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Basel iii Compliance Professionals Association (BiiiCPA)

1200 G Street NW Suite 800 Washington, DC 20005-6705 USA Tel: 202-449-9750 Web: www.basel-iii-association.com

Basel III News, June 2011

Dear Member, Deutsche Bank analyst Matt OConnor warned that forcing banks to hold too much capital could backfire, and: 1. Banks could charge more for loans, hurting consumers and small businesses 2. Banks might take even bigger risks in order to generate more return, creating the possibility of an even bigger financial crisis. Matt is right. But there are two other very important risks: 1. Much reduced lending capacity available - reduction in the supply of credit in order to return equity to shareholders. Most banks are in the business of attracting shareholders, and must generate return on equity (RoE) that is greater than cost of equity (CoE). The Basel III changes will cause RoE to fall below CoE. As a result banks need to change their business models. 2. Bank customers will look elsewhere for credit: To unregulated entities. This would increase the systemic risk. Although at the November 2010 Seoul Summit, in view of the completion of the new capital standards for banks (Basel III), the G20 Leaders recognized the potential for regulatory tightening to increase the
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incentives for business to migrate to the shadow banking system, we have not seen any concrete measures yet. Make no mistake, shadow banking is inherently complex as it mutates over time and varies across jurisdiction.

We have a (June 2011) Basel III revision

Before we cover the new requirements, we will travel to the European Unions counterparty credit risk - frequently asked questions. It will help us understand the Basel III amendment. The financial crisis highlighted that banks massively underestimated the level of counterparty credit risk associated with over-the-counter (OTC) derivatives. This prompted G20 leaders at the September 2009 Pittsburgh summit to call for more OTC derivatives to be cleared through a Central Counterparty (CCP). They also asked that OTC derivatives that could not be cleared centrally be subjected to higher capital requirements in order to properly reflect the higher risks associated with them. Following the G20 leaders' call, the Basel Committee on Banking Supervision (BCBS) started to review the regulatory capital treatment for counterparty credit risk. The BCBS identified insufficiencies and that CCPs were not widely used to clear derivatives trades. As part of the Basel III reforms, the BCBS has changed the counterparty credit risk regime substantially.
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The new regime will strengthen the capital requirements for counterparty credit exposures arising from institutions derivatives, repo and securities financing activities. It will create the right incentives for banks to use CCPs wherever practicable, thus helping reduce systemic risk across the financial system. Specifically, the objective of these amendments will be: 1. Raise the amount of capital backing these exposures, 2. Reduce procyclicality, i.e. dampen the impact of economic fluctuation throughout the cycle and provide additional incentives to move OTC derivative contracts to central counterparties; In effect helping to reduce systemic risk across the financial system.

What are OTC derivatives?

A derivative is a financial contract linked to the future value or status of the underlying to which it refers (e.g. the development of interest rates or of a currency value, or the possible bankruptcy of a debtor). Over-the-Counter (OTC) derivative contracts are not traded on an exchange (for example the London Stock Exchange) but instead privately negotiated between two counterparts (for example a bank and a manufacturer). OTC derivatives account for almost 90% of the derivatives markets. In mid 2010, the notional value of outstanding OTC derivatives was around $583 trillion or 476 trillion. At the same point in time, the notional value of derivatives traded on exchanges was roughly $66 trillion or 54 trillion.
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The OTC derivatives market comprises a wide variety of product types across several asset classes (interest rates, credit, equity, foreign exchange (FX) and commodities) with widely differing characteristics and levels of standardisation. OTC derivatives are used in a variety of ways, including for purposes of hedging, investing, and speculating. What are Central Counterparties (CCPs)? A CCP is an entity that interposes itself between the two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer. A CCP's main purpose is to manage the risk that could arise if one counterparty is not able to make the required payments when they are due, i.e. defaults on the deal. CCPs are commercial firms. There are currently about a dozen CCPs, all but one located in Europe or the USA, clearing interest rates, credit, equity and commodities OTC derivatives.

What is capitalisation of bank exposures to central counterparties (CCPs)?

