0711 Three Intertwined Topics

1
07-11Three Intertwined Topics

• Fair-value Accounting for Capital and Income
• Challenges Bank Managers face in Identifying and
  Managing the Model Risk in Fair-Value
  Measurements of Bank Loans
• Efforts of Basel Committee on Banking to
  Strengthen the Role of Capital Requirements in
  Controlling Safety-Net Subsidies Across Countries

2
Topic I U.S. Banks are being pressed to adopt
fair-value accounting for GAAP balance sheets.

• This would better match values shown for
  hedgeable items with the mark-to-market
  accounting FASB required for hedges and rules
  required for branches and subsidiaries operating
  in foreign countries.
• 2. Use of fair values has been optional
  internationally for a while, but was not
  available for U.S. banks until years beginning
  after January 1, 2007.

3
This discussion of Fair Values and Financial
Reporting isadapted from May 31, 2007presention
by Thomas J. Linsmeier of the Financial
Accounting Standards Board.
4
FASB Definition of Fair Value

• Definition fair value is the price that would
  be received to sell an asset or paid to transfer
  a liability in an orderly transaction between
  market participants at the measurement date.
• Key attributes
• Does not require an actual transaction
• Does not require that a market exist
• Based on whatever information is current at the
  measurement date, including statistical
  information about the dispersion of possible
  outcomes

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Statement 157 (FAS 157) Fair-Value Measurements

• Framework for measuring fair value from the
  perspective of the reporting entity
• Identify the particular asset or liability
  consider level at which the asset or liability is
  aggregated or not (unit of accounting).
• Identify Highest and Best Use for an asset or
  Lowest Price to transfer (not settle) a
  liability.
• Based on b., identify the Valuation Premise
  (either in-use or in-exchange) to determine
  whether the asset or liability should be valued
  individually or within larger group.
• Determine the principal market (or if that is not
  known the most advantageous market) for the
  exchange of the asset or liability considering a,
  b, and c.
• Determine the valuation technique(s) (market,
  income or cost approach) that market participants
  would use to determine a price (consider
  availability of inputs).

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FAS 157 Fair-Value Measurements (continued)

• Exclude transaction costs.
• To the extent possible, use observable inputs
  (Level I (Identical assets) and II (comparables
  inputs that are market-corroborated)
• Determine unobservable inputs (Level III) about
  assumptions market participants would use based
  on the best information available including
  assumptions about Risk Premiums, highest and best
  use (if asset) and nonperformance risk (if
  liability).
• Inputs based on the reporting entitys data, if
  that is the best information available, shall be
  adjusted if there are data available without
  undue cost and effort indicating that market
  participants would use different inputs.

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FAS 157 Fair-Value Measurements

• Goal use observed prices if available
  otherwise, use techniques, models and assumptions
  that market participants would use
• Observations
• Fair-value measurement is based on an economic
  foundation for the measurement objective (exit
  price) allocated transaction amounts have no
  similar economic foundation
• Fair-value estimation errors can be tested
  against economic facts and economic conditions in
  ways that allocation errors cannot
• Discipline on choice of techniques and inputs is
  provided by the requirement to use techniques and
  assumptions that market participants would use

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Controversy over Measurement

• Net income Cash /- accruals/deferrals /-
  estimates /- fair-value changes
• Accounting manipulation cannot be focused or
  blamed on one account.
• SEC enforcement actions demonstrate that vast
  majority of accounting manipulations are in
  accruals/deferrals and estimates and not in
  fair-value changes.
• Still, fair values are subject to manipulation
  when prices cannot be observed.
• Manipulations cause market problems
• For highly leveraged FSFs, conservatism differs
  between up and down markets In SL Mess
  Impairments were not acknowledged.
• Problem must be framed as providing (imperfect)
  financial information that can best facilitate
  business and capital market allocations
• Will involve tradeoff between relevance,
  verifiability, and reliability
• Operative accounting standards differ with
  instruments and circumstances

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Conceptual Framework of Fair Value

• The FASBs Conceptual Framework provides
  definitions and characteristics for information
  recognized or merely disclosed in the financial
  statements
• Basic characteristics for any recognized or
  disclosed financial statement item include
• Relevance
• Can a recognized or disclosed item improve
  financial-statement users decisions?
• Reliability
• Can users of financial report depend on the
  reported numbers to represent the economic
  conditions they purport to represent?
• Verifiability
• Can reliability of source data be verified?

