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NEXT STEPS: AFTER BASEL
The Basel II banking regulations will encourage willing financial institutions to focus on handling more diverse sources of risk. High-street stores try to meet more diverse risks because they recognise that just focusing on one risk (shoplifting) will lower returns at the margin on risk management efforts. Similarly, RAROC analysis shows that we gain through diversification, and that the areas for new investment can be identified profitably.
Rapid progress has been made in analysing market risk; value at risk and its variations still lead the way. Yet, we still have to recognise the correlation between different risks of which market risk is only one. The risk factors are combinative and not mutually exclusive. Loss data will only be useful when the theme of causality is tackled. Then regulators will truly have a safer banking system. Basel II, under Pillar 3, will force banks to become more transparent as they will disclose more information. The Basel II regulations contain some of our organic risk management themes to treat companies as changing dynamic entities, rather than on a static one-size-fits-all basis. Organic risk management techniques complement and build upon components present in Basel II. Organic risk management and Basel II are part of the road for developing more amenable structures for corporate governance and risk-balanced companies.
The Basel and regulatory clout upon the financial institutions means that the banking and funds industry is forced to meet the new Basel II-based guidelines. How they meet the regulatory authorities’ demands in practice is another question.
The Basel II project will most likely cost ten of millions US dollars for large global banks. This will include major changes in bank business and accounting procedures. Staff training, specialist consultancy time and new IT systems will add to the costs. Guesstimates are already flying around. One figure of $50 million has been given for Basel II standard certification, while $150 million has been banded around for a large global bank aiming for the highest advanced certification. How these costs can be expected to compare with business benefits will be a matter for strategic planning and effective project implementation to resolve.
Many banks are unhappy with the high costs of Basel II project implementation. They are still unsure as to the exact reduction in capital charges in some cases. Some banks are unwilling to go for the “Big Bang” for Basel II. They will choose to adopt a migration from standard to advanced level. Other banks may opt for taking a combination of risk management levels. One can pick advanced AIRB credit risk management level on its mortgage loan portfolio because it is a highly volatile and high value business line, while selecting standard operational risk management level on its asset management business line, which is lower volatility and value. Banks have really begun to splinter into different strategy groups.
Banks seeking to implement the Basel loss database have to think of the business rationale in the first place. We are discussing whether it is sensible to think of operational risk in terms of the questions: “Where did go wrong? How much did it cost us? How can we avoid or mitigate it?”
Not all banks will choose to adopt the loss database. Used properly, a loss database can encourage companies to think usefully about the nature or causes of operational risk. It offers three advantages towards building an understanding of risk.
1) Initially, we can think of operational risk in terms of risk events. The loss database matrix in this raw form is not yet detailed enough to be of use for risk management purposes. We need causal modelling, where an incident has a concomitant in a cause-effect relation. 2) The second phase is to link events with their causes. The matrix is just a set of boxes, where to put an initial incident and link it to a subsequent result. This cause-effect relationship is sometimes known as ‘forward chaining’ in knowledge management. Yet, we have yet to see substantial evidence that such data-mapping exercises create real value-added.
SCENARIOS FOR BASEL II OPRISK
The global effects that Basel II will have are not yet clear-cut. Side effects are unknown. However, a two-tier banking world is likely to emerge from the Basel II banking regulations, where there will be those who are in the fast-track for Basel compliance (more regulation and lower risk), versus those banks in the slow lane of compliance. These “slower” banks will have less regulation but more risk, even if they are guarded by more regulatory capital.
This is the possible outcome that there will be a two-tier banking system in the Basel domain:
Fast-track: Advanced banks doing well with lower capital requirements, excellent risk management and risk reporting systems. They will thrive in the new markets.
Slow-track: Other banks, slightly paralysed by higher capital reserves and regulatory requirements, will need to install more sophisticated risk management and risk reporting systems. The market perception of them can be negative (i.e. more risky banks or funds), so they can be doubly penalised by lower credit ratings /raised insurance premiums and lower customer respect.
More likely, there will be a large middle ground of banks and funds that are muddling along, not excelling themselves in advanced Basel II risk classifications, trying to find a niche.
RISK FOR FINANCIAL INSTITUTIONS AND INSURANCE
The convergence of banking and insurance business interests has led to M&A across the industry. Banks in Europe have recognised the benefits of M&A for banks with insurance companies. Cross-selling and strengthening the capital base and skills base. The new business model was clearly aimed at selling insurance products through the bank’s network, so increasing synergistic revenue. This will satisfy a larger proportion of customer service needs through a one-stop shop.
