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Financial regulation: an attempt to regulate complexity

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Title: Financial regulation: an attempt to regulate complexity


1
Financial regulation an attempt to regulate
complexity
  • Imre Kondor
  • Collegium Budapest and Department of Physics of
    Complex Systems, Eötvös University, Budapest
  • International Workshop on Coping with Crises in
    Complex Socio-Economic Systems
  • ETH Zurich (Switzerland), June 8-12, 2009

This work has been supported by the National
Office for Research and Technology under grant
No. KCKHA005
2
Contents
  • Finance as a complex system
  • The existing regulation
  • Outlines of a future regulation

3
THE COMPLEXITY OF THE FINANCIAL SYSTEM
4
  • The financial system consists of a large number
    of very heterogeneous agents, there is no
    symmetry, the mean-field model of the
    representative agent is completely wrong.
  • It is not true that the players are all equally
    informed, equally rational, they all can process
    the available information in the same way, all
    are price takers.
  • It is also not true that the system produces only
    small fluctuations about equilibrium, except for
    some significant exogeneous impacts.
  • Instead, there are recurrent huge endogenous
    fluctuations. (E.g., Black Monday in 1987 was a
    35 sigma event!)
  • Mainstream equilibrium theory provided the
    ideological basis for the neoliberal revolution
    that led to the deregulation of markets.

5
  • There are complicated strong interactions between
    the components of the system (e.g. contractual,
    credit- or ownership relationships)
  • Collective effects (bubbles, herding, exuberance,
    panic, etc.)
  • No separation of scales, the distribution of
    wealth, or the market capitalization of firms is
    power-law-like
  • The system is global, cannot naturally be cut
    into parts.
  • It has a multiattractor structure with several
    metastable states (various financial, economic,
    or political regimes)
  • It is sensitive to initial and boundary
    conditions, all kinds of control parameters

6
  • The number of relevant variables is huge
  • Financial time series are irreducible, cannot
    be reduced to a small number of variables, we
    cannot make an AI system learn them. They
    constitute a non-stationary, multivariate
    stochastic process that exists in a single copy
  • Regression analyses in many (more and more),
    power law distributed explicatory variables (?) !
  • Long (sometimes very short) range memory

7
  • Mode slaving habits, traditions, laws,
    institutions
  • Emergence all these coming about bubbles,
    crises and their consequences.
  • Adaptation (e.g. to regulation), learning,
    self-organization.
  • The system is conditioned by the information
    about it (the impact of the appearence of the
    Black-Scholes formula on liquidity), the system
    reflects upon itself
  • Self-fulfilling prophecies (e.g. panics, Santa
    Claus rally, etc.)

8
SOME ORDERS OF MAGNITUDE
9
  • Rank   Country   GDP (millions of USD)  
  • World 60,689,812
  •   European Union 18,394,115
  • 1   United States 14,264,600
  • 2   Japan 4,923,761
  • China (PRC) 4,401,614
  • Germany 3,667,513
  • France 2,865,737
  •   United Kingdom 2,674,085
  •   Italy 2,313,893
  •   Russia 1,676,586
  •   Spain 1,611,767
  •   Brazil 1,572,839
  •   Canada 1,510,957
  •   India 1,209,686
  •   Mexico 1,088,128
  •   Australia 1,010,699 Source IMF 2008

10
March2009
11
Controlling complex systems
  • Is it possible?
  • On which scale and which time horizon shall we
    optimize?
  • Optimization is value driven

12
Some developments leading up to the present crisis
  • Deregulation (after several decades of rigorous
    regulation)
  • Explosive spread of derivatives (especially
    credit derivatives). Their total gross
    outstanding value reached 20 times the GWP! The
    players are circularly insuring each other, that
    is themselves, a complete nonsense.
  • Among other things, capital adequacy regulation
    made the banks interested in securitisation.
  • Congress, the FED, SEC and other regulators
    actively supported and encouraged the spread of
    OTC trading and off-the-balance-sheet items,
    thereby turning around a century old trend and
    making price discovery and reliable valuation of
    the new instruments impossible.
  • This enabled Wall Street to fabricate the
    packages of opaque, uncontrolled and non-traded
    instruments on an assembly line.

13
  • Because of the development of the originate to
    distribute business model in the mortgage
    lending market, banks have lost their incentive
    to investigate the credit-worthiness of
    borrowers.
  • The originate to distribute model greatly
    contributed to the development of the system of
    perverted incentives (astronomical bonuses,
    compensation linked to short term performance).
  • The frightening mass of colletarized debt
    obligations and structured investment vehicles
    created a totally opaque and infinitely complex
    shadow banking system.

