Crisis and BIS II
There are some lessons to be learned from this crisis and the role of BIS II in it. Several improvements have been formulated. Most of these are focussed on preventing this particular crisis from happening again. However chances are slim, that the next crisis will equal this one. In this section the strengths and weaknesses are discussed on a somewhat more abstract level. Focussed more on how BIS II is used.
Strengths
The first Basel accord had a very distinct drawback. It stimulated banks to finance risky counterparties. Let us reconsider our previous example:
1.A corporate loan of two million to a multinational AA corporation, fully collateralized by machinery.
2.A corporate unsecured loan of two million to an empty company (no actual assets or income production capacity) in a tax haven.
Now we add the impact of pricing to this example. The bank will be able to demand a higher interest rate from the second company, because of the higher risk. Let us assume that the margin (interest rate minus funding costs) for the first company is 1% and the interest rate for the second company is 3%. The solvency requirement for both companies is €160,000. Therefore the return on equity for the first company is 12,5% ((1%x2.000.000)/(8%x2.000.000)). The return on equity for the second company is 37,5% ((3%x2.000.000)/(8%x2.000.000)). This means that a bank will gain higher returns if it engages into riskier deals.
BIS II will eliminate this unwanted stimulation of banks towards risks. Furthermore it encourages banks to set up a risk management system with a certain level of professionalism. It does this not only by legislative force, but also by allowing the market to make its own decision about a banks quality. Thus banks are setting up better management information systems and policy is more directly linked to risk developments.
Weaknesses
The weakness of BIS II lays in the method in which it determines risks. It uses models to determine the risk of a certain bank. These models however can only extrapolate what has happened in the past. They cannot take into account a changed environment. Although BIS II mentions the fact that this should be taken into account but there is no method available to do so. Furthermore, those people considered expert in a particular market are usually also dependant upon this market. In other words, they do not want a market to be risky and therefore in their eyes it never will be.
This weakness renders BIS II useless in preventing the crisis described earlier.
This is best illustrated by a fictional example.
China has been growing rapidly due to large production and exports. Assume that in 2010 China decides to open up its borders and allow banks and investors to finance Chinese production directly. When this happens banks are confronted with an investment opportunity which has a good track record. China has been booming for several years now. The market is also new because banks are not directly involved at the moment. These are two of the characteristics often present with a collective over-valuation. As money continues to be invested in China and production keeps growing the idea of China being a safe investment is confirmed. This will cause more investors to make financing available to China.
As this happens BIS II will also confirm this image of China being a save investment. As long as the money supply keeps growing in China only a few companies will go broke due to mis-management. But over-all the statistical view of low risk confirms the qualitative view of the market.
Now assume that towards 2015 the cost of labour has increased dramatically. The interaction with western culture due to the open borders has increased the desired living standards of employees. They demand their share of the profits which are being generated. This will decrease the profitability of investing in China. The rise in costs continues until China is no longer attractive for its low wages. In other words, the basis for the investments and growth in China has disappeared.
If this happens BIS II models will still say that china is relatively safe (as there have still been few defaults in the past). The market specialist at a bank will probably be the person responsible for the China branches. Therefore he does not want China to become more risky. He or she will generate other reasons why China is still solid. Either, that an internal market has developed (not dependant on export). Or that other investors are also still investing, thus the risk cannot have increased (else everybody would have to be wrong). Companies will not move their production because of possible tax reasons, etcetera. This is not deliberate misinformation. The expert will genuinely believe this, because he wants to believe it.
This means that while the reason for China’s growth has disappeared, banks will not react to it. Not with BIS II and (often) not out of their own accord. The growth of invested money will delay a correction. The newly invested money can be used to artificially increase (basically finance) consumption and refinance companies who cannot repay their loans from their cash flow. This obscures the fact that the financial basis for growth is gone. The growth becomes dependant on the money supply increase.
This can continue for several years until the amount of investments in China can no longer grow or it becomes too obvious that there is no basis for growth any more. At this points bank will massively withdraw their money from China. This will lead to a sudden and dramatic increase in defaults, causing large losses for banks.
This example shows how BIS II will not change anything in this cycle which leads to a crisis. This in itself is not a thread. The thread only develops when bank management assumes that BIS II will prevent a crisis and therefore stop using their own (qualitative) risk assessments. In short, BIS II and risk models are a good tool. But owning a good hammer will not make you a good carpenter.
A development which has been proposed as a solution to this problem is the use of scenario analysis. This means that the potential loss in a particular situation is calculated. The only weak point with this view lies in determining the scenarios. In our example a systematic failure of the Chinese economy would probably be seen as unrealistic and not used as a scenario.