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Fair-value measures Relevance

• Intent of using the fair-value measurement in
  financial reporting is to increase the relevance
  of reported numbers
• Fair value is the only measurement attribute for
  some items, including many derivatives
• Example On-market interest-rate swaps have zero
  historical cost
• Fair value is the most relevant attribute for
  (many) ongoing positions
• Example Marketable securities
• Fair-value measurement is based on current
  economic conditions, including current
  information about the dispersion of possible
  outcomes (i.e., risk)
• Aggregates and summarizes more information
• Timely (relative to waiting to book change in
  value based on the ultimate settlement)

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What do opponents of fair-value measures say?

• Claim Fair-value measurement in the absence of
  observed prices introduces an intolerable amount
  of measurement error
• What is the actual reliability of fair-value
  measures?
• Sometimes very reliable when based on observed
  prices
• How reliable are fair-value measures compared to
  other reported numbers that are based on
  estimates and judgments?
• What are the causes of unreliable measures?

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Fair-value measures-Reliability

• Reliability components
• Representation faithfulness Correspondence
  between the measure and the phenomenon being
  measured
• Are allocated historical amounts (i.e.,
  depreciated values) more representationally
  faithful than fair values?
• Verifiability Consensus among measures of the
  same item
• Implies low dispersion of independent
  measurements. While vouching or confirming is
  one way to verify, verifiability does not require
  that the measure can be vouched or confirmed to a
  separate source
• Key issue can this verifiability test be made
  operational for auditors?

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Verifiability and Approximation-Error Issues must
also be faced in Loss- Reserving

• Both government and stockholder components of
  Bank Capital lack transparency. We have described
  many ways FSFs can use accounting leeway to
  confuse regulators and lessen the observability
  of adverse changes in net worth
• Delay asset writedowns restructure to re-age
  hopeless loans
• Employ optimistic loss reserving
• Engage in gains trading or book nonrecurring
  items
• Falsely deny materiality of adverse events
• Use residual Z tranches of securitizations and
  structured derivative transactions to mask losses
  and risk exposures.

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Management-Induced Measurement Error

• Lack of markets means no observable transaction
  amounts that can be used for vouching or
  confirming
• Estimate are produced by management, so they
  include purposeful management-induced error
• Management-induced error is due to defective
  incentives and to failures of internal control,
  oversight, governance, auditing and enforcement.
  It is therefore (in principle) under the
  collective control of participants in the
  financial reporting system
• Is it appropriate to use a measurement principle
  to address concerns about management-induced
  error? Bias can be controlled by liability for
  false attestations and certifications
• Accountants lack expertise in using statistical
  tools and models
• Provides an overdue opportunity for finance
  educators and professionals to add value to the
  measurement process

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Issues in obtaining reliable measures

• All value-measurement tools are models. A model
  is a deliberately simplified approximation to a
  real-world process or decision. An ideal model
  offers the optimal simplification for
  accomplishing the purposes it is constructed.
• Valuation models and techniques are based on
  assumptions that simplify the valuation task and
  make it tractable.
• Simplifying assumptions introduce measurement
  error
• Research seeks to improve models and their
  applications over time.
• Valuation models require inputs, some of which
  are forecasts and expectations. These inputs are
  bound to contain some error.
• Observations
• Over time, improvements in information systems
  and valuation techniques will alleviate some
  difficulties
• Research seeks (1) to trade off costs and
  benefits of alternative approaches and (2) to
  explicitly account for or minimize bias.

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• II. Identifying and Managing Model Risk in
  Fair-Value Measurements

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Ownership Capital acts as a shield against loss
for nonowner stakeholders, including guarantors.
Its thickness protects them as long as it retains
positive value.
MEASURING CAPITAL

• All corporate stakeholders are not equally
  protected against distress. When losses move
  through the Chain of Stakeholders in a workout
  situation, source of capital transitions from
  original owners to less and less senior
  creditors.
• The Transitioning is governed by Enforceable
  Contracting Protections subordination
  covenants collateral escrowed balances.
• Costs and difficulties of fair-value measurement
  vary across jurisdictions and contracting
  protocols.