14
Securitisation
  • Huge quantities of claims put into tradeable, in
    principle homogeneous, risk-packages and sold to
    pension funds, foreign banks, China, etc.. The
    rationale is to distribute risk among the
    economic players, furthermore, to bring back the
    money tied down in property onto the market,
    thereby increasing liquidity.
  • The rating of these packages is, however, almost
    impossible. (Gaussian copula the formula that
    brought down Wall Street)

15
Surge in Securitization
16
  • By 2007 the total outstanding value of
    derivatives had reached the order of .
    (The net value is, of course, just a fraction of
    this the total Gross Product of the World is of
    the order of , but for the wide
    distribution of maturities clearing takes a long
    time.)
  • Because of their complicated valuation,
    derivatives are typically off the balance sheet
    items.
  • The overwhelming bulk of credit derivatives have
    been traded over the counter, the conditions
    stipulated are vastly different, impossible to
    compare (400 pages long contracts).
  • Nobody knows how much of these toxic items can
    still be found in the portfolios of the various
    institutions, which is the main cause of
    suspicion and global lack of trust.

17
Is it possible to regulate such a system?
18
REGULATION
19
  • Central bank, supervisors, etc., a very
    heterogeneous system
  • It protects the interest of orphans and
    widows.
  • Tries to ensure a level playing field for the
    players.
  • Protects society as a whole from the collaps of
    the financial system, tries to mitigate systemic
    risk.
  • Its main tool has been an obligatory minimum of
    own capital.

20
Why do banks need own capital?
  • The fundamental difference between a bank and,
    say, a manufacturing company is the large
    leverage at the bank.
  • Own capital is meant to provide a cushion against
    risk, against sustained loss.

21
Economic capital
Distribution of loss on e.g. credit portfolio
average (expectation value)
default probability (depends on target rating)
expected loss covered by interest rate spread
unexpected loss to be covered by own economic
capital
22
International agreements
  • The first Basel Capital Accord (1988)
  • Bank of International Settlements, Basel,
    www.bis.org
  • Cook - Committee reviewed the practice of the
    40 best banks Cook-rate 8 - an arbitrary
    value.
  • The Agreement was originally meant to bind the
    large banks of the G10 countries
    (US,UK,D,F,I,CH,NL,S,B,CN,J,L), by now it has
    essentially been accepted globally.
  • The capital charge of 8 contributed to the
    depletion of the credit portfolios of the largest
    banks (securitisation/credit derivatives), the
    risk migrated into sectors unaccessible for
    regulation. An illustration of the law of
    unintended consequences.

23
The trading book regulation
  • An amendment to Basel I (1996)
  • Standard model
  • Risk measures and the calculation of the capital
    charge prescribed by regulator
  • Internal (own) model
  • The bank may develop its own model for risk
    assessment, but must get it approved by the
    regulator
  • The Value at Risk obtained from the internal
    model must be multiplied by at least a factor 3
    to calculate the capital charge

24
  • Hungary adopted the corresponding EU Directive in
    2000. As it happened, I had to intimately
    familiarize myself with this piece of regulation,
    first at the stage of the preparation of the law,
    later in implementing it at a bank.
  • With some colleagues we found that the regulation
    is full of inconsistencies concave risk
    measures, wildly fluctuating capital charges,
    etc.
  • I. Kondor,A. Szepessy, and T. Ujvárosi Concave
    risk measures in international capital regulation
  • in Risk Measures for the 21th Century, Ch. 4.,
    pp. 51-59, ed. G, Szego, John Wiley Sons (2004)
  • A. Gábor and I. Kondor Portfolios with nonlinear
    constraints and spin glasses, Physica A274, 222
    (1999)
  • I. Kondor Spin glasses in the trading book, Int.
    J. of Theor. and Appl. Finance, 3, 537 (2000)

25
  • The Second Capital Accord
  • The result of a long preparatory process
  • Motivations
  • Banks wanted a more flexible, risk-sensitive
    regulation.
  • With the introduction of more differentiated
    capital charges, regulators wanted to encourage
    the spread of more advanced risk management
    practices
  • Main goals
  • to ensure stability of the individual
    institutions, as well as the whole system
  • level playing field
  • to maintain the average capitalization of the
    whole system at the level of 8 , but the banks
    applying advanced methods get a reduction (while
    the backward ones are penalized).