It is the amount of capital that banks will be required to hold against their exposures to central counterparties. According to the existing regulatory framework, banks do not have to hold capital for these exposures provided that certain conditions are met. This will change with the upcoming legislative proposal in order to reflect the fact that exposures to central counterparties are not risk free.

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The proposal will suggest applying different risk weights depending on the type of the exposure the bank has vis--vis the central counterparty.

What is credit valuation adjustment?

Credit valuation adjustment (CVA) is an adjustment made by a bank to the market value of an OTC derivative contract to take into account credit risk of the counterparty, i.e. the risk that the credit quality of the counterparty deteriorates or that the counterparty in question defaults. Specifically, it can be defined as the difference between the 'hypothetical' value of the derivative transaction assuming a risk-free counterparty and the true value of the derivative transaction that takes into account the possibility of changes in creditworthiness of the counterparty (including the possibility of the counterparty's default). As such, in accounting terms, CVA is the "market value" of credit risk.

Why is CVA important?

The Basel Committee decided to introduce an explicit capital requirement for the CVA risk (i.e. a requirement for extra capital) after it was revealed that nearly two-thirds of the losses stemming from derivatives during the crisis were a direct consequence of the deterioration of the credit quality of the counterparty, and not necessarily triggered by the default of the counterparty, already covered by the existing regulatory framework. The calibration of the capital charge for CVA risk was published by Basel in December 2010. The one outstanding issue is what to do in the event that a bank creates a valuation adjustment/provision for CVA risk (i.e. writes down some capital to take account of the risk) (i.e. "incurs CVA"), and how to recognise it in the respective capital treatment, i.e. how does the amount
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of the created valuation adjustment/written-off capital count towards the overall capital requirements to reflect the fact that this amount cannot be lost twice. Addressing this issue requires assessing how much credit banks should get for creating provisions for the CVA risk. Important parts from the paper:

Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010 (rev June 2011) Enhancing risk coverage
One of the key lessons of the crisis has been the need to strengthen the risk coverage of the capital framework. Failure to capture major on- and off-balance sheet risks, as well as derivative related exposures, was a key destabilising factor during the crisis. In response to these shortcomings, the Committee in July 2009 completed a number of critical reforms to the Basel II framework. These reforms will raise capital requirements for the trading book and complex securitisation exposures, a major source of losses for many internationally active banks. The enhanced treatment introduces a stressed value-at-risk (VaR) capital requirement based on a continuous 12-month period of significant financial stress. In addition, the Committee has introduced higher capital requirements for so-called resecuritisations in both the banking and the trading book. The reforms also raise the standards of the Pillar 2 supervisory review process and strengthen Pillar 3 disclosures.
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The Pillar 1 and Pillar 3 enhancements must be implemented by the end of 2011; the Pillar 2 standards became effective when they were introduced in July 2009. The Committee is also conducting a fundamental review of the trading book. The work on the fundamental review of the trading book is targeted for completion by year-end 2011. This document also introduces measures to strengthen the capital requirements for counterparty credit exposures arising from banks derivatives, repo and securities financing activities. These reforms will raise the capital buffers backing these exposures, reduce procyclicality and provide additional incentives to move OTC derivative contracts to central counterparties, thus helping reduce systemic risk across the financial system. They also provide incentives to strengthen the risk management of counterparty credit exposures. To this end, the Committee is introducing the following reforms: (a) Going forward, banks must determine their capital requirement for counterparty credit risk using stressed inputs. This will address concerns about capital charges becoming too low during periods of compressed market volatility and help address procyclicality. The approach, which is similar to what has been introduced for market risk, will also promote more integrated management of market and counterparty credit risk.