Risk management methods of both professions must cross-fertilise each other. This has been expected to happen quicker than both professions can imagine, but already we have many situations where big insurance companies, e.g. SwissRe, MunichRe, AON, AIG lend money to business. The Prudential Assurance owns Egg Bank in the UK, while Lloyds-TSB Bank owns four insurance companies including Scottish Widows. Which major bank does not own an insurance company? They perform corporate and trade finance functions in the same manner as banks.
It becomes difficult to manage the different enterprise cultures required in one new organisation. Change management and a modified Weltanschauung (world view) are needed for the merged entity, especially if your bosses have been changed. Furthermore, financial structures will change and the ground can shift under your feet. Insurance companies used to rely on a steady and relatively predictable revenue stream from customers’ premiums. They have found that new income volatility from the investment banking side had a damaging effect on their retail market financial health.
Risk structures and risk appetites may change in the merged corporation, so organic risk management should analyse the likely behaviour of this new investor animal. Insurers’ initial risk perception was more optimistic than it should have been. Some of this stems from the positive risk outlook from marrying a prestigious investment bank. Similarly, the big four UK clearing banks in 1986 tried to nurture an investment bank for their retail banking business. All four have retreated from this ambitious business strategy to various degrees. They should have put pessimistic scenario into their risk plan. Risk has a price, and many merged bancassurance companies initially had a rough ride.
Nevertheless, insurance offers significant contributions to banking, both in terms of crossselling and tapping a skills base. Basel II sees that insurance will become more closely linked to banking and fund management as the finance industry develops. Credit-ratings agencies and insurance companies will be inextricably tied to banks and funds because market transparency means that relative rankings of company “risk” become public. These directly influence insurance policy costs and, more indirectly, how customers view the reputation of these rated companies.
It is great news for consumers to see that this market combines insurance and banking to offer more choice of financing. Stress tests have so far proved that the market has enough resilience to withstand more competition. Yet, new entrants and new products will put a strain upon revenue streams and profit margins.
Research indicates that the opening of the EU financial markets, and the impact of e-banking on traditional bank business lines, will cause likely profit margin erosion. These range from savings/deposits, mortgages, mutual funds and on brokerage. The different risk and business profiles of European banks make it hard to derive general estimates of this impact. Nevertheless, a fall in profitability from margin erosion has been suggested in the range of fi10 % to fi25 % for most banks.7 Banks would do well to assess their risk profiles in response to the changing market drivers.
Another issue is how the broad spectrum of banks, insurance companies and finance houses can be strongly monitored in the market by regulators who traditionally concentrate on banks. The FSA and Basel II are well geared to supervise banks offering traditional products, but they may be less prepared for non-banks providing the same banking products.
The Basel Committee has had to adopt a wider context of what is a bank and what is not. Furthermore, it took a narrow view of banking risk as a combination of the three factors – market, credit and operational risk. This is often too limited and we should consider in addition:
structural risks
strategic risks
reputational risks.
It may appear that these Basel pillars are independent and stand alone. This is the concept of the risk silos. Basel II concentrates on the three types of risk – credit, market and operational risk. Investors could be led to believe that these are the major risk types, and the only ones that matter. Or worse, these are the only business risks that exist.
Banks may feel that risk is not contagious so long as risks are hedged between its divisions, i.e. risk localisation or damage control. But, sources of risk are related and interlinked, and a culture of lax risk awareness can be pervasive throughout the entire bank. Some banks have been more eager to adopt an enterprise risk management view.
This wider risk view permits the integration of risk management across silos to protect businesses adequately. Basel II recognises this principle and goes part way in linking the pillars in a mutually supportive fashion. Basel links the Three Pillars together, partly with supervisory visits and the imposition of regulatory capital. The explicit Basel II doctrine is that you buy all Three Pillars together in a job-lot; you cannot choose not to comply with any one of the Pillars.
The Basel II major progress has been to integrate some of the split risk silos. It will combine market, credit and operational risk within the combined Basel II operating framework. That is not to say that Basel II has its limits or its detractors.
Instruments such as popularly traded bonds will have a credit rating; other obscure bonds may not. There is a default bond rating, and if the bond is inherently risky or unsafe, then it may not benefit the bank trader to get the bond rated especially if the default rating is more lenient than a fair rating. This is not likely to be a loop-hole that will be closed as it is unlikely that any regulator can force all banks to get external credit ratings for their entire bond portfolio. Leeway for local supervisor judgement and initiative will continue to exist.
