Risk Management Techniques and Systemic Risk Finance Essay

In my opinion, existing risk management techniques are not fit for purpose when examined in the context of overall financial stability. This is because current regulation and risk management techniques focus on protecting individual institutions rather than protecting the economy as a whole. As a result, there is no framework to alleviate systemic risk which has led to financial crises such as the most recent crisis in 2007. Section 1 will begin by defining systemic risk which is a central theme in this discussion. It will then give a brief insight into how the banking system has evolved from the traditional model to the 'shadow' banking system which allows the use of securitization to protect individual institutions from credit risk. Finally, it will identify the negative macro consequences of the 'shadow' banking system. Section 2 will examine the Basel Accords (I and II) to give an insight into past and current regulation of financial markets. Although the Basel Accords originally intended to regulate the macro economy, this section will show that unfortunately this has not been the case. The current focus of financial market regulation centres incorrectly on the micro economy. Section 3 will recommend new regulations for the future with a significant focus on macro-prudential regulation and the implementation of Basel III to ensure financial stability in the future.

Section 1

(a) Systemic Risk Systemic risk is a central concept to this discussion however it is an ambiguous term with no clear defintion. My understanding of systemic risk combines three frequently used concepts as outlined by Kaufman & Scott in 2003: When a large unexpected shock occurs, it has negative consequences for the entire banking, financial or economic system, rather than just affecting a few institutions. This definition distinguishes between the entire system as one entity (macro) and individual institutions (micro). Risk management techniques should consider both the macro and micro consequences of an event. However, up to the present day risk management techniques have concentrated on micro events. (b) Evolution from Traditional to 'Shadow' Banking System In the traditional banking model, banks were obliged to hold loans (and associated risks) until they were repaid. (Brunnermeier, 2009) If the bank issued a twenty year mortgage, it was obliged to hold this mortgage and its risk of default for the full twenty year term. However, the banking system underwent a transformation that led to loans being pooled, tranched and resold through securitization. This 'shadow' banking system got its name from the fact that it sold short-term asset backed investments that were not recorded on the balance sheet. (Brunnermeier, 2009) Rather than a bank holding a twenty year mortgage, it was pooled with other loans, rated according to its risk level and sold to an investor who was willing to take on that level of risk. The aim of this technique was to identify risk accurately and divide the various levels of risk between parties who could easily bear them. (Caprio, Demirgüç-Kunt and Kane, 2008) However, this was a micro-focused technique allowing individual banks to protect themselves from risk by offloading it to investors. Unfortunately, this technique also had negative macro effects. (c) Macro Effect of 'Shadow' Banking System Securitization has had significant effects on the economy as a whole as it led to a decrease in overall credit quality and increased access to home ownership. There was no incentive for a bank to monitor the quality of loans it created when it didn't have to bear the consequences of default on a bad loan. Instead, there was an incentive to issue poor quality loans because this risk was passed on and the individual bank was protected. This is why mortgages were approved for individuals who were previously viewed as less creditworthy under the traditional banking model when banks were not able to offload risk. Therefore, securitization through the 'shadow' banking system increased access to home ownership. (Caprio, Demirgüç-Kunt and Kane, 2008) These mortgages were granted under the false pretence that house prices would only increase so there was no need to undertake background checks. It was believed that if a mortgage holder couldn't afford to make repayments, they would always have the option of using the increased value of the property to refinance the loan incurring no loss. (Brunnermeier, 2009) Ultimately, this was not the case and mortgages were approved to people who now cannot afford to repay them. This was due to the shock of the recession causing the property bubble to burst and house prices to fall significantly. Therefore the macro effects of the 'shadow' banking system are that overall credit quality has fallen and home ownership has been extended to people who cannot afford it.

