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www.fig-uk.com

The Regulatory Framework...A Change of Direction

Bucharest – 12th March 2014

Confidential

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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“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 MadourosBank of England

”The Dog and the Frisbee”Speech given at the FRB of Kansas City’s 36th Economic Policy Symposium

August 31, 2012

A Central Banker’s View of Basel II and Risk Models

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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 CommitteeFundamental 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. MertonHarvard 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 corporate-governance 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

Updated for changes or dynamically through automated interfaces, e.g. ‘People’ via HR system

Daily management dashboards

Risk Metrics

Products / Transactions

V a l u e T a b l eValue Factors Fixed

Inherent Risk Factors

CreditRisk Table

Market Risk Table

Liquidity Risk Table

Risk weight according to product characteristics

Risk Mitigation Factors

Sam

ple

Best

P

racti

ce

Scori

ng

Tem

pla

tes Credit

Assessment & ApprovalQuality

Assurance & MonitoringCredit Risk

Administration

Model Management

Buffer Management

Model Management

Internal Control Evaluation

People

Trading Account Reconciliations

Trading Limits & Controls

Model Management

Electronic Trading Systems

(HFT)

Liquidity Inherent Risk

(RUs)RMI

Residual Risk

Market Inherent Risk

(RUs)RMI

Residual Risk

Credit Inherent Risk (RUs)

RMIResidual Risk

Same inputs as for management accounting

Inputs

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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/papers.cfm?abstract_id=2165034

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Or Contact me...

Paul CosteaTel: +4 0722 301496Email: pcostea@cbp.ro