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(b) Banks will be subject to a capital charge for potential mark-to-market losses (ie credit valuation adjustment CVA risk) associated with a deterioration in the credit worthiness of a counterparty. While the Basel II standard covers the risk of a counterparty default, it does not address such CVA risk, which during the financial crisis was a greater source of losses than those arising from outright defaults. (c) The Committee is strengthening standards for collateral management and initial margining. Banks with large and illiquid derivative exposures to a counterparty will have to apply longer margining periods as a basis for determining the regulatory capital requirement. Additional standards have been adopted to strengthen collateral risk management practices. (d) To address the systemic risk arising from the interconnectedness of banks and other financial institutions through the derivatives markets, the Committee is supporting the efforts of the Committee on Payments and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) to establish strong standards for financial market infrastructures, including central counterparties. The capitalisation of bank exposures to central counterparties (CCPs) will be based in part on the compliance of the CCP with such standards, and will be finalised after a consultative process in 2011. A banks collateral and mark-to-market exposures to CCPs meeting these enhanced principles will be subject to a low risk weight, proposed at 2%; and default fund exposures to CCPs will be subject to risk-sensitive capital requirements.

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These criteria, together with strengthened capital requirements for bilateral OTC derivative exposures, will create strong incentives for banks to move exposures to such CCPs. Moreover, to address systemic risk within the financial sector, the Committee also is raising the risk weights on exposures to financial institutions relative to the non-financial corporate sector, as financial exposures are more highly correlated than non-financial ones. (e) The Committee is raising counterparty credit risk management standards in a number of areas, including for the treatment of so-called wrong-way risk, ie cases where the exposure increases when the credit quality of the counterparty deteriorates. It also issued final additional guidance for the sound backtesting of counterparty credit exposures. Finally, the Committee assessed a number of measures to mitigate the reliance on external ratings of the Basel II framework. The measures include requirements for banks to perform their own internal assessments of externally rated securitisation exposures, the elimination of certain cliff effects associated with credit risk mitigation practices, and the incorporation of key elements of the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies into the Committees eligibility criteria for the use of external ratings in the capital framework. The Committee also is conducting a more fundamental review of the securitisation framework, including its reliance on external ratings.

Addressing systemic risk and interconnectedness

While procyclicality amplified shocks over the time dimension, excessive interconnectedness among systemically important banks also transmitted shocks across the financial system and economy.
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Systemically important banks should have loss absorbing capacity beyond the minimum standards and the work on this issue is ongoing. The Basel Committee and the Financial Stability Board are developing a well integrated approach to systemically important financial institutions which could include combinations of capital surcharges, contingent capital and bail-in debt. As part of this effort, the Committee is developing a proposal on a methodology comprising both quantitative and qualitative indicators to assess the systemic importance of financial institutions at a global level. The Committee is also conducting a study of the magnitude of additional loss absorbency that globally systemic financial institutions should have, along with an assessment of the extent of going concern loss absorbency which could be provided by the various proposed instruments. The Committees analysis has also covered further measures to mitigate the risks or externalities associated with systemic banks, including liquidity surcharges, tighter large exposure restrictions and enhanced supervision. It will continue its work on these issues in the first half of 2011 in accordance with the processes and timelines set out in the FSB recommendations. Several of the capital requirements introduced by the Committee to mitigate the risks arising from firm-level exposures among global financial institutions will also help to address systemic risk and interconnectedness. These include: 1. Capital incentives for banks to use central counterparties for over-the-counter derivatives;
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2. Higher capital requirements for trading and derivative activities, as well as complex securitisations and off-balance sheet exposures (eg structured investment vehicles); 3. Higher capital requirements for inter-financial sector exposures; and 4. The introduction of liquidity requirements that penalise excessive reliance on short term, interbank funding to support longer dated assets.