26
Structure of the new Accord
Three pillars
Market discipline
Minimum capital charge
Role of supervision
  • Capital charge based on rating rating failed
    completely
  • Supervisors got strongly enhanced discretionary
    power did not make use of it
  • Market discipline (would have) meant increased
    transparency total darkness reigns

27
  • Wide range of consultations, debates, impact
    studies, amendments since about 1998.
  • The political arguments, lobbying, horse trading
    diverted attention from the essential questions.
  • EU introduction in 2008-ban. (In the US in 2010)
  • In the meantime huge, 3 to 5 years databases had
    to be created, the preparation lasted several
    years and cost fortunes.
  • The regulation worked out to be complicated at
    the end.
  • By the time it was introduced, the crisis had
    arrived.

28
There were dissenting voices right from the
beginning
  • E.g. Jón Danielsson, Paul Embrechts, Charles
    Goodhart, Con Keating, Felix Muennich, Olivier
    Renault, and Hyun Song Shin An Academic Response
    to Basel II. (LSE Special paper, May 2001)
  • They emphasized that financial risk is
    endogeneous (the metaphore of the Millennium
    Bridge), that VaR is not convex, it is procyclic,
    etc.

29
Systemic risk obtained very little attention
  • Systemic risk is the risk of the collapse of the
    whole system of international financial mediation
  • Such a collapse would be a disaster of historic
    proportion for civilization
  • International regulation seeks to mitigate,
    indeed, to exclude this, but they believed to
    achieve this via ensuring the security of the
    individual shops.
  • Neither regulators, nor the industry could
    imagine such an event could ever occur.
  • The bail-out campaigns of 2008-09 aimed at
    preventing such a disaster.

30
DOES REGULATION STAND A CHANCE?
31
  • In its present form the system is opaque,
    unknowlable and uncontrollable.
  • The complexity of the system must be reduced,
    even at the price of reducing liquidity.

32
More concretely
  • Trading must be driven back to the exchanges
    where prices can be discovered.
  • Derivatives must be valued and should figure in
    the books and reports.
  • The extent of securitisation must be limited,
    banks should be obliged to keep a substantial
    part of the credit packages.
  • Leverage must be limited
  • Regulation must become adaptive Transaction
    costs should grow with the trading volume in
    order to prevent bubbles from running away.

33
The report of the de Larosiere Committee
  • Jacques de Larosiere high position French
    administrator
  • 1978-87 director of IMF
  • 1987-93 governor of the Banque de France
  • 1993-98 president of EBRD
  • The report analysing the crisis was submitted to
    the EU Commission in February 2009

34
Excerpts from their recommendations
  • Recommendation 1 The Group sees the need for a
    fundamental review of the Basel 2 rules. The
    Basel Committee of Banking Supervisors should
    therefore be invited to urgently amend the rules
    with a view to
  • - gradually increase minimum capital
    requirements
  • - reduce pro-cyclicality, by e.g. encouraging
    dynamic provisioning or capital buffers
  • - introduce stricter rules for off-balance sheet
    items
  • - tighten norms on liquidity management and
  • - strengthen the rules for banks internal
    control and risk management, notably by
  • reinforcing the "fit and proper" criteria for
    management and board members.
  • Furthermore, it is essential that rules are
    complemented by more reliance on judgement.

35
  • Recommendation 3 Concerning the regulation of
    Credit Rating Agencies (CRAs), the Group
    recommends that
  • - within the EU, a strengthened CESR (Committee
    of European Securities Regulators) should be in
    charge of registering and supervising CRAs
  • - a fundamental review of CRAs' business model,
    its financing and of the scope for
  • - separating rating and advisory activities
    should be undertaken
  • - the use of ratings in financial regulations
    should be significantly reduced over time
  • - the rating for structured products should be
    transformed by introducing distinct codes for
    such products.
  • It is crucial that these regulatory changes are
    accompanied by increased due diligence and
    judgement by investors and improved supervision.

