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Assessing Financial Stability Conceptual and organisational challenges Istanbul, 18 May 2005

Assessing Financial Stability Conceptual and organisational challenges Istanbul, 18 May 2005. Peter PRAET Executive Director, National Bank of Belgium Member of the Board, Banking, Finance and Insurance Commission. I. The building blocks. Prevention design of rules, regulation, standards...

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Assessing Financial Stability Conceptual and organisational challenges Istanbul, 18 May 2005

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  1. Assessing Financial StabilityConceptual and organisational challengesIstanbul, 18 May 2005 • Peter PRAET • Executive Director, National Bank of Belgium • Member of the Board, Banking, Finance and Insurance Commission

  2. I. The building blocks • Prevention • design of rules, regulation, standards... • Surveillance • micro / macro • Crisis management • "orderly exit"

  3. II. Challenges (1/2) • Traditional bank • illiquid assets, originated & held to maturity • liquid liabilities • uninformed depositors • Highly powered incentive structure

  4. II. Challenges (2/2) • Changing borders of banks • risk profile can change rapidly / more dynamic balance sheet • cross-sector: from narrow banks to financial conglomerates • size: firms as market infrastructures • cross-border • perimeter of control / outsourcing issues • fiduciary role?

  5. III. Three horizontal questions • What is risk? "Just a probabilistic concept"? • What financial structure carries the risks? Understanding leverage • What governance setting takes and manages the risks?

  6. IV. Illustration: credit risk • Major changes over the past 10/15 years in the management of credit risk and in the nature of market participants • Regulation tries to be as close as possible to "Market best practices"

  7. Value-at-risk (VaR) approach • Amount capital >= VaR • VaR measures the maximum loss in value that can occur at a given confidence level and in a specified time period • Example: if confidence interval = 99.9% and time period = 1 year, then there is 1 chance in a 1000 that the loss in 1 year is greater than the VaR.

  8. VaR approach • Realised losses over time gives loss frequency distribution Losses Unexpected losses Expected losses Frequency losses Time

  9. Credit VaR Loss frequency distribution Average A 0.07% AAA 0.01% AA 0.03% Losses Expected losses Unexpected losses Credit Value-at-Risk

  10. Credit VaR: risk parameters • Risk parameters loss distribution • PD (probability of default) • LGD (loss given default) • EAD (exposure at default) • Maturity • Correlation • Additional parameter Credit -VaR: confidence interval

  11. Credit VaR: risk parameters • Illustration maturity

  12. Credit - VaR: risk parameters • Illustration: Impact correlation on loss distribution Correlation = 0 % Correlation = 100 % Correlation = 50 % Loss Loss Loss

  13. VaR in credit institutions: economic capital / rating agencies' capital / supervisory capital • Convergence? "Same business same rules?" • Credit - VaR parameters: market participants and supervisors

  14. Outlook: banks / non-banks Illustration: CDO tranching loss distribution Loss probability Losses Supersenior Junior Senior Equity Mezzanine

  15. Main issues • The increasing difficulty to track the circulation of credit risk (for authorities and markets) • Possible excessive reliance on the output of models that have not been tested sufficiently • Lack of risk management tools that consider the interlinkages between market risk, credit risk, operational risk ("silo" approach to risk) • How to deal with "tail risks"?

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