One factor also lies in the self-certification of risk. Banks at the outset will be presenting their validated risk management models. They know that they will receive regulatory benefits if they can present a good model. It is not in the interests to be forthright with regulators to admit that they have a bad risk management system. Banks are given regulatory capital incentives to validate their risk management models, even when these embed realistic assumptions and inherent weaknesses.
Regulators have to establish consistent standards for comparing across banks and across risk management models. Otherwise, banks will win with the greatest presentations and “sales job” on the regulators. There will be a learning curve for both sides as the banks try to develop ever more sophisticated models, while the regulators gather enough survey data to sniff out who has developed good risk management practices and models. Conversely, this will also lead the supervisors to deduce what constitutes a poor model and risk management practice for Basel II.
Cost-benefits under basel
Banks and funs should already be developing more sophisticated risk analysis and more effective risk managemet. Creating risk profiles for the bank’s counter-parties in the manner of a murder investigation may sound sinister. This process operates within CRM (credit risk management) where risk probabilities, default exposures and customers’ records are logged. A detailed risk map of the customer’s current risk position, plus probabilistic directions, should be drafted for banks.
Business counter-party profiling takes in the whole range of risk appetites, from the conservative to the wildly speculative. Another CRM (customer relationship management) or a detailed KYC (know-your-customer) process will further spotlight the customer’s track performance. Basel II offers incentives for identifying losses and knowing your wise owl to the thieving magpie. Profiling of past risk events will form part of the loss database under Basel II to offer forecasting potential. This is similar to the VaR principle of using a historic dataset to predict the future. The Basel II Accord assumes that in operational risk, past errors and losses can be a guide to the future using the loss database. History repeats itself.
No standard set of business scenarios will fit the bill for any one institution. There will be different reasons why banks lose money. Furthermore, there will most likely be different categorisation money for the same case of why a bank lost. Standardisation will be tough to enforce across all banks, but the regulators will try to advise.
Compliance with regulation has now become more worthwhile. Basel estimates a 6 % drop in capital reserves for a large EU bank that wishes to manage its credit risk at the advanced AIRB level. A similar large EU bank aiming to achieve the lower standardised level on its core portfolios will most likely pay an additional 6 % capital charge.
Nevertheless, there will be some groups who will feel aggrieved that Basel II punishes them unfairly. For example, the EU leasing industry is probably faced with a 6 % capital requirement, derived from a gamma (fi) risk weight of 75 % multiplied by the 8 % capital ratio. The Basel II documentation implies a probability of default (PD) in the 5 % to 25 % region, which is particularly high. The empirical research by the leasing industry indicates that the PD is realistically nearer 3 %.
This is because physical collateral assets such as real estate, cars, trucks and plant machinery have a long-established time-series for developing financial control skills. Understanding of the specific industrial sector, plus the option for securing the lessor’s assets through repossession, means that default risk is low. External banking regulators have given little consideration for these risk mitigation factors, so the leasing industry becomes harshly treated.
The regulator’s seal of good housekeeping is worth winning under the new rules. The Basel II Accord recognises that levels of risk management skills should rise commensurately with lowering capital reserve limits as an encouragement. Fines and punishment of higher capital limits rise to the tipping point of where the pain becomes overbearing. Thus, the probability of being detected by better supervision and monitoring, together with the financial fines impact, make compliance an activity that creates return on investment.
Basel II has to be well designed for every bank so that regulatory capital will be commensurate with their risks. The worst-case scenario is that Basel II will misallocate capital and increase regulatory reporting constraints. Market risk and credit risk may demand more regulatory capital, but more administrative aggravation will hinder current business lines within some banks. Local supervisors would have to be more cognisant of specific industrial needs before applying capital charges in full.
Basel II rules will be applied in the UK by the FSA. There will be some input from the European Commission in Brussels. Some quarters have argued for an EU “super regulator” to coordinate the migration towards Basel II and to standardise EU standards for open financial markets. It would be desirable to have an effective form of Basel II coordination and supervision to monitor the complex migration process. This financial super-cop is unlikely to come about soon given the political and economic diversity within the EU, and the potential conflict between the numerous stakeholder groups.
