As Gulf banks continue to push towards Basel II capital framework compliance, and many have met the conditions already, at least on the standardised approach, the credit crisis has raised questions on standards, regulations and supervision.
With the introduction of new banking rules under Basel II, rules and regulations have become more complex. Moreover, the credit crisis has highlighted deficiencies in a number of areas of the new standards and, inter alia, methodology.
Securitisation structures, the creation of securities from assets with predictable cash flows, brings together lenders and borrowers. It provides credit to borrowers who may not have found it easy to do so through the conventional banking system. For some time this alternative channel generated strong growth and innovation on both sides of the balance sheet. In the first half of 2007 it became evident many collateralised debt obligation vehicles, structured investment vehicles (SIVs) and SIV-Lites, supported by mortgages, were vulnerable as many, particularly the international rating agencies, misjudged the risk connected with these mortgages and the structures within.
Problems increased when the SIVs and SIV-Lites faced severe funding cutoffs and accordingly could not roll over their commercial paper. The crux of the problem, the maturity mismatch between long-dated assets and short-term liabilities, was ignored or not noticed by large global rating agencies and investors. Indeed, these investment vehicles found their way into the portfolios of top-graded AAA-rated liquidity funds. Exacerbating the problem were questionable modelling techniques used to analyse the structures and flows.
Basel II’s new rules to determine capital adequacy for internationally active banks came into being on Tuesday.
Basel II outlines the methods banks can use internally to determine minimum capital requirements. Pillar one of Basel II sets two alternatives. The first, the standardised approach, relies on external credit assessments by external credit rating agencies. The second advanced approach, the internal ratings-based approach, allows banks the opportunity to use their own internal models to estimate credit risk.
Another premise of Basel II is the principle of ‘self-regulation’ by which large banks with sophisticated risk management systems can monitor and control their own risk. However, neither regulators nor the banks truly understand the risk profile of complex and sophisticated trading and asset positions, as has been demonstrated by the losses sustained in recent months. The value at risk (VAR) system, for example, carries an underlying assumption that by analysis of past data, a 99 per cent VAR can be determined, which provides a reasonable assessment of a position’s risk, and is likely to be inaccurate by only a moderate amount. Basel II allows banks to assess their risk levels based on their 30-day VAR, which is supposed to be the maximum loss that can arise over a 30-day period – and provide capital accordingly.
VAR is a key tool for risk assessment in the Basel II regulations. VAR can provide an estimate of the maximum loss a portfolio is likely to experience, generating a single number that represents the worst outcome. It also is able to recognise the fact different types of securities have different responses to the same event, providing a more complete prediction. Although financial institutions relied on VAR to assess risk, they have often failed to recognise that the analysis of mathematical models is based on the assumption the future will look like the past. The models estimating default probabilities for the sub-prime market assumed real estate prices would continue to rise.
Critics of the model say it is impossible to determine anything solely from financial data, especially risk, which by definition is uncertain even for the most advanced mathematical models.
The upheaval in the financial markets and the wide off the mark, and slow to react, ratings attached to structured assets and collateralised debt again raises the question on the credibility, accuracy, and timeliness, of ratings assigned by the big three global rating agencies. Their ratings will form an integral part of Basel II.
Moreover, banks, mainly the flagship international institutions, have also been deficient in their judgement of risk and exposures in a number of cases. The large focus on ratings and internally based models brings into question the reliability of banks’ capital models and positions going forward.
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