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The Time-Travel Hypothesis

What would you do if you had a time machine to travel back in the past?  Show Da Vinci an iPhone? Invest in the start-up Google? Hang out with yourself chatting about your life in the future? Accelerate singularity by teaching science to cave men? Well, the list is endless...

But, if BCBS had travelled back in time with Basel III, what would have become of the financial ecosystem that surrounds us? Would the crisis have been averted? An assessment of what was lacking in Basel II and hence a wish-list in its newer successor would explicate this.

As we know, reliance on credit ratings to determine the purportedly low Basel II capital, through RWA led to the 'manufacture' of AAA-rated CDOs backed by lousy sub-prime mortgages, which fuelled the crisis. In Basel III, while specific problem areas in risk weighting (addressed through increase in risk weight for super-senior tranches of (re)securitization products; elimination of regulatory arbitrage between banking and trading book, by treating securitization exposures on the latter on par with the former; and strengthening requirements on OTC derivatives and repos through capital for MTM losses, rather Credit Valuation Adjustments) and quantum & quality of capital (addressed through higher tangible common equity, capital conservation and counter cyclical buffers) have been dealt with, the larger issue pertains to the concept of risk weighting itself. This approach still urges the banks to "find" apparently risk-free assets which can be leveraged much higher than their riskier counterparts - We may be witness to some whacky financial engineering, yet again!

While zero risk weight assumption for AAA and AA-rated sovereigns (which caused the Sovereign debt crisis), has been acknowledged as faulty, yet, it has been let be. Well, the governments which put Basel III together needed some incentive, didn't they? - Cheap borrowing!

While oligopoly of rating agencies and the Gaussian Copula-powered symbiotic growth of CDS' and CDOs played their part in harmonised synchronicity, the use of internal rating models finished things off. The dumbed down simplification of VaR garnered attention in expressing and interpreting individual and firm-wide risk as a single figure for any asset class, its limitations were however forgotten. The assumption that the bank was in the best position to measure its own risk, when coupled with VaR's "normal", no-extremities market, failed to pay-off. Risk-based compensation in this case proved counter-productive, further encouraging managers to paint a low-risk picture.

The back-stop non-risk based measure viz. leverage ratio is a step in the right direction, albeit low. If the past is any indication, Lehman was levered 31-1, whereas the current Basel III rules peg the requirement at 33-1. Ultimately, this treads on a fine line - What cost of economic growth is a fair price for curbing risk?

Lehman's folding was a result of liquidity problems from unwinding of huge derivative positions. The 30-day stressed Liquidity Coverage Ratio; encouragement of medium to long term funding through Net Stable Funding Ratio; and the variety of monitoring tools do well here. However, there are arguments implicating that the LCRs bias toward government bonds could hamper credit to small businesses, which is also interesting given that they are the ones who do not have access to capital markets, and hence turn to banks for fundraising, where their 'unrated' status again tend to extend the 'halo effect'.

Let's assume BIS travels into the future with Basel III, would it have avoided a recurrence? There's no telling Black Swans, much like Miles Dyson did not know his neural-net processor would create Skynet and bring upon the Judgement Day - no one ever sees it happening, that's why it does! That really explains the two Basel accords prior and the ones after...hopefully not!

All said, Basel III is one of swiftest and smoothest regulations in modern history.

Comments

Vikram,

Love the analogy and the linkage to the crisis and Basel III. I am not much of a subject matter guy, nevertheless, a smartly conveyed article.

Vikram, so true and very well articulated article.

Good point on the SME lending - This is going to be quite a challenge. Not only does their unrated status creates discrimination due to the higher risk weights, but also they may be penalised by way of higher interest rates. They take a blow either way!

Infact, apart from the failure of risk models, there was actually an over-reliance on them. Little heed was being paid to reviewing controls and implementing better ones i.e. the qualitative aspect.

Some of this was a total bouncer for me. I had never thought of it this way. Very critical observations. Thanks for this

I have been an ardent follower of risk management articles. While many of the stuff I have read around the internet have been just news or extracts from Basel III; this article has done some seriously good analysis and it also covers the breadth of key points...Excellent

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