Recent turmoil shows the internal risk models of many banks are inadequate, underestimating the degree of risk exposure. The Basel Committee must therefore conduct further study before allowing banks to use the internal ratings based (IRB) approach for calculating regulatory capital, says Harald Benink.

The current turmoil in world financial markets, triggered by defaults on subprime mortgages in the US, raises questions about macroeconomic policy, financial stability and the design of financial regulation, including Basel II of which the internal ratings based (IRB) approach is due to be implemented in many industrialised countries in January 2008. The formulation of an appropriate policy response to the uncertainty generated by the current turmoil requires an understanding of developments that have led to the situation today.

The global economy has enjoyed a long period of relatively low interest rates and an ample supply of liquidity. Underlying factors include high savings rates in China and other Asian economies, and low and stable inflation rates in Europe, the US and Japan. In addition, some key countries have maintained unsustainably low interest rates and undervalued currencies. In this macroeconomic environment, fading memories of previous turbulent periods and efforts to reach out for higher yields supported a relatively low risk-premium on credit.

It was inevitable that global imbalances would eventually require an upward correction in the price of risk. As this occurred, it was similarly inevitable that the weakest borrowers would find themselves unable to pay some of their debt obligations. Defaults on subprime mortgage loans in the US must be seen in this light.

In September 2007, in order to draw lessons from the recent financial turmoil, the Shadow Financial Regulatory Committees of Asia, Australia-New Zealand, Europe, Japan, Latin America and the US issued a joint statement in which they identified some important weaknesses in the financial infrastructure, explained how they have contributed to the turmoil observed and analysed appropriate regulatory responses.

In particular, the Committees focused on conduits and special investment vehicles (SIVs), outsourcing of risk assessment and due diligence to rating agencies and credit scoring programs, and the implications of recent turmoil in financial markets for Basel II.

A key weakness in the current period of financial turmoil is the linkage – through either explicit or implicit guarantees – between either conduits or special purpose investment vehicles and sponsoring investment banks and commercial banks. The activities of these conduits and vehicles are extremely complicated and opaque, which is a big part of the problem.

Conduit debt was typically distributed to investors including pension funds, insurance companies and hedge funds. Linkage between a sponsoring bank and the conduit was established either by using puts, guarantees or other mechanisms that transfer residual risks in the conduit back to the commercial or investment bank if and when the value of assets declined significantly.

Underestimating risk

Current regulatory and accounting standards, such as Basel I, fail to recognise sufficiently the degree of risk to the residual risk holders. Uncertainty about the value of assets in the conduits has dried up temporary and permanent sources of funding for the conduits. In Europe, where substantial proportions of the structured

securities have been placed in commercial banks, the declining value of subprime mortgages has engendered uncertainty about the quality of bank assets and contributed to problems in the inter-bank credit market.

This suggests that regulators and supervisors must be concerned not only about the quality and transparency of assets in the conduits, but also about the nature of the obligations and risks that the conduits pass on to banks and banking systems. In particular, they must make sure that bank managers and board members take their responsibility of having a reliable risk management system in place.

In traditional lending, the ability of individual loan officers to analyse and price risk is monitored by senior management and subjected to reputational and career disciplines. Officers that originate a disproportionate number of bad loans are invited to leave the banking business.

In many new forms of lending, responsibility for analysing and pricing loan risk is shifted to credit scoring programmes and outsourced to credit rating agencies. Because data on loan defaults develop slowly, loan officers

are rewarded more for the quantity than the quality of the loans they originate. This reward structure is particularly inappropriate for low-quality loans such as subprime mortgages.

The ways in which outsourcing due diligence misaligns lenders’ incentives at the origination stage explain many of the problems that are surfacing in structured securitisations. Except in unusual cases when defaults surface early in the life of a loan, investors rather than originators absorb the losses generated by the underwriting mistakes.

To restore investor confidence and discipline in the securitisation process, loan originators must accept the responsibility for tracking the long-term performance of their underwriting staff and establishing systems of deferred compensation that make loan officers share in the losses generated by borrower defaults. The shadow committees urge regulators and industry study groups to address this incentive realignment issue.

Basel II implications

Basel II has been in force in many industrialised countries since January 2007. The standardised ratings approach became applicable in January 2007; the internal ratings based (IRB) approach, to be used by large banks which have made substantial investments in sophisticated risk management systems, will enter into force in the EU and the US in January 2008 and 2009 respectively. Basel II aims to address weaknesses in the Basel I capital adequacy framework for banks by incorporating more detailed calibration of credit risk and by requiring the pricing of other forms of risk. It assigns more responsibility to bankers to implement proper risk governance.

Despite these intentions and the meticulous preparation over a decade, including a series of quantitative impact studies (QISs), recent events challenge the accuracy and usefulness of important elements in Basel II. The standardised ratings approach makes heavy use of debt ratings assigned by credit rating agencies. The wisdom of relying on these ratings is thrown into doubt by the numerous delays credit rating agencies have shown in making appropriate downward revisions in recent months.