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A bank needs to post enough capital to support
its unhedged risks. Its depositors and other
stakeholders must be satisfied with the
combination of enterprise-contributed and
taxpayer risk capital that cushions or buffers
the net or enterprisewide risk exposure the bank
passes through to them.
Megatheme Risks that are Not Transferred or
Perfectly Hedged Need Capital Support
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In Oct. 1999, John Reed, then-CEO of Citigroup
said Our objective is to operate with more
capital than were going to need --ever- -so that
you never have to deal with the markets
perception of not having enough capital. Let me
tell you, Im going to be long dead before were
ever undercapitalized again.Lesson he learned
from the near-failure of a major hedge fund
concerns the necessity of looking at
second-order exposures to risks taken by the
banks counterparties Necessary capital is
that which is necessary to take a hit and still
be able to operate effectively within the
marketplace... Citicorp had no direct exposure
to Long-Term Capital Management, the hedge fund
that flirted with a failure in 1998. But
Citibank was the primary lender to half the
companies that came to Long-Term Capitals
rescue... None of these firms had the capital
to sustain the losses.
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• TRUE NW (A - LLR) Liabilities
• To protect depositors, creditors, other
  contractual counterparties, and stockholders, LLR
  decisions that management makes are subject to
  review by
• 1. Board of Directors
• 2. Internal and external auditors
• 3. Bank regulators
• 4. The Securities Exchange Commission (SEC).
• Despite huge advances in relevant databases
  and valuation software, no enforceable obligation
  yet exists for accountants to validate procedures
  statistically. Yet, statistical validation of
  rules is a requirement of science.

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• Conflicting perspectives exist about functions
  that capital and the LLR account are asked to
  perform
• 1. Prudential Reserve
• 2. Valuation Reserve
• 3. Shock Absorber
• In rulemaking, additional conflicts exist across
  various desirable properties that LLR procedures
  might show
• Simplicity of Estimation
• Precision
• Documentability (Verifiability)
• Consistency with Academic Analysis of Loss
  Factors
• Consistency Both Across Accounts at Same
• Bank and Across Different Banks

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CONFLICTS IN PURPOSE JUSTIFY EXCEPTIONS TO
PRINCIPLE OF TRUE AND FAIR REPORTING

• LLR should be adequate to absorb credit losses
  that are probable and estimable on all loans.
• However, some important exceptions are allowed by
  GAAP
• Losses need not be estimated for loans that are
  not delinquent.
• Chargeoffs and provisioning may be estimated by
  mechanical methods that do not surface the
  lenders best estimate of changes in the
  discounted present value of collectable future
  payments.
• Loans can pass down i.e., migrate across the
  borders of the various criticized categories
  without triggering either additional provisioning
  or chargeoffs.
• Similarly, observed violations of covenants need
  not trigger additional LLR provisioning.

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Sources of Model Risk in Fair-Valuing Bank Loan
Portfolios

• Most loans never trade.
• All banks apply a present discounted value (PDV)
  model to the stream of expected future cash
  flows
• C1, C2, CT.
• But methods for establishing the CTs and discount
  rates are not standardizable for many deals. How
  to handle
• Private information?
• Optionality in contracts (prepayments
  conversions drawdowns collateral and other
  coventant rights and resulting quids)?
• Illiquidity premiums imbedded in discount rates?
• Credit Default Swap market can help, but best
  information only covers high-rated names.

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Validating and Managing Models of Loan Value is a
Long, Long Road

• Top managers must oversee the costs and benefits
  of the validation process.
• Team of competent professionals must be
  assembled, empowered, and given up-the-line
  reporting responsibility. (Dangers of
  Outsourcing and Off-shoring?)
• Families of models used in different parts of the
  FSF muct be inventoried, categorized as to
  materiality, tested, and scheuled for re-testing
  at regular intervals.
• Imbedded assumptions in PDV models concern
  probability distributions in different cycle
  stages
• Probabilities of default (PD)
• Exposures at default (EAD)
• Loss given default (LGD)

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• Topic III Basel Accord seeks to Strengthen the
  Role Played by Bank Capital in the Safety Net

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INSOLVENCY-PREVENTION POLICIES
FDIC Guarantees and other elements of the
Government Safety Net absorb some of each banks
risk Creditor protection Kt KEt KGtTo
protect FDIC reserves and taxpayer wealth from
bank risk-shifting, government regulators engage
in various supervisory activities
Monitoring (including on-site examinations)
Enforcing risk-based requirements for minimum
regulatory capital and dividend
restrictions Evaluating internal controls
and issuing cease-and-desist orders for unsafe
and unsound practices Replacing poor or
dishonest managers fear that client
relationships have been corrupted Regulatory
capital consists of specified combinations of
stockholder equity, loan-loss reserves,
subordinated debt, and other accepted
instruments.
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Three Principal Lessons Taught By Wave 1975-2000
Banking Crises and 2007 Turmoil