Stress testing
Banks must have a comprehensive stress testing program for counterparty credit risk. The stress testing program must include the following elements: 1. Banks must ensure complete trade capture and exposure aggregation across all forms of counterparty credit risk (not just OTC derivatives) at the counterparty-specific level in a sufficient time frame to conduct regular stress testing. 2. For all counterparties, banks should produce, at least monthly, exposure stress testing of principal market risk factors (eg interest rates, FX, equities, credit spreads, and commodity prices) in order to proactively identify, and when necessary, reduce outsized concentrations to specific directional sensitivities. 3. Banks should apply multifactor stress testing scenarios and assess material non-directional risks (ie yield curve exposure, basis risks, etc) at least quarterly. Multiple-factor stress tests should, at a minimum, aim to address scenarios in which a) Severe economic or market events have occurred;
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b) Broad market liquidity has decreased significantly; and c) The market impact of liquidating positions of a large financial intermediary. These stress tests may be part of bank-wide stress testing. 4. Stressed market movements have an impact not only on counterparty exposures, but also on the credit quality of counterparties. At least quarterly, banks should conduct stress testing applying stressed conditions to the joint movement of exposures and counterparty creditworthiness. 5. Exposure stress testing (including single factor, multifactor and material non-directional risks) and joint stressing of exposure and creditworthiness should be performed at the counterparty-specific, counterparty group (eg industry and region), and aggregate bank-wide CCR levels. 6. Stress tests results should be integrated into regular reporting to senior management. The analysis should capture the largest counterparty-level impacts across the portfolio, material concentrations within segments of the portfolio (within the same industry or region), and relevant portfolio and counterparty specific trends. 7. The severity of factor shocks should be consistent with the purpose of the stress test. When evaluating solvency under stress, factor shocks should be severe enough to capture historical extreme market environments and/or extreme but plausible stressed market conditions.

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The impact of such shocks on capital resources should be evaluated, as well as the impact on capital requirements and earnings. For the purpose of day-to-day portfolio monitoring, hedging, and management of concentrations, banks should also consider scenarios of lesser severity and higher probability. 8. Banks should consider reverse stress tests to identify extreme, but plausible, scenarios that could result in significant adverse outcomes. 9. Senior management must take a lead role in the integration of stress testing into the risk management framework and risk culture of the bank and ensure that the results are meaningful and proactively used to manage counterparty credit risk. At a minimum, the results of stress testing for significant exposures should be compared to guidelines that express the banks risk appetite and elevated for discussion and action when excessive or concentrated risks are present.

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Remarks from Herv Hannoun, Deputy General Manager, Bank for International Settlements 2011 Research Conference: Financial crises: the role of deposit insurance International Association of Deposit Insurers, Basel, 8 June 2011 Reducing the default probability of systemically important financial institutions by increasing their loss absorption capacity Although substantial progress is being made in strengthening national resolution regimes and improving coordination on cross border issues, we need to be realistic about the feasibility of a global resolution regime that can cope with the failure of a global SIFI. It is therefore critical to reduce the probability of SIFI failures by increasing the loss absorption capacity of such institutions. At the G20 Seoul Summit in November 2010, the leaders reiterated the importance of the work on SIFIs. Global SIFIs were defined as institutions of such size, market importance, complexity and global interconnectedness that their distress or failure would cause significant dislocation in the global financial system and adverse economic consequences across a range of countries. It was also agreed that global SIFIs should have loss absorption capacity beyond the minimum Basel III standards. Indeed, additional capital requirements for global SIFIs find their rationale in externalities that Basel III does not fully address. To deal with the externalities of global SIFIs, the FSB and the Basel Committee are currently developing an assessment methodology for systemic importance that will identify global SIFIs.
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Based on their systemic importance, global SIFIs will be required to bolster their loss absorbency by holding a systemic capital surcharge or adding contingent capital.

I would like to underline that the Basel III capital requirements (the 7% common equity ratio, comprising the 4.5% minimum plus a 2.5% capital conservation buffer) should be seen as setting a minimum requirement; they are not a maximum. This is a fundamental point, which is the subject of an important debate at the moment in the European Union. It is important in our view to allow national authorities to set higher capital requirements than the Basel III minima. It is equally important to recognise the ability of supervisors, within each jurisdiction, to require additional loss absorbency for SIFIs in the form of common equity beyond the 7% common equity ratio established by Basel III. To conclude, in the absence of a global resolution framework for the time being, the only reasonable course of action is to make SIFI failures less likely by imposing systemic capital surcharges.