The USA prefers to adopt a more laissez-faire attitude, where only their globally active major banks will be in the vanguard of Basel II adoption. These top 20 US international banks will have to comply with Basel II with the rest of the European rivals, but not the US domestic banks.
The FSA and SEC can move around banks during supervisory visits with a check-list for Basel II framework and other compliance controls. These have performance bands based upon aggregate data for similar banks in their banking sector. It is rather akin to the IRS or Inland Revenue tax authorities audit checks. A potential disadvantage of this check-list method is that financial supervisors may have less time to evaluate the banks’ financial modelling thoroughly. Just ticking off a check-list makes it simpler to hide errors and pass off riskier banks with advanced IRB and AMA risk management certification.
Parachuting in the experts
The mainstream train of building investment expertise in the emerging markets rests on the twin tracks of speed and economy. Yet, predicting major market and political movements cannot be built upon expert local knowledge after two days at the airport Hilton hotel. The changes just after the army onslaught on civilians in Beijing’s Tien An Men Square or the events following Gorbachov’s fall from power in 1990, or any Latin American putsch cannot be evaluated by an armchair expert who is in the country on a whistle-stop tour. This cannot be cost-effective in the long run as the local knowledge gained is superficial and the chances of committing market mistakes are commensurately higher.
A real-life view of handling risk means messy problems – and that requires managing operational risk effectively. Many companies are poorly structured to handle operational risk overseas; in fact, they behave more like risk-ignorant investors.
The effect of interest rates and volatility
It is important to know that interest rates and volatility exert an influence on option prices. When interest rates are highel; call option prices are higher and put option prices are lower. This effect is not obvious and strains the intuition somewhat. When investors buy call options instead of the underlying, they are effectively buying an indirect leveraged position in the underlying. When interest rates are higher, buying the call instead of a direct leveraged position in the underlying is more attractive. Moreover, by using call options, investors save more money by not paying for the underlying until a later date. For put options, however, higher interest rates are disadvantageous. When interest rates are higher, investors lose more interest while waiting to sell the underlying when using puts. Thus, the opportunity cost of waiting is higher when interest rates are higher. Although these points may not seem completely clear, fortunately they are not critical. Except when the underlying is a bond or interest rate, interest rates do not have a very strong effect on option prices. Volatility, however, has an extremely strong effect on option prices. Higher volatility increases call and put option prices because it increases possible upside values and increases possible downside values of the underlying. The upside effect helps calls and does not hurt puts. The downside effect does not hurt calls and helps puts. The reasons calls are not hurt on the downside and puts are not hurt on the upside is that when options are out-of-the-money, it does not matter if they end up more out-of-the-money. But when options are in-the-money, it does matter if they end up more in-the-money.
Volatility is a critical variable in pricing options. It is the only variable that affects option prices that is not directly observable either in the option contract or in the market. It must be estimated.
The effect of cash flows on the underlying asset
Both the lower bounds on puts and calls and the put-call parity relationship must be modified to account for cash flows on the underlying asset. In earlier posts we discussed situations in which the underlying has cash flows. Stocks pay dividends, bonds pay interest, foreign currencies pay interest, and commodities have carrying costs. As we have done in the previous posts, we shall assume that these cash flows are either known or can be expressed as a percentage of the asset price. Moreover, as we did previously, we can remove the present value of those cash flows from the price of the underlying and use this adjusted underlying price in the results we have obtained above.
In the previous posts, we specified these cash flows in the form of the accumulated value at T of all cash flows incurred on the underlying over the life of the derivative contract. When the underlying is a stock, we specified these cash flows more precisely in the form of dividends, using the notation FV(D,O,T) as the future value, or alternatively PV(D,O,T) as the present value, of these dividends. When the underlying was a bond, we used the notation FV(CI,O,T) or PV(CI,O,T), where CI stands for “coupon interest.” When the cash flows can be specified in terms of a yield or rate, we used the notation 6 where Sd(1 + is the underlying price reduced by the present value of the cash flows.
Using continuous compounding, the rate can be specified as 6″ so that S, ~C”~ is the underlying price reduced by the present value of the dividends. For our purposes in this series of posts on options, let us just write this specification as PV(CF,O,T), which represents the present value of the cash flows on the underlying over the life of the options. Therefore, we can restate the lower bounds for European options as and put-call parity as co + Xl(1 + r)T = po + [So - PV(CF,O,T)] which reflects the fact that, as we said, we simply reduce the underlying price by the present value of its cash flows over the life of the option.