Basel II - a case study in risk management, Study notes of Business

Download Basel II - a case study in risk management and more Study notes Business in PDF only on Docsity! BIS Review 20/2003 1 Roger W Ferguson, Jr: Basel II - a case study in risk management Speech by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal Reserve System, at the Risk Management Workshop for Regulators, The World Bank, Washington, D.C., 28 April 2003. * * * I am pleased to join you this morning as you begin your conference on risk management in banking. As many of you may know, I have been spending time on the initiative to increase the risk sensitivity of the Basel capital accord - the subject of your first panel discussion. In the last analysis, our Basel II efforts are geared to improving risk management - measuring risk more accurately; communicating those measurements to management, to supervisors, and to the public; and, of course, relating risk both to capital requirements and to the supervisory focus. This morning I will not discuss the details of the Basel proposals. Tomorrow, the Basel Supervisor's Committee will publish its third consultative document describing the proposal in its near-final form, and I urge you to review it and provide your comments and suggestions to the Committee. It is not too late to shape the details. This morning, however, in keeping with the theme of the conference, I will spend my time talking about the objectives of the proposed Basel II, particularly as they relate to risk management. Risk in Banking Any discussion of risk management in banking must start with the understanding that banks exist for the purpose of taking risk, and the objective of supervision is certainly not to eliminate, and perhaps not even to lower, risk-taking. Rather, the objective of supervision is to assist in the management of risk. We cannot lose sight of the fact that banks' willingness and ability to take risk, in turn, has allowed them to contribute significantly to economic growth by funding households and businesses. Nonetheless, this economic function, especially when conducted with a relatively small capital base and using mainly funds that have been borrowed short-term, has historically led to periodic rounds of bank failures and changes in credit availability that have exacerbated macroeconomic cyclical patterns and inflicted losses on households and businesses alike. Such a history has often led to proposals to change dramatically the business of banking; it clearly has been a major reason for central banks and for the regulation and supervision of banking. These developments, however, did not change the risk- taking function of banking nor the need for risk management. Banks, from the very beginning, have, to be sure, managed risk - even before there were supervisors or regulators to insist that they do so. Banks managed risk because they were in the business of banking and did not want to fail and lose what, at least initially, was their own capital. Even in modern banking, with professional management largely divorced from the owners, the desire of management to have the institution survive is still a major impetus to risk management. But, until quite recently, systematically and formally managing many of the key risks taken by banks, in particular their credit risk, was difficult. The techniques for quantifying and measuring risk, and the technology and instruments to manage and distribute it, simply did not exist. Individual credit-risk decisions tended to be made by lending and credit officers who used their judgment to decide who was given credit and who was not. A characteristic of lending officers is that they are paid to make loans, and in competitive lending markets they want to make sure they maintain, if not increase, market share. This is to say not that lending officers are uninterested in risk management but rather that their focus is on finding a way to make the loan. In a world of judgment, the risk manager had considerable difficulty in persuading lending officers, indeed management, about excessive risk when quantitative procedures and systems did not exist. Differences in judgments are difficult to resolve. I want to emphasize that historically bank credit availability has demonstrated a clear cyclical pattern that is both consistent with the credit-making decision process I have just described and that, in turn, has exacerbated real economic cycles. During economic recoveries, bank credit officers would become more optimistic and willing to lend, an attitude that only strengthened during booms; in such times the voice of risk managers, even supervisors, calling for caution was likely to carry less weight. During recessions, with losses clear and write-offs rising, caution would come to the forefront, attitudes 2 BIS Review 20/2003 toward lending would become much more restrictive, reinforced by the arguments of risk managers and supervisors who could point to the losses. One can, I think, begin to notice a change in recent years in this typical pro-cyclical behavior in bank credit availability. It first became apparent in the minimal credit losses at the large US banks during the Asian debt crisis and Russian debt default in the late 1990s. It was also noticeable when these same entities began to tighten lending standards during the later years of the last expansion, in contrast to typical patterns where tightening occurred near or after the peak. It is also apparent in the continued strength in the portfolios of these entities during the recession. To be sure, part of the explanation is new techniques for shifting and sharing risks through various new instruments. But at bottom, I would argue that we are beginning to see the payoff from more formal and rigorous quantitative risk- management techniques for credit decisionmaking, techniques that have also been central to the development of new instruments for hedging, mitigating, and managing credit risk. Encouraging Risk-Management Techniques The proposed Basel II attempts to do two things: to apply the concepts of these new risk-management techniques in banking to the supervision of banks and to encourage the widening and deepening of the application of these concepts to the largest and most complex internationally active banking organizations. It is true that the ideas embodied in Basel II began inside banks themselves; but not all banks are using all the concepts, and the advance across banks has been uneven. Increasingly investors and counterparties are asking whether they are being used, and Basel II adds to such pressure. Running through all three pillars of the Basel II proposal is encouragement for banking organizations to invest in and improve their risk-management capabilities. The advanced approaches to credit risk will require large banks to analyze their credit exposures in a formal and systematic way, assigning both default and loss probabilities to such exposures. Basel II is rooted in modern finance and seeks to develop in the larger banking organizations a comprehensive, systematic approach to assessing the various risks to which they are exposed. It inevitably raises both the supervisors' and the market's expectations for banks' risk-management systems. It clearly will increase the resources and management attention devoted to the details of risk management, focusing attention on the kinds of risks being taken and the potential losses that may accompany them. It is exactly that kind of attention, that kind of support for the risk managers, that will minimize the pro- cyclical swings that have historically marked the bank credit cycle: unintended risk-taking from an overly optimistic view followed by intervals of limited credit availability for even low-risk borrowers as pessimistic views came to the fore. Unintended risks are neither priced correctly nor adequately reserved or capitalized. Reductions in credit availability limit economic growth. As the scale and scope of banking has increased and as banking systems have become more concentrated, the effects of mistakes from excessive risk-taking and reductions in credit availability on national and world financial markets and economies has simply become too large to tolerate. The alternatives to strengthening risk management are limited and not very attractive: prohibitions on activities or very intrusive supervision and regulation. Bank managers and stakeholders, as well as those who believe in the market process, have an important stake in making Basel II work because the alternatives to it are so unappetizing. Pro-cyclicality Some observers grant the desirability of better risk management but have voiced concern that a set of rules for risk-sensitive capital requirements still will be excessively pro-cyclical. They argue that as banks re-evaluate the probabilities of default and loss over a business cycle, regulatory capital requirements will fall in booms, as risks are perceived to be low, and increase in recessions, when pessimism replaces optimism, aggravating the underlying real economic cyclical pattern. Better risk management, these critics seem to be saying, will make the world less stable. Let me stipulate that a regulatory structure based on formal risk-management techniques will imply, to some degree, a cyclical pattern of minimum regulatory capital requirements, exactly like the internal pattern of economic capital needs at a bank using modern risk-management techniques on its own. The question is: Is that a bad or good thing?