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The Japanese earthquake and tsunami

6 June 2011 (Extract from pages 4-5 of BIS Quarterly Review, June 2011) The destruction and human tragedy following the earthquake and tsunami in Japan have been huge. There was an immediate drop in economic activity due to damage to facilities, disruptions to supply lines and power shortages. Recent data releases show that household spending and production have plunged. Damage to the nuclear power plant in Fukushima and ensuing radiation leaks have added to the challenges. The possible implications of these events for the Japanese economy as well as the global economic outlook and financial markets are manifold, and uncertainties associated with these effects continue. Initial assessments by the Japanese Cabinet Office put the damage to the economy's capital stock at around $240 billion, which is more than double the damage following the Kobe earthquake in 1995. GDP declined by 0.9% on the previous quarter in the first three months of 2011. For the year, GDP growth is expected to be about 1 percentage point lower than earlier estimates. Financial markets reacted very strongly in the immediate aftermath of the disaster (Graph A). The Tokyo stock market plummeted by almost 20% in the first two business days after the earthquake, and Japanese sovereign CDS spreads
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jumped by 30 basis points, probably reflecting concerns about the extra fiscal burden implied by reconstruction. The foreign exchange market was also very volatile, with the Japanese yen appreciating sharply against the US dollar, reaching a high of 76.3 on 17 March. Reportedly, this was driven by market speculation that Japanese insurance companies would repatriate US dollar funds to meet yen-denominated claims. The Bank of Japan responded swiftly. To ensure ample liquidity, it offered funding of 82.4 trillion in the first week after the earthquake, of which 57.8 trillion was actually provided to the market. The Bank also increased the amount of its asset purchase programme by 5 trillion, to prevent a deterioration in risk sentiment from adversely affecting output. In response to the yen's sharp appreciation, the Ministry of Finance and the central bank, together with other G7 countries, embarked on a concerted intervention in the foreign exchange market. On 6-7 April, the Bank of Japan unveiled a 1 trillion special lending facility to channel funds to banks for lending to distressed businesses in the affected areas, and broadened the range of eligible collateral assets for money market operations. In addition, the government announced a supplementary budget of 4 trillion for reconstruction purposes on 22 April. These measures supported market functioning despite the severity of the shock.
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Markets calmed quickly after their initial reaction: the stock market recovered somewhat; the yen retreated to trade in the range of 82-83 against the US dollar; and Japan's CDS spread declined.

Outside Japan, the impact on financial markets was limited, and largely confined to sectors seen as being most directly affected by supply chain disruptions or direct loss exposures. A primary concern in financial markets has been that an extended period of power shortages in Japan might adversely affect industrial production through global supply chains, given that Japan is a major producer of components for the semiconductor and automotive industries. Thus, while broad equity market indices have shown signs of resilience (Graph B, left-hand panel), certain sectoral indices fell sharply following the news of the disaster, and have subsequently recouped only part of their initial losses (Graph B, right-hand panel).

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Monetary policy in a world with macroprudential policy

Remarks by Mr Jaime Caruana, General Manager of the BIS, at the SAARCFINANCE Governors' Symposium 2011, Kerala, 11 June 2011. We need proper governance arrangements: independence, clarity and accountability. Regardless of the specific type of cooperation mechanisms put in place, financial stability requires governance arrangements that incorporate the principles of independence, clarity and accountability. Independence from political cycles is needed for macroprudential policy no less than for monetary policy. A common problem for both policies is the need to intervene during the upswing, when things are going well and the public might be sceptical that problems loom down the road.
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Operational independence will be needed to shield unpopular policy decisions. Strong accountability and clarity of communication will bolster public support for the independence of macroprudential policy and hence its credibility and effectiveness. Clarity about mandates, responsibilities and powers is important for the effectiveness and timeliness of actions and for managing the difficult trade-offs. Sufficient powers imply control over relevant instruments and appropriate safeguards. For example, access to micro supervisory data is important. At the same time, our limited technical knowledge means that macroprudential frameworks need room to adapt and grow with experience. Very specific and inflexible mandates raise the risk that the specified targets are, or quickly become, poorly matched to the economy's and financial system's needs. As a result, the policymaker's ability to respond to unexpected circumstances could be severely constrained. Accountability is critical. That said, since financial stability objectives are difficult to quantify or define precisely, accountability is harder to achieve than, say, for price stability objectives in monetary policy. A clear and transparently communicated strategy that sets out the central bank's intentions can serve as the basis for accountability.

