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What is all this Basel regulation stuff about, anyway?

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Back in the mists of time (about 10 years ago) it must have been; that was the question I was asked to answer; I did a lot of work so the client must have been seriously interested;-

What the bloody hell is this Basel Thing Anyway?

You see I have been clearing out my ‘Chambre de Bonne’[1] [ChdeB] (attic to the anglophiles); in Brussels these can be quite commodious. In Paris they sell for millions! I am quite an hoarder of old papers and reports but over the years I progressively slim them down.

Back then my client was in Zurich. I wont name him/her[2] but I will remember here that there was a beautiful model of a ‘J-Class’ in the office; (unusual since Zurich is a thousand miles from the sea in any direction) and the obvious old Scottish jokes about the “Swiss Navy” were great ‘icebreakers’ in the pitch meeting. You see I grew up on the Clyde; & it is a part of my development mythology that the J-Class was originally designed by G L Watson[3]; or at least G L Watson & Co.; the company which maintained his name & was still trading from beautiful offices near a slipway on the Clyde when I was a little boy. The offices of G L Watson & Co. (then) were a single storey modern building (Scandinavian style) with ‘high’ windows, for the drawing office but they were located in the grounds of a demolished ancient house behind the ‘still standing’ very high stones walls of the old house. The walls dribbled ivy down to the abandoned road on which the entrance gates to the offices were. I used to cycle down to the slipway (I had an ‘Elswick Hopper[4]’) & once or twice a pipe smoking naval architect showed me around the drawing office! Noone could tell me what G L Watson did! There wasn’t the interest then but it has re-surged now; see Dykstra and partners and their re-imagining of the J-Class! I think my detailed diversion on G L Watson & Co. (for my Zurich client), won me the ‘gig’ to do the analysis to answer the question;-

 “What is all this Basel regulation stuff about, anyway?”

Doing that detailed background study was a help and a hindrance as time went on but as I am clearing out my ChdeB & 10 years on everything is even more ‘paperless’ than it was then, it seems appropriate now to bring that deep background research from out of the closet where it has been hiding for the last 10 years. It’s the sort of material which has not been fashionable for a long time but I can see the world turning backwards towards this fundamental stuff; the world of “Basel” that is.

My naval architecture spin might have won me the gig but I was in a way the man for the job. I had just been wrestling with IAS39[5]; valuation of complex securities as traded instruments for another part of the same client. Even there, I couldn’t make sense of the desperation to develop ‘arithmetic’ if you like synthetically algebraic ‘rules’ to arrive at valuation of complex instruments. It seemed to me that the accountants were developing a private language of valuation which obfuscated the instruments of focus. But more than that, the accountants were throwing away, perfectly good econometric techniques for the same function which had a far longer intellectual pedigree than the synthetic private language they were dreaming up.

I think I had voiced that opinion several times in workshops and in wine bars & I think it had been noticed. I did have a background in that type of thinking; I mean I had a background in econometrics which I discuss a little here[6].

Transparency in Financial Institutions cannot be achieved[7] if the standards are so arcane that even a profession cannot get its head around the requirements. That seems to me to be a 'no brainer". The ultimate goal of initiatives such as Basel should be to restore Transparency to Financial Markets and Banking. That objective should be, if not to eliminate permanently systemic risk then to make it so transparent that informed investors can act without asymmetric disadvantage when making fully rationally informed decisions about capital deployment. Is it really possible right now for institutions to ensure their own compliance with requirements of the Transparency objective when there are potentially several road maps of confusing and conflicting rules and regulations which not even the regulators themselves consider coherent once properly compared and considered for impact?

My Zurich  client wanted to know; what Basel II was driving at, where it was coming from! These are not easy sub-clauses to answer you know, it wasn’t clear at the time & I think its fair to say that the Basel II took on a life of its own and became an un-manageable beast in the hands of the implementers both on the ‘eye tea’ side but in fact worse on the ‘business’ side in my view.

