of significant local,national and global financial services firms…but what causedthese trusted brands to fail?

Complexity of business failures

Often, there will be numerous factors that lead to thecollapse of an organization e.g.

Inappropriate business model Inadequate systems and controls Poor oversight and governance External influences

The interlinked nature of risks requires an appreciation of allrisk types, . . .

Key Challenges for the Future of the FinancialService Industry

• Continued economic uncertainty Impact of unraveling the Quantitative Easing program Rising interest rates / inflation Double-dip recession

Regulatory developments The Walker Review on Corporate Governance Capital regime reforms Solvency II Basel III

Retail Distribution Review

• Regulatory supervision Intensive / intrusive supervision of larger firms Greater focus on individual responsibilities and

accountabilities of senior management High profile enforcement action / fines

A return to the pre-credit crisis practices Risk v Reward not adequately monitored Fewer market participants = greater opportunities

Key Challenges for the Future of the FinancialService Industry

What Does this Mean for Risk Managers?

Risk managers will need to adopt the CRO perspective Appreciation / awareness of other risk categories – multi-

discipline approach Understand consequential impacts across risk categories Greater depth / breadth of industry knowledge

Greater profile for risk management in Financial Servicefirms, however, this equates to higher expectations Need to instigate change before regulators impose their

requirements

Increasing need to access and influence senior management Increasing focus on risks within the business model Increasing importance on personal skills, credibility and

persuasiveness

Greater scrutiny of risk functions and risk managers Demonstrating success

Increasing demand for skilled individuals with appropriateknowledge and experience…and qualifications!

What Does this Mean for Risk Managers?

Who Is The Supervisor?

Who Is The Banker?

Economy & Finance

My 2010 basel accord controversy