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Systemic risk models: issues and prospects Discussion by: Kostas Tsatsaronis Bank for International Settlements FMG / CCBS conference Macroprudential policy: issues and challenges London, 2 November 2010 1 Disclaimer I am speaking for myself. The views expressed are not necessarily those of the Bank for International Settlements or of the Basel Committee on Banking Supervision 2 Overview of paper A pragmatic approach to dealing with systemic risk Observation: • Risk measurement technology is not yet up to speed in capturing the complexities of financial system behaviour Conclusion: • We cannot play “god engineer” with micro-prudential tools and actively protect institutions from shocks • We should pay more attention to prevention and to reducing the systemic/economic costs given a shock 3 My take … I very much agree with the observation • I would even strengthen some of the messages I would qualify the conclusion Things are moving to the right direction The tougher part would be to change mindsets of private sector as well as supervisors 4 Complex nature of financial system risk The financial system is not a collection of introvert individuals Interactions are complex and “non-linear” The whole is larger (more complex) than the sum of the parts • Individual institutions think of themselves as price takers when they are really shaping the environment they live in • Some more than others… Risk assessment is very tricky business 5 Systemic risk measurement is problematic We do not yet have robust, manageable models of interactions that can be used for analysis of macrofinancial risk How can we calibrate the instruments of policy? • ex ante engineering is tricky How can we assess policymakers’ success ex post? • Political economy , governance 6 The pitfalls of relying on market prices Prices are particularly unreliable indicators of risk because they are part of the problem Large shocks are by definition not embedded in prices: if they were we would not have crises • True meaning of the “efficient markets” proposition They can almost be seen as contrarian indicators I am very sceptical about any model/measure that relies exclusively on prices • Especially those with short horizons because it claims that the past is not the best description of the future 7 So what we do? Multi-pronged approach: • Active protection: try to make institutions more robust to shocks • Prevention: try to reduce the likely size of the shocks so to reduce the stress on institutions • Passive protection: make sure to contain damage once hit by a shock Do not obsess with the first (limits to effectiveness) and develop the second and third 8 What do we do? Hard to disagree • Diversification usually helps in the presence of risk and uncertainty. • Consistent with what macroprudential perspective implies • Some of it already happening I would add: • Rules of thumb • Changing mind frames 9 Rules of thumb There are empirical regularities in systemic episodes that can be exploited • Credit and asset price booms precede busts • Pretty decent track record in detecting forthcoming problems • Important: adopt a longer horizon and forget about timing 10 Credit, asset prices and the financial cycle 1.5 30 1 Credit/GDP (rhs) Property prices (rhs)1 Charge-off rate (lhs)2 1.0 20 0.5 10 0.0 0 –0.5 –10 –1.0 –20 80 85 90 95 00 05 11 Rules of thumb There are empirical regularities in systemic risk that can be exploited • Credit and asset price booms precede busts • Can be detected with good track record once we adopt a longer horizon and forget about timing • Asset price mean reversion literature • How did Warren Buffet make his money? Understanding the financial cycle by following macro- economists’ example • Model-free analysis / NBER approach 12 Changing mindsets That’s a tough one Private sector needs incentives to break away from group- think mode, broaden the horizon for its analysis and its understanding of macro-type risks Policymakers have to make the same transition in perspective and develop a healthier appetite for acting on contrarian instincts • After all they are “overweight” the bad side of the distribution 13 Practical example: Basel III countercyclical buffers Simple system of increasing (micro) capital requirements in boom times and allowing them to be consumed in bad times Authorities use judgment in calling the boom and bust phases (flexibility)… …but there is a simple guide (credit-to-GDP gap) deviations from which need to be publicly explained (discipline) Main objective to protect the banks form the system Side effect: contribute to dampening of procyclicality 14 Novel features Use of buffers (not minima) Link to a macro variable (not the internal models, spreads or ratings) • Simple, relatively robust indicator Blending of rules with discretion Public communication: • “Comply or explain publicly” • Force supervisor to take a stance on the state of the financial cycle Potential for contributing to the change of mindsets 15 THANK YOU ! [email protected] 16