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There are two set of regulations that that apply to financial firms. Risk regulations are designed to prevent failure of individual financial firms by imposing minimum standards to the capital base that are risk driven. Accounting standards affect the value assessment of financial assets and liabilities, and have a direct influence on capital base and the bottom line of the income statement.

Risk Regulations

Financial risks are precisely defined because they are regulated. Regulations impose a quantification of potential losses stemming from risks, and such potential losses are the foundation for determining the capital base of financial institutions. The regulations of the financial system are reviewed in Chapters 19 and 20 of this text. Only the basic principles are summarized here. The core concept of risk regulations is the "capital adequacy" principle, which imposes a capital base commensurate with risks to which each bank is exposed. The principle is sound and makes a lot of sense. Instead of "dos and don'ts"," banks simply need to have enough capital to make their risks sustainable[1].

The rationale of the principle is that lenders can always absorb "statistical losses," such as those that are measurable in retail banking where there are millions of commitments, through adequate provisions. Risk provisioning can go beyond with provisions for general factors, should banks feel that they are exposed to such factors in their portfolios. But what would happen for the first Euro or Dollar of loss beyond the provisions? In the absence of capital, there would be no further buffer for such "average" losses. The rationale of the capital buffer is that banks should have a capital capable of sustaining much higher than average losses. It sounds natural, for ensuring bank solvency, to impose a capital base in line with such unexpected losses. Of course unexpected losses are future and potential losses. They are not supposed to materialize in other than unexpected ways. And they depend on current risks taken by the bank. The challenge of regulators and of banks as well, is in measuring potential losses in line with current risks.

The capital adequacy principle was the starting point of the strong emergence of modern risk management because it requires translating risks, which appear, at first sight, as intangibles, into Euro or Dollar values. Risk quantification and modeling made tremendous advances under the impulse of capital regulations.

Guidelines are defined by a regulators meeting in Basel at the Bank of International Settlement (BIS), hence the name of "Basel" Accords. The sequence of Accords in Basel started 20 years ago with the Accord for credit risk, or Basel 1, which relied on the very simple Cooke ratio. The Cooke ratio stipulated that the capital charge for lending or credit risk in general should be 8% of risk-weighted assets. Risk-weighted assets are the amount at risk, subject to loss, weighted by a coefficient between 0% and 100%. Such values were supposed to match rough proxies of the likelihood of unexpected credit losses, after considering the diversification effect of lending portfolios. Since they were very few weights, the first capital accord was very easy to implement, which was the purpose of its simplicity.

The 1996-1997 amendments targeted market risk, and allowed to use a standard approach using risk weights and, for the first time, the internal model approach, or the value-at-risk model for market risk. The challenge for measuring potential losses is to turn intangible risks into quantified measures in monetary value. The conceptual solution to that challenge is the "value-at-risk" concept, which synthesizes risks into a Dollar or Euro value through risk models. Value-at-risk gained popularity because it measures in a single figure the potential losses, a measure imposed by the bank's supervisors. Value-at-risk is the potential loss that is not supposed to be exceeded in more than a very small fraction of all feasible scenarios. It has now a track record of around 10 years and is implemented in most banks as the basis for the calculation of the capital charge against market risk.

In January 2007, the Basel 2 Accord for credit risk was enforced in European counties and for major international banks. The Basel 2 Accord essentially differentiates the capital charge according to the credit risk of the borrowers, using as an intermediate step internal credit ratings assigned by banks to all borrowers (in approaches other than the simpler Standard approach).

Ratings are measures of the "credit standing" as a rank along a scale. For bonds, rating agency scales are widely used. Those are letter grades such as, in the simplified Moody's scale: Aaa, Aa, A, Baa, Ba, B. Detailed scales are also extensively used. Under Basel 2, any borrower from a bank (corporations, banks), should be assigned an internal credit rating, which drives the capital charge. For individuals, in retail banking, the large volume of data allows using statistical measures, or "scores," for measuring credit standing, already used by many banks. Some are nationwide such as the famous FICO (Fair Isaac Corporation) score in the US. Others are proprietary to banks, such as in Europe.

Regulations were stringent, but regulations "holes" remained. Mismatch risk is a case in point, since it is left mainly to the self-discipline of market players, and without any capital charge. In addition, the scope of regulations does not extend to the entire industry. Another case in point is that of hedge funds. Hedge funds use proprietary trading techniques for enhancing their return, providing alternate sources of returns to straight investments in securities. For doing so, they use various techniques, such as betting on convergence of market parameters of different regions, or stock prices, or using event-driven strategies, betting on the outcome of mergers or even elections for example. Creativity has no bounds. Regulations would make proprietary strategies more public than they are, removing the added value of hedge funds policies, as some argue. Head fund management was left to self-discipline as well, contrasting with standard mutual funds subject to stringent restrictions. Moreover, funds can be highly leveraged (using debt financing), posting as collateral the assets held. A well-known effect of debt financing is that, under favorable conditions, it enhances the returns to investors (and to the fund managers as well). This could be fine, except that funds rely a lot on market liquidity and on mismatch risk for enhancing return. As explained subsequently, hedge funds participated to the aggravation of the crisis because of rules applying to collateral-based financing and mismatch risk.

Other entities are supposed to follow a "code of conduct" enforced by the market. The case in point is that of rating agencies. The business model of rating agencies is assigning credit ratings which serve the investors. Since they help issuers of bonds to raise financing, they are paid by issuers. Self-discipline can be powerful enough to impose self-regulation because the reputation of agencies depends on how well they do. At least, this was the prevailing view, since no one regulated rating agencies. Once the role of rating agencies in monitoring risk was heavily criticized, it become a common perception that self-regulation was not enough, and that the "issuer paid" model might raise conflicts of interest for agencies rating issues.

The debate on regulations before the crisis was how to weight self-regulation, or self-discipline, versus rule-based regulations enforced over financial firms. Since the crisis, it became official that regulation could not depend any more on self-discipline or "codes of conduct." Rather, all official documents point to the deficiency of existing regulations, and universally recommend that existing regulations should be more consistent and reinforced[2]. The contrast is striking. Extending the scope of regulation and how stringent regulations should be, have become hot issues.

Accounting Standards

"Fair value accounting," under the new accounting standards, focuses on the price at which an asset can be sold[3]. For market products, stocks, bonds, and derivatives, prices are usually liquidation values unless they are loans and receivables or held until maturity assets. For assets valued at fair values, valuation depends on whether markets are active or not. Active markets are such that the volume of transactions allows defining clear prices. For other instruments, prices can be derived from other traded instruments in active markets. For instruments for which prices cannot be derived from active markets, valuation is model based. The classification in accounting categories is based on management intent.

Amain drawback of fair value, as it used to be discussed, was to make the net income more volatile because it was directly related to market movements, thereby blurring the profitability picture. This drawback was addressed by making a distinction between assets held for trading purpose, for which capital gains and losses of traded instruments are transferred to net income, and those for which capital gains and losses are transferred to the capital rather than to the bottom line.

When markets went down, fair value rules triggered markdowns of portfolios, even if there was no intention to sell them, which translated into losses that eroded the capital base of banks.

  • [1] Among others, important documents on risk regulations by the Basel Committee for Banking Supervision (BCBS) are for credit risk in sources [7] and [10] and [8] for market risk, supplemented by publications available on the Bank of International Settlements (BIS) website.
  • [2] See the concluding chapter, Chapter 61.
  • [3] See Chapter 21 on accounting standards.
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