Quantifi whitepaper basel lll and systemic risk

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One of the key shortcomings of the first two Basel Accords is that they approached the solvency of each institution independently. The recent crisis highlighted the additional ‘systemic’ risk that the failure of one large institution could cause the failure of one or more of its counterparties, which could trigger a chain reaction.

Basel III addresses this issue in two ways:

1) by significantly increasing capital buffers for risks related to the interconnectedness of the major dealers and
2) incentivising institutions to reduce counterparty risk through clearing and active management (hedging). Since Basel III may not explicitly state how some of the new provisions address systemic risk, some analysis is necessary.

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Quantifi whitepaper basel lll and systemic risk

  1. 1. Basel III andsystemIc rIskDAvID KElly, Director of Credit, QuantifiOne of the key shortcomings of the first two Basel of 3%, subject to further calibration. There are twoAccords is that they approached the solvency of reasons for this addition. First, countries that imposedeach institution independently. The recent crisis a leverage ratio, e.g., Canada, seemed to fare betterhighlighted the additional ‘systemic’ risk that the during the crisis. Second, the leverage ratio servesfailure of one large institution could cause the failure as a form of safety net for the capital ratio, which isof one or more of its counterparties, which could vulnerable to arbitrage in both the numerator (capital)trigger a chain reaction. and denominator (risk-weighted assets).Basel III addresses this issue in two ways – 1) by In addition to the leverage ratio, Basel III introducessignificantly increasing capital buffers for risks a short-term liquidity coverage ratio and a longerrelated to the interconnectedness of the major term net stable funding ratio, designed to addressdealers and 2) incentivising institutions to reduce the duration mismatches in bank assets and liabilities.counterparty risk through clearing and active Banks fund a substantial portion of assets in themanagement (hedging). Since Basel III may not repo markets and when these markets froze due toexplicitly state how some of the new provisions declining mark-to-market collateral values, inter-bankaddress systemic risk, some analysis is necessary. lending also dried up causing systemic shocks. The link between liquidity and leverage amplified theseBasel III Provisions shocks. This linkage comes from widening haircutsBasel III substantially raises the amount and quality of on repo collateral, which banks must fund with theircore Tier 1 capital from 2% to 7%, plus introduces an own capital. Ultimately, these liquidity requirementsadditional countercyclical buffer of up to 2.5% and a are intended to prevent another ‘run’ on the shadowdiscretionary surcharge for ‘systemically important’ banking system and global seize-up of credit.institutions, i.e., the big dealers. It also fixes knownmispricing of securitisation risks, which is very One of the critical sources of liquidity risk came fromimportant given the fundamental role of securitisation short-term funding of securitised assets in the repoin the global banking system. Another key innovation is markets, a practice that banks had ramped up tothe inherent recognition that the risk-weighted capital take advantage of regulatory arbitrages. Basel I and IIratio alone is not sufficient. Basel III supplements under-priced risk weights for securitisations allowingthe capital model with a leverage ratio and liquidity banks to increase leverage (and returns). They furtherrequirements. Each of these enhancements has a increased leverage by manufacturing additionalsystemic risk management objective. super senior collateral through re-securitisation (e.g., CDO-squareds). The fact that Basel made noRestricting the leverage of major dealers is clearly distinction for re-securitisations encouraged thisimportant from a systemic risk perspective. Basel III activity. Banks also moved securitised assets fromadds a minimum Tier 1 balance sheet leverage ratio the banking book to the trading book to access the
  2. 2. more favourable capital treatment. Basel III (II ½) of the higher capital requirements on the real economy,firmly addresses all of these regulatory arbitrages banks may choose to curtail or exit certain lendingwhile providing a detailed ‘carve out’ for dealers with businesses if the returns are too low. A consequencesufficiently robust risk management processes. could be the expansion of the unregulated and relatively opaque sector of the shadow bankingAlong with the supplemental leverage and liquidity system to fill the credit gap.measures, the core capital model has been enhancedto address systemic risks more effectively. Capital The second set of challenges is structural. Banks aremodels typically involve (Monte Carlo) simulations moving toward active management of counterpartyof future market scenarios using historical volatilities risk. However, there is limited or no liquidity in CDSfor the relevant market factors. An obvious weakness contracts needed to hedge a significant numberis that volatility tends to go down in normal (stable) of counterparties and institutions will continue totimes, resulting in lower capital reserves. Correlations manage a substantial portion of counterparty creditalso tend to be under-estimated during normal risk through traditional reserves and exposure limits.times. Conversely, when volatilities and correlations The residual counterparty risk portfolio is essentiallyspike during a crisis, banks are forced to raise capital a pool of loans and therefore fraught with theand deleverage as credit markets tighten. Basel III complexities of CDO structures. These complexitiesattempts to mitigate this ‘procyclicality’ through new include model specification and configuration,capital charges for ‘stressed’ CvA vaR and correlation manipulating large and diverse sets of positionbetween financial intermediaries, which are expected and market data, and managing unhedgeableto more than triple counterparty risk capital. correlation and basis risks. Therefore, counterparty risk portfolios will continue to be susceptible toWith the dramatic capital increases, Basel III large unexpected losses.incentivises banks to actively manage (hedge)counterparty risk. Many larger banks already hedge Another structural issue is related to clearing. Whilea significant portion of counterparty risk through the near zero risk weight encourages dealers tocentral CvA desks and there appears to be general clear CDS and other hedge transactions, not allconsensus and movement towards this model, products will be cleared, which means a critical massaccelerated by Basel III (and the desire to reduce of bilateral counterparty risk will likely remain in theearnings volatility). However, there are immense system. Clearinghouses may also specialise in specificoperational and practical challenges in setting products, potentially increasing net counterparty risk.up a CvA desk. The main operational challenges Finally, a clearinghouse could conceivably fail andinvolve gathering position and market data and there is no evidence that the 1-3% risk weighting willimplementing scalable technology with robust CvA provide an adequate capital cushion to contain theanalytics. Some of the practical issues are illiquidity systemic fallout.of many names, managing residual correlation andbasis risks, and handling of DvA. DvA represents again (that can never be realised) based on the creditquality of the trader’s own institution and can’t behedged with CDS.Clearly, the best hedge for counterparty risk iscollateral. While dealers typically have margin About Quantifiagreements between them, central clearing Quantifi is a leading provider of analytics, trading andstandardises the process and enforces tighter risk management software for the global capitalcontrols around collateral risks and re-hypothecation. markets. Top-tier financial institutions in over 15Clearing also helps immunise the system from the countries trust Quantifi to provide integrated pre andfailure of any one big bank. Basel III assigns a minimal post-trade solutions that better value, trade and risk(1-3%) risk weight for cleared transactions, thereby manage their exposures, allowing them to respondfostering central clearing and the systemic benefits. more effectively to changing market conditions.ConclusionsWhereas Basel III represents progress, there are several London + 44 (0) 20 7397 8788ongoing challenges. The first set of challenges has to New York + 1 (212) 784 6815do with the regulation itself. The timeline provides for a Sydney + 61 (02) 9221 0133phased implementation period extending out to 2019.Another crisis could certainly occur within that time. enquire@quantifisolutions.comWhile quantitative studies have shown limited impact www.quantifisolutions.com

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