The Future of Banking Regulation 78 April 2005, LSE

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The Future of Banking Regulation7-8 April 2005,
LSE

• Oliver Page OBEDirector
• Major Retail Groups Division

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• G10 a key issue - cyclicality

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Stress

• In estimating necessary levels of risk capital,
  the primary concern should be to address those
  disturbances that occasionally do stress
  institutional insolvency - the negative tail of
  the loss distribution that is so central to
  modern risk management. As such the
  incorporation of stress scenarios into formal
  risk modelling would seem to be of first-order
  importance Alan Greenspan

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Pro-cyclicality

• Main risks for banks is still credit risk
• So main potential for Pro-cyclicality is capital
  requirements for credit risk
• Basel 2 makes clear that capital is for
  unexpected losses
• Clear that probability of defaults and the losses
  given default highly cyclical
• So is it a problem?
• Basel 2 tried to ensure not

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Cyclicality in PDs

• Rules require long term view for PDs
• Plus P2 stress test
• Important that banks and supervisors deliver

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Cyclicality in LGDs

• Rules require LGDs cannot be less than the long
  run default weighted average loss
• And if higher in downturns than average, then
  must use downturn values
• i.e. LGDs must reflect economic downturn
  conditions stressed LGDs
• Similarly for EADs
• The problem banks dont have enough data
• to be able to do this

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Why is this an issue
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Why is this an issue
Mortgages
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Summary

• Basel 2 is a contribution to financial stability
• But this requires that cyclicality is dealt with
• Banks and supervisors are not on different sides

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Non-G10

• Implementation of Basel 2 in the near future may
  not be a first priority for all non-G10
  supervisory authorities in terms of what is
  needed to strengthen their supervision
• But
• Basel 2 has a lot to say to banks and supervisors
  on governance, risk management and controls not
  new but rather a codification of what is already
  good practice in well managed banks

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Non-G10

• Pillar 1
• Aim to adopt the standardised approaches as these
  are a material improvement, even if external
  ratings not widespread
• Dont aim to implement the advanced approaches
  too soon nor push banks too early to adoption by
  them
• Press banks to adopt improved governance and
  controls as in Basel 2
• Press banks to adopt advanced risk methods of
  Basel 2 for their own internal use
• Pillar 2
• Apply this whatever approaches are adopted under
  P1
• Press banks to develop capability to assess own
  risks and adequacy of capital
• As a supervisor adopt the supervisory review
• Pillar 3
• In many markets less usable, but worth thinking
  through how market discipline can be made to work

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Conclusions

• Basel 2 is what it set out to be
• A framework that further strengthens the
  soundness and stability of the international
  banking system while maintaining a level playing
  field between internationally active banks
• Achievement of those objectives depends on
  effective implementation