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In a speech to the Global Association of Risk Professionals in New York on Tuesday, Sheila Bair, Chairman of the Federal Deposit Insurance Corporation (FDIC), called for a back to basics approach in risk management, stating that, on their own, the mathematical modeling of the Advanced Approaches of Basel II was not the solution.
In illustrating the difference a year has made in the finance markets, Bair said we had moved from a highly liquid market, with high bank profits, apparently solid AAA CDOs and where many people believed the capital calculated from the quantitative models underlying the advanced approach of Basel II accurately reflected the risk. The view was that triple-A ratings bonds equated to minimal or no risk at all. Today over 1,200 triple-A-rated CDOs have been downgraded, many by multiple notches, US house prices have fallen by 8.4 percent in the year and US bank profits have taken significant hits from sub-prime restatements.
Bair says that it is the breakdown in lending standards, the lack of transparency, the lack of use of available data, and the over-reliance on ratings and quantitative methods as a substitute for good judgment and traditional credit discipline, that were to blame. Banks economised on credit analysis as they were dealing in top quality, AAA bonds, and regulators may have unintentionally accelerating events by lowering the risk weight in the Basel II approaches on many of these CDO securities to as low as 7 percent. She said, "The advanced approaches in general represent a heavy bet on the accuracy of models and quantitative risk metrics."
Bair called on a return to basics and said that the US regulators would be looking for demonstrations of this before allowing US banks to move up from the US Basel II imposed floors. Bair also said "Most important, we retain the leverage ratio. By providing capital even when the risk-based measures erroneously indicate minimal risk, the leverage ratio is a critical part of our overall approach to capital regulation." She said that a recent Financial Times Lex article had called for a return to traditional equity ratios. "I could not agree more" said Bair, "Who knows if we'll ever see a leverage ratio in Europe? Dare I revive my call for an international leverage ratio? One thing is for certain. The capital suggested by the advanced approaches can be far off the mark. Now widespread recognition that there is more to sound risk management than mathematical formulas is progress in and of itself."
A speech well worth reading in full by all risk policy makers and managers.
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