• Through the safety net, delays in recognizing and
  closing or recapitalizing economically insolvent
  Zombie institutions contribute Dividend-Free
  Government Risk Capital to owners of these
  institutions.
• Zombie institutions can expand Government-Contribu
  ted risk capital by rapidly increasing the size
  or riskiness of their enterprise
• Conscientious government officials responsible
  for the loss exposure of a deposit-insurance fund
  have to overcome accounting, bureaucratic, and
  political obstacles thrown up to buy time
  either individually or collectively for zombie
  firms and their managers.

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Creditors May be Fooled by Accounting Façade that
Weak Institutions Erect to Keep Capital Looking
Good Long After it is First Exhausted
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NATIONAL AND GLOBAL FINANCIAL SAFETY NETS ARE
SOCIAL CONTRACTS

• Counterparties are Major Sectors of an
  identifiable political or economic Community
• Three Contract Segments
• 1. Clauses that define and assign
  responsibilities for preventing disruptive
  financial-institution insolvencies.
• 2. Clauses that define a range of tax-transfer
  techniques for financing this supervisory
  activity and losses it fails to prevent.
• Clauses that dictate the political and economic
  incentives under which operators discharge their
  responsibilities.
• To control cross-country risk-shifting, each
  segment must be rewritten Basel I and II.

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Bank Regulation and Supervision are Games of Cat
and Mouse

• Most banks conceal from societys watchdogs
  some
• 1. Adverse Elements of Their Condition and
  Performance
• 2. Unhedged Elements of Their Net Risk
  Exposures.
• All bankers are tempted to cook the books to some
  extent. However, insolvent banks routinely
  mischaracterize lasting problems as temporary
  ones by disinformational accounting forecasts.

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Causes of Distress

• Distress and Insolvency are driven by economic
  forces
• Failure of internal controls against crime
  customer fraud employee negligence or
  embezzlement looting by top management computer
  hacking
• Interaction of particular bank risk exposures
  with subsequent economic events

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Another Megatheme The Size of the Capital Shield
Differs for Different Stakeholders. Rules for
Calculating Thickness of Protection Vary for
Differently Prioritized Stakeholders in a Bank.

• 1. For subordinated debtholders
• 2. For foreign branch depositors and uninsured
  domestic depositors
• 3. For FDIC.

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EXAMPLE OF HOW STAKES TRANSITION IN A WORKOUT
Crippled Bank shows the
following tangible Balance Sheet, constructed
according to GAAP.
Insured Deposits 60 Uninsured Deposits
25 Subordinated Debt 10 Tangible Net Worth 5
Tangible Assets 100 Loss Reserves 0
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• Exercise Lets calculate the Capital Shield
  protecting various stakeholders (subordinated
  debtholders, uninsured depositors, BIF) assuming
  net intangible assets are worth 15 in market
  value and all tangible items are booked at market
  value
• a. according to GAAP? 100-95
• b. according to market-value accounting
  principles? 115- 95
• Suppose regulators apply an average risk weight
  of 90 percent to the banks tangible assets.
  Would the banks capital be adequate in the
  U.S?
• Suppose the Market Value of the Banks tangible
  assets is 75.
• a. How much of the banks GAAP assets would
  have to be sold to cover a 100 run by the
  uninsured depositors?
• ANS. Each dollar of book value
  sold generates only 75 cents, so 4(25)/3
  in GAAP assets have to be sold to meet the run.
• b. What would the banks GAAP balance sheet look
  like after paying off
• all uninsured deposits?
• ANS. Assets 66.67 TNW ?
• c. ENW ?
• Under what circumstances would new stockholders
  be willing to invest in a bank that has fallen
  into tangible insolvency? ANS. When intangible
  values are large and obvious enough to offset the
  tangible shortage.

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WHAT HAPPENS TO AN INDIVIDUAL BANK WHEN RISKS EAT
UP ITS CAPITAL?