As with IAS39 the core of Basel II is this attempt to synthesize into an algebraic expression what is essentially a statistical estimation; see my discussion here; in retrospect that artifice sent the wrong signals to those who were to be eventual users of the regulations; the first sign of that is the return to focus of the concept ‘macroprudential’ after the Credit Crisis arrival & during the development of Basel III; we at asymptotix developed a blog on that[8] nearly 2 years ago; as we were seeing questions on the concept. A lot of that blog is research from the work for this Swiss client which I am discussing here. Basel II was always about ‘macroprudential’ supervision, that is the point of Pillar 2 but the focus on Pillar One and this synthetic equation diverted the focus of the implementers and left Basel II ‘Flawed and not fully implemented’[9].

Often during Basel II implementations at requirements definition workshops one would see young analysts from the bank client side, banging massive folders of thick paper on the table, with hundreds of little yellow sticky page markers flickering from between the poured over paper. The analysts wanted to go through the artifice of an arithmetic synthesis, ‘line by line’. If one was trying to get anything actually done it became impossible; because one was forced onto a back foot of defending an artificial synthesis that one didn’t believe in oneself. Then you would find the really clever analyst who understood statistical analytics; & that gaping black hole in Basel II would appear; the confusion over EL (Expected Loss) and UL (Unexpected Loss); trying to implement Pillar One and Pillar Two couldn’t get passed that impasse, particularly if such an analyst who could recognise that problem was on the bank management side, then the Basel Committee had handed a ‘game – winning’ weakness on the regulatory side to any bank which saw the regulatory and supervisory process as a winnable game. The issue of what capital was for & particularly where Unexpected Loss (UL) was supported (& how) was confused in the initial rules specification mainly due to this determination not to include statistical techniques, in my view. But that confusion over UL which sits at the core of the capital purpose ‘Equation’ if you like entailed that any bank determined to game the system could maintain a Basel Programme chasing its tail in an infinite loop around the first Pillar & never enter the supervisory engagement of the second.

UL is (‘Unexpected’ Loss); note that ‘expectational’ element to the concept which is an econometric reference; in econometrics everything is only expected to a degree, by a factor; on some percentage if you like; to an extent everything is relatively ‘unexpected’ it’s only by how much. I remember using the word ‘epistemic’ in a Basel II requirements workshop and everyone looked at me & wondered what I had been drinking the previous evening! This is why I say that studying Basel II closely, understanding where it had come from had more downsides than up, as time went on during the Basel implementation window (’04 -> ’08 ?); since most people had not done that, indeed were determined not to; since to game the regulation required the text to be taken prima facie and demolished where possible. It was un-cool to know what Basel was really about. UL sits at the connector between Pillar One and Pillar Two in Basel II; it is the objective of the synthetic smoothing of the algebraic interpretation of a statistical function (in Pillar One) & it is what you are quantifying or more strictly demonstrating you can quantify (statistically) in Pillar Two. Pillar 2 was underspecified by the UK authorities (and European supervisors) who sent a strong signal to the banking industry to in a way “carry on regardless”. As many experts argued in the spring of 2006, the banking system does require supervisory guidance to be spelled-out clearly not presented in working papers in such academic language that only an academic “monetary econometrician” can interpret! The bankers won’t read them! But the Credit Crisis (CC) changed all that, particularly as Capital transitioned to the state[10], enforcement has become more popular and less game-able.

The evidence for the under-specification of Pillar 2 by the supervisors pre-CC is clear in many Central Bank, Supervisory and related publications of the credit crunch period. In its FSR of December 07 the ECB hints that full implementation of B2 is the correct response to the CC;

The new Basel II Capital Accord, which is currently being implemented, should address several of the weaknesses that have been unearthed by the market turmoil. Indeed, the new accord strongly relies on significantly improved risk management in determining the appropriate capital buffers for banks.[11] The ECB continues “financial firms in particular should step up their efforts and improve their practices to manage effectively the risks that may lie ahead. In this respect, the full implementation of the Basel II Capital Accord as well as initiatives and measures that are being taken, both by policy-makers and by the financial industry, aimed at restoring confidence and addressing the weaknesses that have been revealed by the recent market turbulence should contribute to strengthening the resilience of the financial system.

Finally the ECB points out

The Basel Committee is currently working on methodologies that would improve the understanding among banks and investors of the various links between credit risk and market risk and how these could be better taken into account in stress tests, expected loss calculations and in setting capital reserves.