In one notable example of delay, the senior tranche of a special purpose vehicle was downgraded 17 notches overnight from a AAA rating when the credit rating agency covering the security finally acted. Such delays are consistent with the research evidence that ratings changes lag increases in market assessments of risk.

Using agencies’ credit ratings for borrowers to set regulatory capital requirements for banks represents an outsourcing of bank supervisors’ responsibilities. As noted, the outsourcing of due diligence places the risk assessment task with agents who have no financial responsibility to cover losses from their mistakes. This suggests that the Basel Committee on Banking Supervision ought to re-evaluate the heavy reliance on credit rating agencies in the standardised approach and insist that supervisors conscientiously introduce their own supplementary assessments into the process.

It is also important that the Basel Committee recognises the incentive conflict between them and the credit rating agencies. The current incentive structure entails the rating agency being paid by the issuer of the securities, which may dampen the agencies’ enthusiasm to highlight weaknesses in the client’s financial condition.

The turmoil also reveals that the internal risk models of many banks, which will be used under the IRB approach, performed poorly and underestimated the degree of risk exposure, forcing banks to ‘re-assess’ and ‘reprice’ credit risk. To some extent, this reflects failure to estimate these models with observations from previous crisis periods and, thus, the difficulties of capturing low probability events in internal models created by large banks under Basel II. On these grounds, the shadow committees urge the Basel Committee to conduct another quantitative impact study using observations from the recent turmoil before allowing banks to use the IRB approach for calculating regulatory capital.

A more fundamental problem related to an internal ratings standard, as noted in a report I co-authored with Clas Wihlborg, professor of finance at the Copenhagen Business School, in 2002 (The New Basel Capital Accord: Making It Effective with Stronger Market Discipline), is that it creates new opportunities for risk arbitrage because risk weights are based on banks’ private information rather than on externally imposed or verifiable variables.

Banks generally have access to private credit risk-relevant information that may be excluded from the system for risk-weighting presented to the supervisory authority. The resulting underestimation of credit risk may be deliberate (in case a bank is consciously over-optimistic about the credit risk) or undeliberate (in case a bank is not aware of the underestimation of the credit risk).

The Basel Committee recognises the potential scope for underestimation of credit risk. Two pillars of Basel II, supervision and market discipline, carry the weight of having to limit this scope. Supervision and market discipline should also limit the scope for non-deliberate underestimation of risk by raising the consciousness and quality of risk assessment.

Interestingly, under Basel II most of the burden of controlling banks’ internal risk assessment is placed on expanded and active supervision (pillar two of the Accord). Supervisory authorities are expected to build up their expertise substantially in both quantitative and qualitative terms. In fact, supervisors are expected to work closely with the banks, when they develop and upgrade their internal risk-scoring models.

This envisioned very close co-operation between banks and supervisors is naturally intended to reduce the information and knowledge asymmetry between banks and supervisors. However, banks will always be able to make decisions based on private information. The intensified involvement of supervisors could instead lead to greater ‘regulatory capture’ in the sense that supervisors identify themselves more strongly with the banks they supervise.

Market discipline

The implication of the discussion so far is that the need for market discipline (pillar three of the Accord) as an instrument to induce banks to hold sufficient capital is stronger under Basel II. By market discipline we mean that banks are given incentives by market participants’ evaluation of banks’ activities to assign costs of capital to credits reflecting the banks’ best evaluation of credit risk from the point of view of share and debt holders.

Market discipline could play a counterbalancing role since the risk assessment by professional investors on financial markets (such as pension funds and insurance companies) would prevent banks from lowering their capital too much and, hence, would reduce the need for (potentially arbitrary) discretionary actions by supervisors based on pillar two.

Pillar three of the Basel II Accord contains many information disclosure requirements. At the same time, however, it fails to create incentives for professional investors to use this information in an optimal way. The reason for this is, as long as professional investors holding bank liabilities have the perception that large banks are too big too fail, they will have the idea that their money is not really at stake, mitigating their incentives to use the disclosed information. A mandatory requirement for large banks to issue credibly uninsured subordinated debt as part of the regulatory capital requirement could improve the strength of pillar three.

Therefore, recent financial turmoil reveals that the internal risk models of many banks, which will be used under the IRB approach, performed poorly and underestimated the degree of risk exposure. To some extent, this reflects failure to estimate these models with observations from previous crisis periods and, thus, the difficulties of capturing low probability events in internal models created by large banks under Basel II. On these grounds the Basel Committee must conduct another quantitative impact study using observations from the recent turmoil before allowing banks to use the IRB approach for calculating regulatory capital.

It is also advocated that the IRB approach be complemented by a more credible and effective form of market discipline. To the international banking community the big advantage of this new approach would be less risk of potentially arbitrary supervisory discretion, since the supervisory assessment of the reliability of a bank’s internal ratings system will be assisted and objectified by the assessment of professional investors on financial markets.

Harald Benink is a professor of finance at the Rotterdam School of Management at Erasmus University Rotterdam and a senior research associate to the Financial Markets Group of the London School of Economics. He is also chairman of the European Shadow Financial Regulatory Committee.

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