• 1. Regulators try both to stop and to correct the
  undercapitalization Prompt Corrective Action.
• 2. Customer Runs Occur Depositor Efforts To
  Avoid Losses Can Create Extreme Market Discipline
  (Especially for Uninsured Depositors).
• 3. Silent Runs vs. Open Runs (metaphors?)
• 4. Coping with Rational vs. Irrational Runs
• a. Assets Sales and Outside Credit Support
• b. Policy Response Differs for Illiquidity vs.
  Insolvency
• c. Taxpayer Bailouts Explicit vs. Implicit

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THEMES

• Individual-bank exposure to examination,
  supervision, and enforcement activity unfolds
  within a national Regulatory Culture.
• This culture is a shaped by
• Reconstruction and Response lags generated by
  bureaucratic checks and balances.
• Regulatory Competition
• Regulatory personnels exposure to influence
  activity from a discipline-resistant firms
  political clout
• Social norms that protect fraudsters and bumblers
  against prompt regulatory discipline

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Incentive Conflict in the Bank Failure Process

• Troubled banks usually spend time on a watchlist
  of problem banks while disinformation and other
  difficulties are resolved.
• Decisions to fail or continue a problem bank
  unfold within a national Regulatory Culture
  whose norms protect some classes of Insolvent
  Banks from socially desirable Growth Restraints
  or Exit Pressure.
• Bank Failure is a Last-Ditch Administrative
  Response to strong Evidence of either fraud or
  unresolvable bank insolvency.

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Basel Supervisory Strategy

• To keep government-contributed capital from
  trending upward, regulators and supervisors must
  continually adapt their rules, monitoring,
  penalties, and administrative procedures to
  overcome clients political clout and innovations
  in bank concealment capabilities. Regulatory
  lags inevitably occur.
• RBC supervision has proved highly vulnerable to
  accounting misrepresentation and dynamic
  deterioration risk. This vulnerability comes
  in part from political deal-making required to
  get big banks to accept three-pillar structure
• Pillar I Minimum Capital Requirements
• Pillar II Supervisory Review Process (duties not
  spelled out)
• Pillar III Disclosure Market Discipline
  (reliance on competitive forces to impose losses
  and force exits).

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Basel I Overconcentrated on Credit Risk

• Capital Needs to Cover Many Kinds of FSF Risks
• CREDIT Risk that borrower will default.
• LIQUIDITY Risk that bank wont meet its
  obligations without selling assets at fire sale
  prices.
• MARKET Risk from shifts in interest rates and
  foreign exchange rates.
• PRICE Risk from changing values in securities
  portfolio
• REPUTATION Risk of bad publicity.
• STRATEGIC Risk of making bad business decisions.
• OPERATIONAL Risk of trouble from inadequate or
  failed internal processes, people, and systems or
  from external events.
• REGULATORY Risk of adverse changes in the Rules
  of the game

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STRESS TESTS UNDER PILLAR II
A stress test examines an FSFs vulnerability to
particular scenarios of market events. It
estimates how the value of the firms positions
would change if an exceptional but plausible
change in market conditions were to occur. Each
hypothetical shock is based on a different
scenario and most useful for products and
markets for which probability modeling seems
inadequate. Shocks are usually sized with
reference to historical patterns of events in
past crisis episodes. For example, movements in
interest rates or credit-swap spreads during

• The 1998 Russian Crisis
• The 1987 stock market crash.
• 9/11

42
Basel I and Basel II are NeitherTreaties Nor
Accords

• They are not treaties because the formal
  agreement is not executed between --or ratified
  by-- governments of sovereign nations. The
  signatories are merely short-lived incumbent
  regulators cannot constrain even their
  successors, and do not obtain consent from
  representatives elected by the citizenry of their
  nation.
• Basel I and II are not accords because the
  agreement cannot be said to settle the points
  put at issue in either agreement. Credible
  closure plans are not included.
• Each is better characterized as an incomplete
  contract a deal with many loose ends. Its value
  lies in providing a framework for continual
  renegotiation They represent a succession of
  preliminary agreements that have not been
  finalized in an enforceable way.
• ? changing COUNTERPARTIES FSAs added
• ? changing STAKES- value of contract performance
  breaches
• ? changing STAKEHOLDERS

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Basel Capital Regulation uses the Metaphor of a
RISK BUDGET Whose Contents are Distributed across
a series of RISK BUCKETS

• What is budgeted and expended is ownership
  capital.
• To support recognized risks, management must hold
  sufficient regulatory capital and allocate it
  across the specific positions that expose the
  institution and its stakeholders to loss e.g.,
  credit ratings collateral type maturity of
  instrument country and industry of borrower
  seniority of claim.
• Modern regulators are expected to verify the
  adequacy of a banks risk support. The Basel
  Accord seeks only to set risk-based minimum
  requirements for accounting value of ownership
  capital.