The Governor of the Bank of the England (Mervyn King) considered aloud the under-specification of Pillar 2 before the UK Treasury Select Committee[12] with particular reference to Liquidity Risk;

 “Unlike capital regulation, there is no international set of regulatory requirements for liquidity, apart from requirements under Pillar 2 of Basel II. At the time when the Basel capital regime was being negotiated the Bank of England did start an initiative to begin a parallel Basel liquidity adequacy regime, and it never got off the ground; other central banks were not so enthusiastic. It is a shame, but maybe we need to get back that.”

I have (possibly over?-) interpreted Basel III as all about the Business Cycle[13] (I think I am correct) & in that you can see the development of ‘expectational’ thinking from UL to Business Cycle driven modeling of capital; that should be the point about Stress Tests[14] if conducted properly. One useful lesson from an understanding of the underlying academic or intellectual drivers of bank regulation is that capital quantification is quintessentially econometric; it’s all about quantitative techniques; funneling the enormous exposure data of a large bank whilst discounting for collateral by a quality measure through a single synthetic algebraic rule is computational insanity, which will be viewed retrospectively in the future as if we all had some OCD problem, like the British MPs[15], athletes, comedians and David Beckham were being transparent about just before the holidays. I agree OCD and other so called ‘disorders’ can contribute to the development of very valuable people but enforcing a banking regulation & transparency framework underpinned by some confused dysfunctional aversion to statistics is in my view just asking for a crisis.

Doing the deep background reading way back then (10 years ago) allowed me to understand where the Basel thing was going as it morphed into Basel III but left me exasperated and confused as B2 was implemented. For software architecture[16] a focus on the underlying objective of the requirement can help build systems which are more robust and have greater longevity but we know now that was far from the agenda in Basel II over the last ten years. Maybe a deeper understanding will be required now as Central Banks become the locus of supervision and independent regulatory agencies are no longer flavour of month. It seems to me that the integral nature of Banking Supervision to Monetary Policy management, which is clear from my [CURRENT] background reading list that issues of 'Systemic Risk' entail the necessity for Central Bank supervision of private sector financial institutions.

The challenge today is ‘Financial Stability’ which basically means controlling the development of bubbles in Asset Prices, identifying them before they burst and bring the whole economy crashing down. Many new papers are being published by Central Banks and Academics[17] now in the Macroprudential[18] Supervision space, which argue that the models of games in Monetary Policy are just as applicable to Financial Stability or Macroprudential strategies and policies as they are to management of inflation expectations. These ring true, we are dealing with monetary phenomena, indeed everything is monetary nowadays.  As Mervyn King said in his Mansion House Speech after the election of the new Coalition government in the UK in June 2010;

“Monetary stability and financial stability are two sides of the same coin. During the crisis the former was threatened by the failure to secure the latter[19]. “

Approaching Monetary Stability and Financial Stability as two sides of the same coin is what is termed Macro-Prudential Supervision. In the new millennium there has been a great deal of discussion of this topic. One could argue that this was the underlying theory of the Basel II accords developed by the Bank for International Settlements (BIS). The Basel III[20] accords with their focus on the Business Cycle[21] and Macro-Financial Stress Testing[22] were to make Macro-Prudential principles more explicit. Macro Prudential supervision became a key response recognised by public authorities to intensify the regulation and supervision of financial markets in response to the credit crisis; one could argue that the central bankers had always known that, there is clear evidence for this.

My view is that “this Basel thing” is going to morph into what it should have been in the first place. The centering of banking supervision in the Central Bank and thus the proper focus on Econometric values defined from a view of the Business Cycle; which the Central Bank needs to monitor and manage systemic risk[23] & monetary policy will mean that quantification of risk factors will have to be done properly by the financial institutions being supervised. Thus a deeper understanding of what is required in terms of the Political Economics will be needed and a line by line exegesis of the rules in a regulatory game will become the redundant process, it always appeared to be to me & thus the blueprint of the future of the business response to banking supervision requirements, might (ought to?) look something like this!

[2] You can x-refer my CV if you r that ‘snoopie’ (I don’t mind)

[11] European Central Bank FINANCIAL STABILITY REVIEW DECEMBER 2007, http://www.ecb.int/pub/pdf/other/financialstabilityreview200712en.pdf


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