36
  • Recommendation 4 With respect to accounting
    rules the Group considers that a wider reflection
    on the mark-to-market principle is needed and in
    particular recommends that
  • - expeditious solutions should be found to the
    remaining accounting issues concerning complex
    products
  • - accounting standards should not bias business
    models, promote pro-cyclical behaviour or
    discourage long-term investment
  • - the IASB (International Accounting Standard
    Board) and other accounting standard setters
    should clarify and agree on a common, transparent
    methodology for the valuation of assets in
    illiquid markets where mark-to-market cannot be
    applied
  • - the IASB further opens its standard-setting
    process to the regulatory, supervisory and
    business communities
  • - the oversight and governance structure of the
    IASB be strengthened

37
  • Recommendation 6 The Group considers that
  • - Competent authorities in all Member States must
    have sufficient supervisory powers, including
    sanctions, to ensure the compliance of financial
    institutions with the applicable rules
  • - Competent authorities should also be equipped
    with strong, equivalent and deterrent sanction
    regimes to counter all types of financial crime.
  • Recommendation 7 Concerning the "parallel
    banking system" the Group recommends to
  • - extend appropriate regulation, in a
    proportionate manner, to all firms or entities
  • conducting financial activities of a potentially
    systemic nature, even if they have no
  • direct dealings with the public at large
  • - improve transparency in all financial markets -
    and notably for systemically important hedge
    funds - by imposing, in all EU Member States and
    internationally, registration and information
    requirements on hedge fund managers, concerning
    their strategies, methods and leverage, including
    their worldwide activities
  • - introduce appropriate capital requirements on
    banks owning or operating a hedge fund or being
    otherwise engaged in significant proprietary
    trading and to closely monitor them.

38
  • Recommendation 8 Concerning securitised products
    and derivatives markets, the Group
  • recommends to
  • - simplify and standardise over-the-counter
    derivatives
  • - introduce and require the use of at least one
    well-capitalised central clearing house for
  • credit default swaps in the EU
  • - guarantee that issuers of securitised products
    retain on their books for the life of the
  • instrument a meaningful amount of the underlying
    risk (non-hedged).
  • Recommendation 10 In order to tackle the current
    absence of a truly harmonised set of
  • core rules in the EU, the Group recommends that
  • - Member States and the European Parliament
    should avoid in the future legislation that
  • permits inconsistent transposition and
    application
  • - the Commission and the level 3 Committees
    should identify those national exceptions,
  • the removal of which would improve the
    functioning of the single financial market
  • reduce distortions of competition and regulatory
    arbitrage or improve the efficiency of
  • cross-border financial activity in the EU.
    Notwithstanding, a Member State should be
  • able to adopt more stringent national regulatory
    measures considered to be domestically
  • appropriate for safeguarding financial stability
    as long as the principles of the internal

39
  • Recommendation 11 In view of the corporate
    governance failures revealed by the current
    financial crisis, the Group considers that
    compensation incentives must be better aligned
    with shareholder interests and long-term
    firm-wide profitability by basing the structure
    of financial sector compensation schemes on the
    following principles
  • - the assessment of bonuses should be set in a
    multi-year framework, spreading bonus payments
    over the cycle
  • - the same principles should apply to proprietary
    traders and asset managers
  • - bonuses should reflect actual performance and
    not be guaranteed in advance.
  • Supervisors should oversee the suitability of
    financial institutions' compensation policies,
    require changes where compensation policies
    encourage excessive risk-taking and, where
    necessary, impose additional capital requirements
    under pillar 2 of Basel 2 in case no adequate
    remedial action is being taken.

40
  • Recommendation 12 With respect to internal risk
    management, the Group recommends that
  • - the risk management function within financial
    institutions must be made independent and
    responsible for effective, independent stress
    testing
  • - senior risk officers should hold a very high
    rank in the company hierarchy, and
  • - internal risk assessment and proper due
    diligence must not be neglected by overreliance
    on external ratings. Supervisors are called upon
    to frequently inspect financial institutions'
    internal risk management systems.
  • Recommendation 16 A new body called the European
    Systemic Risk Council (ESRC), to
  • be chaired by the ECB President, should be set up
    under the auspices and with the logistical
    support of the ECB.
  • - The ESRC should be composed of the members of
    the General Council of the ECB, the
  • chairpersons of CEBS, CEIOPS and CESR as well as
    one representative of the European Commission.
    Whenever the subject discussed justifies the
    presence of insurance and securities supervisors,
    the Governor could choose to be represented by
    the Head of the appropriate national supervisory
    authority
  • - The ESRC should pool and analyse all
    information, relevant for financial stability,
    pertaining to macro-economic conditions and to
    macro-prudential developments in all the
    financial sectors.
  • - A proper flow of information between the ESRC
    and the micro-prudential supervisors
  • must be ensured.
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