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• In principle, the amount of an institutions
  enterprisewide exposure to loss in any asset or
  liability position (Ai or Lj) that needs to be
  priced and that capital should be asked to
  cover varies with the loss exposure of the asker.
  Each stakeholder may express its requests as
  fractions (wi) of each positions value 0?wi ?1.
• Capital is adequate for a given stakeholder when
  
• Two Issues
• 1) weights and position values are sensitive to
  cross- portfolio correlations and
  hard-to-observe Information Events.
• 2) Marginal and average values of ideal weights
  
• may diverge.

45
The budgeting used in Basel I and in the
standardized version of Basel II is
embarrassingly simplistic. It assigns ad hoc
weights to a few broad asset classes and
incorporate no market-based risk sensitivity into
the weights

• Authorities assigned a unit risk weight to
  ordinary private loans.
• Judgmentally assign weights for other positions
  (vi) as fractions.
• Risk-Weighted Assets (RWA)
• Two-Tier RBCR w1 (RWA) and w2(RWA)
• w1 4 w2 8
• Basel II would improve on the weighting process.

46

• Full force of Basel I does not strictly apply
  to all banks Basel II proposes that all
  internationally active or large banks (250B in
  US) use so-called Advanced Internal-Ratings
  Based models to set aside specified capital
  amounts to support their on-balance-sheet and
  off-balance-sheet risk exposures. Basel I system
  seeks

• (1) to impose comprehensive capital
  requirements (i.e., to factor in off-balance
  sheet risks) and
• (2) to do so globally in standardized (i.e.,
  equal-opportunity) fashion in all major
  financial environments.
• Previously, capital requirements had been linked
  exclusively to accounting measures of a banks
  total on-balance-sheet assets, so that
  Off-Balance-Sheet items expanded.

47

• To risk-weight derivatives positions,
  standardized approach uses a two-part method
• 1) Choose a conversion factor, (ci) converting
  each OBS position to an on-balance-sheet credit
  equivalent.
• 2) Then apply a judgmental credit-risk weight
  (vi) that determines a capital requirement
  appropriate for the credit-equivalent amount.

48

• Except for swaps, conversion factors and risk
  weights are limited to 0, 20, 50, and 100.
• No formal market testing is done to justify
  these conversion factors and risk weights.
• Lack of accountability lets political pressure
  influence weighting. E.g., risk weights for
  subprime mortgages and for securities issued by
  national governments are kept unduly light.
• RBCR are so simplistic that their burden is so
  easily circumvented that one has to challenge
  either the honesty or the competence of officials
  willing to rely predominantly on this supervisory
  protocol.

49
BASEL ADEQUACY TEST IS TOO NARROWLY FOCUSED
50
Three Obvious and Large Loopholes in RBCR

• 1. Risk weights focus on credit risk in
  individual instruments (rather than firm-wide
  risk), are too few in number to track the
  capital needed to support individual positions,
  and benefits of risk mitigation are not
  incorporated (e.g., collateral, default swaps,
  insurance).
• 2. Regulatory requirements are set much too high
  on safe instruments and much too low on very
  risky ones.
• 3. Regulatory Dialectic authorities lag behind
  the market in understanding how to analyze
  supervise the values and risks of complicated
  derivatives.
• Analogy Weaknesses in rules induce a mutation of
  derivatives that resembles mutation of bacteria
  to make antibiotics ineffective on them.

51
Regulatory Arbitrage I
Market Capital Ratio
Market vs. BIS Capital Requirements
Hypothetical Market Requirements
too low
BIS Minimum
4
too high
too high
Middle Market Business
Closely Followed Large Corporations
Prime Households
Small Business
Borrower Size
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Even with a specified horizon and confidence
level, Basel I requirementcould be made as low
as managerswant it to be.

• Arbitrage Opportunity No. 1 Identify and hold
  assets with low regulatory charges relative to
  the risks they pose.
• Arbitrage Opportunity No. 2 Unscrupulously
  manipulate unverifiable internal Value-at-Risk
  models for self-assessing risk exposure to
  understate need for capital. Another form of
  accounting gimmickry.