Download The Regulatory Framework... A Change of Direction Bucharest – 12

Confidential
www.fig-uk.com
Bucharest – 12th March 2014
The Regulatory Framework...
A Change of Direction
Paul Costea
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The Basel Regulatory Framework is Undergoing a
Fundamental Rethink
• The financial crisis has revealed major weaknesses in
traditional approaches to risk management
• Performance and risk management reporting systems
continue to rely on lagged risk measures that are dependent
on quantitative models, risk indicators and self-assessments
• These techniques have failed bank management, regulators,
investors and other stakeholders because they do not
provide a basis on which exposures to risk can be quantified,
aggregated and reported as they accumulate
• The Basel Committee and Financial Stability Board have
conducted a number of studies of the regulatory framework
and their conclusion is that it has become overly complex, its
outputs are unreliable and lack comparability and there is a
general inability to aggregate risk data
• For example...
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Basel Committee – Balancing Risk Sensitivity, Simplicity and
Comparability
“...the pursuit of increased risk sensitivity has considerably
increased the complexity of the capital adequacy framework in
some areas – particularly the calculation methodology for
risk-weighted assets”
“...banks are likely to employ a large number (possibly
hundreds) of models to determine their consolidated capital
requirements which are, in turn, based on a very large number
of inputs estimated using complex quantitative techniques”
“… these methods are intended to improve the accuracy of risk
assessments, but clearly make the calculation process highly
complex”
Basel Committee
‘The Regulatory Framework: Balancing
Risk Sensitivity, Simplicity and Comparability’
July 2013
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A Central Banker’s View of Basel II and Risk Models
“The quest for risk-sensitivity in the Basel framework, while
sensible in principle, has generated problems in practice. It has
spawned startling degrees of complexity and an over-reliance on
probably unreliable models”
“With thousands of parameters calibrated from short samples,
these models are unlikely to be robust for many decades, perhaps
centuries to come. It is close to impossible to tell whether results
from them are prudent”
Andrew G Haldane & Vasileios Madouros
Bank of England
”The Dog and the Frisbee”
Speech given at the FRB of Kansas City’s 36th Economic Policy Symposium
August 31, 2012
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Basel Committee – Fundamental Review of the Trading Book
“...definition of the regulatory boundary has been a source of
weakness... A key determinant of the boundary is banks’ intent to
trade, an inherently subjective criterion that has proved difficult to
police and insufficiently restrictive from a prudential perspective in
some jurisdictions.”
“Weaknesses include: its (VaR’s) inability to adequately capture
credit risk; its inability to capture market liquidity risk; the
provision of incentives for banks to take on tail risk; and,
in some circumstances, the inadequate capture of basis risk”
“...the large number and size of backtesting exceptions observed
during the crisis serve to highlight regulatory concerns with
continued reliance on VaR”
Basel Committee
Fundamental Review of the Trading Book
May 2012
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The Regulatory Authorities in Basel are Challenging the
Industry to Resolve the Issue
• Recent papers that signal a regulatory change of thinking and direction include:
– Basel - Principles for effective risk data aggregation and risk reporting
– Basel - The regulatory framework: balancing risk sensitivity, simplicity and
comparability
– FSB - Principles for an effective risk appetite framework
– FSB - Supervisory interaction with financial institutions on risk culture
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Academics are Advocating an Accounting Solution... ‘Risk
Accounting’
“Determining appropriate relative comparisons of systemic-risk
exposure is the prime measurement issue in the short run. In the
longer run… financial accounting needs fundamental revisions
and a specialized new branch called 'risk accounting' must be
created… Exposure or risk accounting is going to be adapted if
we are to have effective external financial accounting and
regulation. Current accounting practices are focused on
valuation, which is inherently a static measure of financial
conditions. Focused on exposures, risk accounting is inherently a
dynamic measure of financial condition because it indicates how
the individual balance-sheet values are likely to change in
response to changes in the underlying financial-economic
environment.”
Prof. Robert C. Merton
Harvard Business School
Financial Innovation and the Management and
Regulation of Financial Institutions
Journal of Banking and Finance, July 1995
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Academics are Advocating an Accounting Solution... ‘Risk
Accounting’
“The very fact that so many smart and experienced corporate
leaders were all led astray suggests that the crisis can't be
blamed on the mistakes of a few greedy CEOs. In my view,
there's something fundamentally wrong with current corporategovernance structures and the language of corporate
management. We just don't have the proper lexicon to have a
meaningful discussion about the kinds of risks that typical
corporations face today, and we need to create a new field of
‘risk accounting’ to address this gap in GAAP”
Prof. Andrew Lo
MIT Sloane School of Management
quoted in ‘Understanding Our Blind Spots’
Wall Street Journal, March 2009
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Academics in the UK Have Successfully Codified a System of
Risk Accounting
• Risk accounting involves the tagging of risk information onto transactions that is used in a
calculation of each transaction’s exposure to risk using a new standardised risk metric - the
Risk Unit (RU) - that is then accounted for in a system of enterprise wide risk accounting and
reporting
• This same principle is used in management accounting, i.e. transactions are tagged with
management information (product, customer, cost centre, market segment codes etc) to
drive enterprise wide management reporting
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Risk Accounting – An Overview
Products / Transactions
Inputs
Inherent
Risk
Factors
Credit
Risk Table
Value
Factors
Risk
Metrics
Sample Best Practice
Scoring Templates
Risk
Mitigation
Factors
V
Market
Risk Table
a l u e
Liquidity
Risk Table
T a b l e
Credit Assessment
& Approval
Trading Account
Reconciliations
Buffer
Management
Quality Assurance
& Monitoring
Trading Limits &
Controls
Model
Management
Credit Risk
Administration
Model
Management
Internal Control
Evaluation
Model
Management
Electronic Trading
Systems (HFT)
People
Credit Inherent
Risk (RUs)
Market Inherent
Risk (RUs)
Liquidity Inherent
Risk (RUs)
RMI
Residual Risk
RMI
Residual Risk
RMI
Residual Risk
Same inputs as for
management accounting
Risk weight according to
product characteristics
Fixed
Updated for changes or
dynamically through
automated interfaces,
e.g. ‘People’ via HR
system
Daily management
dashboards
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A Common Risk Measurement and Reporting Framework – Is
This the Future?
• Risk reporting can then be built around 3 core metrics:
– Inherent Risk (RUs) – maximum potential for loss
– Risk Mitigation Index (RMI) – risk mitigation effectiveness
of the operating environment
– Residual Risk (RUs) – inherent risk reduced by risk
mitigation effectiveness
• The 3 core metrics need to be calculated for all transactions
approved for processing per the General Ledger grouped by product
• Accounting for risks of business units, customers, products etc.
using the 3 core metrics results in ‘Risk Accounting’ as an extension
of management accounting
• This has been the vision of academics and others for some years but
finding a viable, replicable and mechanisable method of Risk
Accounting has been the unsolved challenge
• Now it has been done!
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More Information on Risk Accounting is Available via Free
Downloads
On the BIS website:
https://www.bis.org/publ/bcbs258
/unileeds.pdf
On the SSRN website:
http://papers.ssrn.com/sol3/paper
s.cfm?abstract_id=2165034
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