Section 2

Basel I Basel I was implemented in 1988 to regulate capital requirements in banks. It aimed to ensure banks had enough capital to cope with unexpected losses in order to protect the global financial system. (Council of Mortgage Lenders, 2010) Evidently, the aim of Basel I was macro-prudential regulation. However, it regulated in a way that continued to provide incentives for banks to act recklessly in order to protect themselves. Banks were required to hold total capital of 8% of risky assets, with 4% of this held as Tier 1 Capital i.e. shareholders' funds and preference shares. (Caprio, Demirgüç-Kunt and Kane, 2008) Basel I further encouraged securitization because securities backed by mortgages were considered less risky (20%) than holding mortgages themselves (50%). Therefore Basel I failed to protect the global financial system due to its micro focus. In section one I have already identified the significant negative consequences of securitization for the macro economy. (Caprio, Demirgüç-Kunt and Kane, 2008) Basel II Basel II was implemented in 2008 to promote stronger risk management practices and address the weakness that Basel I was too simple. Basel II consists of 3 pillars relating to minimum capital requirements, supervisory review of banks' capital adequacy and strengthened market discipline of capital adequacy. Borio (2008) claims that Basel II is a much better method of regulation than Basel I. Pillar One ensures that capital is much more sensitive to the relative riskiness of exposures. It measures risk according to external credit ratings assigned to the borrower rather than having a fixed risk weighting as seen under Basel I. Where a residential mortgage was weighted as having a 50% credit rating under Basel I, this may be higher or lower depending on the risk associated with the particular borrower under Basel II. This seems more appropriate as mortgages do not carry a single risk level. In this manner, Pillar 1 reduces opportunities for regulatory arbitrage. In the most recent 2007 crisis, investors trusted credit rating organisations to assess risk on their behalf until it was too late and it became apparent that these ratings could not be trusted. They did so because they only had to hold the risk for a few months until it was passed on to the next investor in the securitization chain. It was easy for them to trust that credit ratings were correct because if they weren't, it was unlikely that they would personally suffer a loss. Basel II promoted holding assets with good credit ratings while underestimating the fragile position of banks' portfolios. In the U.S. many highly rated securities have since defaulted and been downgraded proving that they should not have been rated so highly in the first place. (Caprio, Demirgüç-Kunt and Kane, 2008) Pillar 2 gives national regulators discretion to require additional capital to the minimum in order to compensate for additional risks that are not captured under Pillar 1. (e.g. interest rate risk) which may apply to individual institutions. This is a significant development from Basel I. It recognises that individual banks are faced with different risk factors. By allowing individual institutions to protect against individual risk, this should protect the financial system as a whole. Pillar 3 aims to improve market discipline and risk disclosures by requiring financial institutions to provide details of their risk management and risk distributions through the publication of financial statements. Unfortunately, Basel II does not include any measures to prevent financial institutions from becoming insolvent. It also doesn't impose any requirements on regulators to step in and implement corrective action if this does occur. This implies that under current regulation, banks may not be able to cope with shocks to the system which may lead to negative consequences for the macro economy.

Section 3

Basel III Objective In September 2009 the Basel Committee agreed the basic framework for a new agreement, Basel III. This agreement aims to implement both micro and macro regulation to improve the ability of banks to absorb shocks arising from both economic and financial stress (it also includes the aims of previous Basel agreements to improve risk management and transparency). In essence, the Basel committee is attempting to alleviate systemic risk from financial markets in the future. Basel III should be fully implemented by 2018. (Bank for International Settlements, 2010) Basel III Techniques In 2008, Caprio, Demirgüç-Kunt and Kane recommended that a 'simple leverage requirement' is worked into Pillar 2. They believed that the current emphasis on weighting risk is a mistake and that this technique should be abandoned. In its place, they recommended that all items, both on and off the balance sheet should be included in a ratio that determines maximum leverage. This would include securitized assets and would eliminate arbitrage opportunities to acquire securitized products in order to minimise capital requirements as was the case under Basel I. The Basel Committee have announced that Basel III will supplement risk based capital requirements with a non-risk-based leverage ratio. This will reduce the emphasis on risk weighting. These combination of these two methods will result in a stronger treatment of non balance sheet items. (Bank for International Settlements, 2010) Basel III recognises that not all financial institutions pose systemic risks. Persaud (2009) advises that systemically important banks should receive closer scrutiny and have a greater requirement to contain their behaviour. Basel III has acknowledged this need for systemically important institutions to have a loss absorbing capacity beyond the minimum standards. This improves upon Basel II which did not include any method to reduce the risk of insolvency to institutions. Requiring systemically important banks to hold more capital will reduce their risk of insolvency. In short, Basel III has proven that we do not need more regulation, we need better regulation. This latest agreement addresses the need for an increased focus on macro prudential regulation. By regulating individual institutions in this manner with a view to protecting the overall macro economy, systemic risk can be alleviated.

Conclusion

Although Basel I and II aimed to protect the global financial system, they regulated in a way that provided opportunities for individual banks to gain through the 'shadow' banking system that encouraged securitization. Ultimately, they encouraged micro risk management techniques that had negative implications for the overall economy. However, Basel III has moved away from this approach by introducing a non-risk based leverage ratio that will regulate in a way that monitors all assets both on and off the balance sheet. This means that banks will not be able to gain via securitization in the future. This, together with recognising that some financial institutions are of greater systemic importance and must be monitored more closely will lead to better regulation focused on the macro economy in future years. To conclude, I agree with Persaud (and it seems the Basel Committee also) that micro-prudential regulation is not adequate by itself and must be complemented by macro-prudential regulation that 'catches the systemic consequences of all institutions acting in a similar manner.' We cannot prevent crises but we can reduce the number of them and their impact by implementing better regulation with a greater focus on macro-prudential regulation. (Persaud, 2009)

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