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Regardless of the specific governance and cooperation arrangements, the emerging reality is that central banks have a key role to play. This role requires mandates and governance structures that are consistent with their primary monetary policy function. In some cases, central banks' duties and powers to promote financial stability are being enhanced. More active financial stability roles will raise issues of reputational risk that central banks will need to manage carefully, especially if their views on specific decisions are not shared by other agencies involved in the process. Central banks will also face additional challenges. They will face an added burden to be very clear about what policy actions are being taken and for what reason. They will need to be careful not to undermine price stability mandates and hard-won credibility. And they will need to preserve their operational autonomy, including financial independence. In turn, this requires control over their balance sheet and ex-ante clear mechanisms to transfer losses to the Treasury. A forthcoming Central Bank Governance Forum report describes the current range of practice across central banks and analyses the issues posed by various choices.

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The European Systemic Risk Board (ESRB)

Mission, objectives and tasks According to the ESRB Regulation: The ESRB shall be responsible for the macro-prudential oversight of the financial system within the Union in order to contribute to the prevention or mitigation of systemic risks to financial stability in the Union that arise from developments within the financial system and taking into account macro-economic developments, so as to avoid periods of widespread financial distress. It shall contribute to the smooth functioning of the internal market and thereby ensure a sustainable contribution of the financial sector to economic growth. For this purpose, the ESRB shall carry out the following tasks: 1. Determining and/or collecting and analysing all the relevant and necessary information; 2. Identifying and prioritising systemic risks; 3. Issuing warnings where such systemic risks are deemed to be significant and, where appropriate, make those warnings public; 4. Issuing recommendations for remedial action in response to the risks identified and, where appropriate, making those recommendations public; 5. When the ESRB determines that an emergency situation may arise issuing a confidential warning addressed to the Council and providing the Council with an assessment of the situation, in order to enable the Council to adopt a decision addressed to the European Supervisory Authorities (ESAs) determining the existence of an emergency situation; monitoring the follow-up to warnings and recommendations;
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cooperating closely with all the other parties to the European System of Financial Supervision (ESFS); where appropriate, providing the ESAs with the information on systemic risks required for the performance of their tasks; and, in particular, in collaboration with the ESAs, developing a common set of quantitative and qualitative indicators (risk dashboard) to identify and measure systemic risk; 6. Participating, where appropriate, in the Joint Committee of the ESAs; coordinating its actions with those of international financial organisations, particularly the International Monetary Fund (IMF) and the Financial Stability Board (FSB) as well as the relevant bodies in third countries on matters related to macro-prudential oversight; 7. Carrying out other related tasks as specified in Union legislation.

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Intellectual challenges to financial stability analysis in the era of macroprudential oversight

Jean-Claude Trichet, President of the European Central Bank, Chairman of the European Systemic Risk Board This article discusses the main intellectual challenges related to the conceptual foundations, analytical models and regulatory assessment tools in the field of financial stability analysis. The focus is on ways to detect and contain systemic risk. The article also tries to point in directions that could be helpful in resolving these intellectual challenges. The article starts with a discussion of the nature and origins of financial stability and systemic risk. It then goes through four areas in which lessons from the present crisis have illustrated major analytical challenges in enhancing the understanding of financial stability and systemic risk. The article concludes that 1) The understanding of the fundamental working of financial systems and the risks they generate needs to be deepened, in particular in relation to financial innovation and the role of nonbank financial intermediaries 2) Better insights need to be developed about when and how financial systems migrate from stability to instability, 3) Models need to be developed that capture the interactions between widespread financial instability and the performance of the economy at large (including the related amplification effects and nonlinearities), and

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4) Such models need to be further extended to be able to assess the effectiveness and efficiency of macroprudential regulatory policies in containing systemic risks. Meeting this agenda will require reorienting signifi cant resources in academia, central banks and supervisory authorities in these directions. It will also require enriching the way of thinking in economics and finance. New approaches should be considered that do not necessarily rely only on the notions of equilibrium, universal rationality and efficiency, but go beyond those concepts. Approaches that have been used successfully in other fields, such as the natural sciences, may be a helpful source of inspiration. My starting point is that we have recently entered a new era of financial stability policies, the era of macroprudential oversight. The new supervisory bodies that have just been created in Europe such as notably the European Systemic Risk Board (ESRB) in the European System of Financial Supervision (ESFS) would benefit significantly from intellectual progress in those directions. The article starts with a discussion of the nature and origins of financial stability and systemic risk, in particular how systemic risk can be defined and which factors can make financial instability widespread and dangerous. It then goes through four areas in which lessons from the present crisis have illustrated major analytical challenges in enhancing our understanding of financial stability and systemic risk.

