Managing Risk BY CHRISTOPHER WHALEN A skeptic s view of Basel II S ince the failure of Penn Square Bank in 1974 successive chairmen of the Federal Reserve Board have attempted to protect the U S financial system from a systemic shock that might bring the whole game to a crashing halt As my father Richard Whalen once told me after attending a meeting on Capitol Hill in the early 1980s It is the duty of the current generation to pass the bubble on to future generations The means of maintaining market stability have evolved since the 1970s even as the scope of the risks to the system have likewise multiplied Since the October 1987 market break in particular the Fed has provided any amount of funding demanded by the marketplace using only the cost of credit as a policy tool a tacit admission that any link between the dollar and tangible valuation measures is gone forever It may seem intellectually inconsistent for the U S central bank to at once encourage greater risk management by financial institutions while at the same time following regulatory and monetary policies that increase the probability of a systemic event but that is a concise description of the Fed s role in America s political economy No Fed Chairman can ignore the ultimate power of politicians to create fiscal chaos and Greenspan is a good enough politician to know it But the Fed s own tendency toward statist rather than free market solutions has allowed the Fed to actually exacerbate America s financial problems Christopher Whalen is Technology Editor of TIE and co founder of Institutional Risk Analytics a provider of fundamental analysis systems for managing credit risk FALL 2004 THE INTERNATIONAL ECONOMY 51 WHALEN consistent effort among the industrial nations to set uniform financial standards for banks Also at that time was born the informal policy of too big to fail under which the Fed and other regulators took extraordinary means to keep several money center banks afloat during the 1989 91 recession With the renewed focus on capital adequacy fostered by Basel I the U S financial system successfully navigated the 1989 91 real estate crash although George Bush I did not The Fed saved the bank at least temporarily by printing money but set the monetary stage for the New Economy investment bubble later in the decade With Basel I Wall Street began to C Whalen accelerate the movement of assets off balance sheet to evade the very same capital requirements The Basel Committee of bank supervisors was concerned about Compromised politically the independent Fed derivatives and off balance sheet financing in the earaccommodates Washington s fiscal excesses even as it ly 1990s but the failure of Long Term Capital preaches the gospel of price stability It encourages Management in 1998 provided the first major warning the growth of derivatives trading and other types of that something was amiss Within a year of the LTCM risktaking not traditionally associated with banking rescue a flurry of proposals came forth from the Bank even as it pushes for higher bank capital levels and for International Settlements in Basel Switzerland in better internal controls through the Basel process The particular the June 1999 statement entitled A new economist priesthood at the Fed attacks Fannie Mae capital adequacy framework and other bloated government sponsored entities as a Under the Basel II proposal that has evolved since potential systemic threat to the U S economy while then and was announced this past summer regulators allowing the creation of goliath universal banks that have sought to address the vastly increased complexpose similar risks The schizophrenic quality of the Fed s approach to its dual responsibilities for monetary policy and bank soundness is a good argument for getting the central bank out of the business of regulating banks but we ll leave that juicy morsel for another day At issue here is the latest set of bank capital rules being championed by the Fed known as Basel II and how these new rules square with the mandate from Congress to all regulators to measure and anticipate risk to the U S financial markets When the first Basel agreement was announced by the Group of Seven regulators in 1988 it set broad relatively simple minimum levels of capital for banks based on a percentage of assets This approach was focused on addressing market and interest rate risk The Basel Accord followed the near failure of several large U S banks and investment houses after the Third World loan crises of the 1980s and was the first ed Vice Chairman Roger Ferguson is the point man for the Fed Board of Governors on Basel II and banking issues generally Sources at the OCC say that Ferguson and the Fed Board s research unit are the intellectual champions of the Basel II framework within the Fed system while officials within the examinations and bank supervision areas are skeptical to put it politely Regulators from the FDIC and the Office of the Comptroller of the Currency have continued to oppose the framework as unworkable and possibly even harmful to bank soundness Indeed sources inside the OCC say that the Fed s own examiners also oppose Basel II but have been silenced by the globalist tendency that dominates the Board of Governors research division F The New Basel Accord proposes to use precisely those measures of risk and credit quality that caused such fiascos as Enron WorldCom and Parmalat 52 THE INTERNATIONAL ECONOMY FALL 2004 WHALEN ity of risk using what is called an internal risk based approach Similar to the now discredited practice of risk based auditing Basel II requires banks to calculate the precise risk profile of each major counterparty Whereas in the past large money center banks could use an estimate of say two standard deviations from the mean of loan losses to determine the adequate ratio of loan loss reserves to total loans Basel II requires banks to identify which particular credits in a given loan portfolio are most likely to default Nobody would argue that the goals of Basel II are not entirely laudable but it remains to be seen whether the analytical tools and methods currently employed by the banking industry are up to the task The accompanying chart illustrates some of the top level measures that Basel compliant banks must be able to calculate using current data from the Federal Deposit Insurance Corporation The banks must also calculate these risk measures for each different type of loans mortgages credit
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