“Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence-especially in cases in which large short-term debts need to be rolled over continuously-is the key factor that gives rise to the this-time-is-different syndrome.Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang!-confidence collapses, lenders disappear, and a crisis hits.” – This Time is Different (Carmen M. Reinhart and Kenneth Rogoff)
Not just in 2008, every major financial cataclysm in recent times has been a result of the derivative market running amok. Orange County’s bankruptcy in 1994, Long Term Capital Management in 1998, the Russian rouble crisis, Argentine default, Mexican peso etc – the list goes on and on. And the response from the government and the Fed in the vast majority of cases has been a bailout.
The below pictorial (courtesy AT Kearney) captures a timeline of the events that led to the great financial meltdown of 2008.
Source – https://www.atkearney.com/paper/-/asset_publisher/dVxv4Hz2h8bS/content/seven-tenets-of-risk-management-in-the-banking-industry/10192
The set of events that cascaded down in 2008 was incredibly complex and so were the causes in terms of institutions and individuals. Many books have been written and more than five hard-hitting documentary films made on what is now part of history.
Whatever be the mechanics of the financial instruments that caused the meltdown – one thing everyone broadly agrees on was that easy standards with respect to granting credit (and specifically consumer mortgages in the US with the goal of securitizing & reselling them in tranches – the infamous CDO’s) were the main causes of the crisis.
Banks essentially granted easy mortgages with the goal of securitizing these and selling them into the financial markets as low risk & high return investments. AIG Insurance’s financial products (FP) division created & marketed another complex instrument – credit default swaps – which effectively insured the buyer from losses in the case any of the original derivative instruments made a loss.
Thus, the entire house of cards was predicated on two broad premises –
1. that home prices in the bellwether US market would always go up
2. refinancing debt would be simple and easy
However, prices in large housing markets in Arizona & California first crashed leading to huge job losses in the construction industry. Huge numbers of borrowers started to default on their loans leaving Banks holding collateral of dubious value. Keep in mind that it was very hard for banks to even evaluate these complex portfolios for their true worth.
None of their models predicted where things would end up in the event of the original loans defaulting – which all followed pretty quickly.
The overarching goal of any risk management regulation is to ensure that Banks understand and hedge adequately against these risks.
There are a few fundamental pieces of legislation that were put in place precisely to avoid this kind of meltdown. We will review a few of these – namely Basel III, Dodd Frank and CCAR.
Let’s start with Basel III.
Basel III (named for the town of Basel in Switzerland where the committee meets) essentially prescribes international standards for capital & liquidity adequacy and were developed by the Basel Committee on Banking Supervision with voluntary worldwide applicability. The Bank of International Settlements (BIS) established 1930, is the world’s oldest international financial consortium. with 60+ member central banks, representing countries from around the world that together make up about 95% of world GDP. BIS stewards and maintains the Basel III standards in conjunction with member banks.
The goal is to strengthen the regulation, supervision and risk management of the banking sector by improving risk management and governance so that a repeat of 2008 never happens where a few bad actors and a culture of wild west risk-taking threatens main street. Basel III (building upon Basel I and Basel II) also set a criteria for financial transparency and disclosure by banking institutions.
Basel III sets an overlay framework called “Pillars” in three major areas.
Pillar 1 covers
– the levels and quality of Capital that Banks need to set aside. There is now a minimum standard for high quality tier 1 capital
– Risk coverage in terms of credit analysis of complex securitized instruments
– Mandates higher capital for trading and derivative activities
– Standards for exposures to central counter-parties (CCP)
– A leverage ratio for off balance sheet exposures
Pillar 2 mandates firm-wide governance and risk exposure extending to off balance sheet activities.
Pillar 3 revises the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. The overarching goal of Pillar 3 is to provide market participants & bank boards with standard metrics to sufficiently understand a bank’s activities.
As a result of the Basel III standards and the list of Phase In arrangements that can be found here – http://www.bis.org/bcbs/basel3/basel3_phase_in_arrangements.pdf, Banks will have to raise, allocate and manage increased & higher quality reserves (equity and retained earnings) over the next few years which will have an impact on profitability. Basel III also looks to stabilizing the leverage ratio as a incremental multiple of the banks capital to prevent runaway risky betting which can destabilize the whole system .
Banks will need to conform to specific qualitative measures – the important ones being a tier one capital adequacy ratio, capital conservation buffer, minimum tier one capital, net stable funding ratio (NSFR) etc. The committee lays out specific targets (all risk weighted) all the way to 2019.
We will focus on Dodd-Frank,CCAR and BCBS 239 in the next post. The final part of this series will discuss the capabilities that are lacking in legacy IT risk platforms and how these gaps can be well filled by Big Data technologies.