Basel III - Cracks Appear Part 2

In part 1 of the "Basel III cracks are appearing" post which can be accessed by clicking here, we discussed the general misunderstanding on how capital works in Basel III. In this article we are going to look at some of the disparate issues around the new Liquidity Coverage Ratio.

LCR & NSFR

The Liquidity Coverage Ratio or LCR and the Net Stable Funding Ratio or NSFR, work hand-in-hand with capital as a three pronged mechanism and the entire system, can be viewed as an "all encompassing" solution designed to reduce liquidity funding feedback loops. All that aside, there are some broad concerns with the way in which specific elements are being interpreted by national regulators across the globe.

These new aspects of Basel III need careful tweaking to avoid unintended market consequences.

  

Basel III - Cracks Appear Part 1

A few months ago, when I first reviewed the Basel III guidelines, I was relatively positive about the proposal. Sure it is difficult to achieve in places but more or less on the mark. The credit crisis needed a global regulatory response and as heavy handed as it is, Basel III appears on the surface to address the causal factors for the collapse of the markets in 2008.

There are a lot of fears over Basel III which have been voiced by quite a few risk analysts across the planet. These concerns mostly revolve around the following argument that a strict rule is a linear or straight line concept that may not fix the banking system but may dampen economic growth. Yet, if the regulation is not strict enough, it won't be effective.

This interpretation of the ideal behind Basel III is incorrect in my opinion and is driving the banking community to act in a regulatory discordant manner.

In this article we are going to review a couple of concerning eventualities that seemed to have occurred as a response to Basel III. We will look at these concerns from the perspective of the banks and the regulators.

Cat Bonds and Catastrophe

In our first blog article on catastrophes and Extreme Value Theory which can be found by clicking here, we looked at methods for predicting outcomes from climatic events. We are going to follow up in this post with a review of structured products that can be used to provide financial cover for losses caused by weather and other environmental predicaments.

A year of catastrophes and Extreme Value Theory

This year has been particularly negative with respects to natural disasters and the associated impacts that obtrude the livelihoods of those communities affected. Considering we are only a couple of months into the year, the number of catastrophes that have struck various countries around the world is quite astonishing. 

To list a few disasters alone, we saw Queensland which is normally a drought suffering state of Australia inundated with so much rain that mass flash flooding ensued, Christchurch was flattened by an earthquake (warning these images are disturbing) on the 22nd of February and only two days ago Japan suffered the fifth largest earthquake since 1900, along with a devastating tsunami where the estimated damage and loss is currently unknown.

From a risk perspective of disaster management, this article investigates methods for predicting catastrophes and their potential loss. 

We have also followed up with a second article on how institutions can cover the fiscal loss from these environmental disasters by using financially structured products. This posting can be found by clicking here.

Best Practice RCSA Framework

View Presentation

For a long time, the activity of Control Self-Assessment has been a recognized industry wide approach that is used by both operational risk and audit departments to assess whether a specific business function is operating its controls effectively. The program is supposed to identify whether any control breaches have occurred during a reporting period and how congruent each control is within the network of controls.

In this blog we are going to highlight the key points for making a Risk Control Self-Assessment program a success and a presentation has been included here which outlines a best practice Risk Control Self-Assessment (RCSA) method.

Basel III might be the sun behind the dark clouds for rating agencies

Dark clouds are on the horizon for rating agencies and while many banks have become public enemy number one, the rating agencies aren't off the hook from their hand in the Credit Crisis either.  I am not saying it is curtains for the rating agencies but the world is certainly going to change for them.

The affront on rating agencies

In 2006, the Securities and Exchange Commission passed a Credit Rating Agency reform act which was to stipulate a set of guidelines to determine which rating agencies can be classified as Recognized Statistical Rating Organisations and to guard against conflicts of interest, the act can be found by following this link.  Given the outcome of the Credit Crisis in the backdrop of this act and the role the rating agencies played in masking risk across a whole range of assets, not to mention the credibility of the credit assessment process itself, the act might be deemed as being ineffective. I fair the issue was more likely that the SEC ruling was simply passed into law too late in the day and the Credit Crisis was already underway.

None the less, the US regulators aren't letting go of this.