Financial Stability Review
Themes and Issues, Issue 13
12 December 2002
Issue
13 December 2002 - Themes and Issues (Full Article)
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During the past six months, financial systems around the world have withstood sharp declines in equity markets, higher market volatility, and a deterioration in the macroeconomic outlook. In this uncertain environment, there have been occasional signs of fragility and a retreat from risk-taking. This issue of the Bank of England's Financial Stability Review explores the factors contributing to changing appraisals of risk, and considers various public and private sector initiatives designed to strengthen risk management.
The Bank's regular assessment of The financial stability conjuncture and outlook is complemented for the first time by a separate article reviewing developments Strengthening financial infrastructure. Perhaps the most important of these in the past six months has been the successful launch of continuous linked settlement (CLS) in foreign exchange markets, which can greatly reduce foreign exchange settlement risk. The article considers efforts generally to make financial systems more robust and initiatives to improve crisis management - two of the three key aspects of the Bank of England's financial stability work, along with the surveillance of risks.
The greater resilience of banks in most industrial countries is attributable partly to larger buffers of capital compared with the 1980s and early 1990s. Encouraging internationally active banks to hold more capital was one of the objectives of the original (1988) Basel Accord. Central banks and supervisors have been working to amend the Accord to make it more sensitive to risk. The article by Patricia Jackson, Bank capital: Basel II developments, describes the current state of play. The Basel Committee on Banking Supervision set out its latest proposals on 1 October. These modified earlier proposals in the light of comments, the results of quantitative impact studies which sought to assess the likely effect of the proposals on minimum capital, and concerns about the potential procyclicality of the new approach. The latest proposals are currently being tested in a third quantitative impact study.
One concern has been that, if Basel II increased capital requirements for loans to certain classes of borrower, it could increase their cost of funds. In The impact of the new Basel Accord on the supply of capital to emerging market economies, Simon Hayes, Victoria Saporta, and David Lodge consider whether emerging market (EME) borrowers are likely to be materially affected. The authors argue that the regulatory capital charge will not rise - and may indeed fall - for lending to a number of emerging markets. In any case, banks seem already to price their loans to reflect the perceived creditworthiness of their customers rather than being based on regulatory capital requirements; Basel II is simply likely to bring the regulatory charge more into line with existing practice. The authors also point out that bank finance is only one of several sources of credit for EMEs, and that the new Accord will not apply to the others.
Another concern about Basel II has been that the adoption of risk-based requirements could amplify market volatility at times of financial crisis. In an invited article, Fallacies about the effects of market risk management systems, Professor Philippe Jorion investigates whether value-at-risk (VaR) methods of risk measurement for trading books do in fact increase market volatility in crisis periods. His answer is reassuring. He finds that asset price volatility over the 1990s, when the techniques were introduced, was lower than previously, not higher as is sometimes suggested. Also, rather surprisingly, the markets which in 1987 used portfolio insurance - another risk management tool - declined less than the markets in which it was not used. Jorion also notes that the existing Basel VaR capital requirements are calculated in such a way as to react slowly to changing market conditions.
Basel II is designed to make regulatory capital requirements more responsive to risk. Similarly, there have been proposals to make accounting frameworks reflect more clearly the risky nature of banks' lending. Fiona Mann and Ian Michael explore one such proposal in Dynamic provisioning: issues and application. The advocates of dynamic provisioning argue that it would encourage the build-up of a buffer, in the form of an 'expected loss reserve', against potential losses. It might also reduce a distortion in the measurement of banks' income over time which arises because margins set to cover expected losses are treated as profit. The approach would reduce both profits in times of boom (when many riskier loans are taken on) and losses in recessions (when the losses inherent in holding a portfolio of loans tend to crystallise). But the authors point out that all of the various ways in which a dynamic provisioning approach might be implemented in practice raise practical issues which would need to be overcome.
