What are we doing when we are modelling risk from a banking supervision perspective?
Consider the capital adequacy ratio of the banks in a simple arithmetic equation; CAR = (Tier 1 capital + Tier 2 capital)/Risk-weighted assets, OK? Government policy strategies increase bank solvency, but in different ways. Capital injections increase the numerator of the CAR, asset guarantees decrease the denominator, and asset purchases decrease the denominator. That is focusing on Pillar One of Basel II.
Presenting Basel II as a single pillar framework misses the second pillar. The second pillar is about economic capital, that capital to cover other risks and to be considered in addition to the Pillar One arithmetic, to be privately defined on the basis of the quality of each individual financial entity’s modeling capability and governance structures. That level of economic capital to be held by the institution agreed between that institution and the supervisor, privately.
Pillar One is arithmetic, Pillar Two is econometric, Pillar One is operationally specific it is derived from the historic asset type exposure matrix of each individual entity, Pillar Two is holistic, it looks at the overall risk exposure of the entity and at its strategy going forward. Pillar One, was in general implemented between 2004 and 2007, Pillar Two was not. Indeed Pillar Two was; it is now generally accepted not enforced by Banking Supervisors. Pillar Two is econometric, it is quantitative; therefore some people (even supervisors) find it a complex requirement; sums are hard, right?
The Basel II framework is being criticized left right and centre right now as if it were inherently procyclical i.e. that it requires higher capital in business cycle downturns and vice versa, that is inherently true of an arithmetic equation, the reverse is true of through the cycle capital estimation required of an econometric or simply quantitative approach to risk capital.
The great and the good of the commentators on the Credit Crunch, calling themselves economists; are appearing before government committees in Europe, the US and the UK right now, pontificating on about Basel II being inherently procyclical. This is self satisfied smug hubris, influencing government policy and frightening the public when they cannot even be bothered to read the contents of the Basel Accords. These smug talking heads (worst in the UK) do not realize that in their laziness they are complicit in a cover up of the fact that the banks failed to implement the modern banking supervision requirements of the Basel Accords and that the domestic supervisors failed to enforce the new approach to supervision.
Blaming Basel II as flawed is a justification for failing to implement it, a cover up for not implementing all of its requirements. That argument for the defence of banking practice pre Credit Crunch (that is what it is) is itself flawed, it is inconsistent with holding the position that supervisors failed to enforce supervision. Only one of those propositions can be true at the same time – either supervisors did not enforce banking supervision (technically termed Basel II Pillar 2) or it was enforced and the banks did implement it but it was flawed. The facts support the former position, failure to enforce and failure to implement, thus being covered up by claims that the Basel II rules are inherently flawed. These idiot commentators are obfuscating the reasoning process, so necessary right now, to allow us to innovate ourselves out of this recession.
The Governor of the Bank of England, Mervyn King, is not one of these, by the way; he recognised the failure to implement Pillar Two at the Northern Rock hearings.
Only through the cycle (a priori not pro cyclical) risk capital estimation predicated upon either full blown DSGE models or pragmatic stochastic positivism is the answer to risk capital estimation commensurate with the complexities of the financial technology we need today to meet the Demand for Money which our ever wealthier economy necessarily throws up.
Only the deployment of econometric and quantitative techniques in banking risk management will enable the reopening of the wholesale credit markets in Europe and the US, without which we will remain in this recession, no matter what the governments do to prop up the banks on a Pillar One perspective.
It was failure to enforce and implement Pillar Two, failure to implement systems which reported accurate forward looking metrics of capital at risk to the boards (i.e. lack of understanding of risk) which caused the Credit Crisis; I think we can all be fairly sure of that by now.
The mathematicians and econometricians are going to take over the bank, transparency in complexity is demanding that now! All this spin blaming mathematics for the credit crisis is just spin from middle management who never understood risk management anyway, protecting their reputations, it was their failure to put quantitative analytics at the top of the systems thinking agenda which caused this crisis and which is stretching it out longer than is necessary. The complicity of the talking heads in this as a result of laziness, is shameful; particularly when they grab the agenda and the media attention, they should be more responsible to their positions, in my view.