The interaction between accounting practices and assessments of risk and return has also been prominent in the recent debate about deficiencies in financial reporting in the corporate sector. In the second invited article in this issue, Renewing confidence in the markets, Sir David Tweedie, Chairman of the International Accounting Standards Board (IASB) sets out his view of the issues at stake. He argues that fears about the quality of financial reporting have undermined investor confidence, in turn damaging economic prospects. Good financial reporting requires clarity of accounting standards, sound auditing practices and an effective enforcement framework. Accounting standards must be based on clear principles, rather than detailed guidance, to avoid manipulation and a 'rule-book mentality'. There is growing international consensus around this view, and the IASB has agreed with the US Financial Accounting Standards Board to work to remove major differences between international and US standards. New standards need to be developed too, to reflect how a modern economy works. Reported earnings are likely to become more volatile as a result, but it is better to confront investors with the reality that the financial performance of complex companies in today's environment is bound to fluctuate.
In the same area, but focusing more on how accounts are used by investors and analysts to assess firms' earnings prospects, Fabio Cortes, Ian Marsh, and Michael Lyon ask, Is there still magic in corporate earnings? It had often been suggested, in the United States in particular, that audited reported earnings were not necessarily the best basis for equity valuation. However, alternative measures - for example, pro forma earnings - appear to have excluded systematically certain recurring expenses, so exaggerating earnings and sometimes giving an excessively rosy view of likely future cash-flows. The authors review some of the academic analysis of this subject, which indicates that items often excluded from pro forma earnings statements do in fact contain information useful in forecasting cash flows. They also explore the use of national-accounts-based measures of aggregate corporate earnings as a way of checking the implications of firm-level accounting data.
The accounting framework used in the corporate sector is a vital part of the 'infrastructure' on which companies - and those who invest in or lend to them - depend. Clear principles and an understanding of the economic significance of accounting data enable better assessments of likely risks and returns. But, however good the accounting framework, occasionally some firms will still face insolvency. In these circumstances, insolvency and bankruptcy law are important, as they affect both the stability and the efficiency of the financial system. To explore the Economics of insolvency law further, the Bank held a conference on 27 September, reported here by Bethany Blowers. As well as the Bank's general interest in promoting effective management of financial problems, to avoid them having systemic implications, it has had a long-standing practical involvement in pre-insolvency workouts via its role in the 'London Approach'.
Some of the same risk management issues arise in an international context. There has been an active debate for some time about the best means of resolving international financial crises. In Fixing financial crises, Andrew Haldane reports a conference hosted by the Bank on 23-24 July on the subject of the role of the official and private sectors in resolving sovereign debt crises. Amongst the specific topics discussed were the role of the IMF, and the pros and cons of collective action clauses and the IMF's proposal for a sovereign debt restructuring mechanism (SDRM).
The articles outlined above are primarily about how to improve the resilience of the framework within which financial intermediaries operate. Market-driven initiatives along these lines include the development of central counterparties (CCPs) in financial markets. In Modelling risk in central counterparty clearing houses: a review, Raymond Knott and Alastair Mills consider what academic studies have revealed about risks in this key part of the financial infrastructure. CCPs originally arose to protect market participants from counterparty risk in exchange-traded derivatives markets, but they also now have an important presence in cash and OTC derivatives markets. In helping to manage counterparty risk for market participants, CCPs are themselves exposed to various risks - and their position at the centre of a web of financial exposures raises issues about possible contagion. The article notes that margins alone may not be sufficient to protect CCPs from extreme, but rare, events. As a consequence, the level of additional default resources needs to be carefully considered.
CCPs raise questions about the systemic significance of different networks of exposures. So do interbank wholesale markets. In UK interbank exposures: systemic risk implications, Simon Wells explores a possible approach to measuring the direct impact on other banks of the sudden and unexpected failure of a single institution, in the unlikely event that such a failure were to occur. Data limitations make it impossible to put together a complete map of interactions between banks; but, using a stylised framework, some progress can be made in investigating the patterns of potential spill-overs. The article is part of the Bank's continuing work to understand more fully the links between financial institutions and the systemic risk they pose.
Key Resources
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Memorandum of Understanding between HM Treasury,
the Bank of England and the Financial Services Authority
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