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The first area concerns challenges at the very fundamental level of the functioning of financial systems, in particular how they change over time through innovation. The second area relates to challenges with respect to our understanding of the transition from tranquil times to crisis times. Third, it is extremely challenging to develop better tools assessing the macroeconomic implications of financial instabilities. Fourth and last, we have very limited analytical tools and models (and experiences) to assess how regulatory policy can be used to contain risks at the level of the financial system as a whole and the overall economy.

1| FINANCIAL CRISES, STABILITY AND SYSTEMIC RISK 1|1 The meaning of systemic risk and experiences with systemic crises
The crisis that we have experienced over the last three years is an overwhelming case of the materialisation of systemic risk. Systemic financial risk can be defined as the risk that financial instability becomes so widespread that it impairs the functioning of a financial system to the point where economic growth and welfare suffer materially.

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Chart 1 displays one indicator a Composite Indicator of Systemic Stress (CISS) that ECB staff developed to capture in real time how much systemic instability is present at a given point in time. The chart clearly shows how systemic stress emerged in the European Union in August 2007, how the situation degenerated to a full-blown systemic crisis in September 2008 with, in particular, the bankruptcy of Lehman Brothers (when the indicator shoots up towards its maximum value of 1) and how the process of relaxation was countered in May 2010, in particular due to the Greek debt crisis. There were many financial crises in history and a share of them reached systemic dimensions. Examples include in particular the worlds Great Depression in the 1930s and, at national levels, the Nordic and Japanese banking crises during the 1990s.

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Every crisis possesses its own characteristics, and having learnt the lessons from the last crisis does not provide protection against future, necessarily different, crises. Moreover, in a dynamic economic system, progress and growth can only be achieved in accepting risks, which could indeed include a tail risk of crises. The experience of the last three years suggests that policy authorities in all advanced economies need to improve considerably their capacity to detect and contain systemic risks. Financial supervision was too much focused on the microprudential dimension of individual risks at the level of single intermediaries and markets, rather than looking how risks could add up and compound each other. In order to become better in this regard, authorities need to consider more the deep underlying sources of systemic instability and, in particular, how risks can reach the systemic dimension.

1|2 How financial instability can become systemic

Research suggests that there are, in particular, three broad ways through which financial instability can reach systemic dimensions. The first is contagion. The failure of one financial agent (or crash of one market) can lead to failures of other financial agents (or crashes of other markets), even when the latter have not invested in (or are exposed to) the same risks and are not subject to the same original shock as the former. Second, widespread financial imbalances can build up over time and then unwind abruptly.
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Hyman Minsky described how in good times consumption and investment increase, generating income, which fuels the financing of more consumption and investment but also the neglect of increasing risks. Even small events can then lead to a re-pricing of risk and an endogenous unravelling of the credit boom, which adversely affects many agents and markets at the same time. Third, severe negative aggregate shocks can adversely affect intermediaries and markets simultaneously. Historical research has shown that many banking crises were related to severe economic downturns. Note that the three mechanisms can happen independently, but that most of the time they are mutually reinforcing. There are a number of inherent features of financial systems that make them particularly prone to these forms of systemic risk. The first is externalities. They particularly relate to the complex and dynamic network of exposures among major intermediaries. What in tranquil times is an efficient mechanism to share risk, can, in times of stress, become a dangerous channel for transmitting instability. Two contracting parties do not have an incentive to take account of the effects of their risk-taking on third parties. As a consequence, the risk at the level of the system may be higher than the sum of perceived individual risks. The second feature is asymmetric information.
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Financial systems allocate funds from agents who have them but possess no specific knowledge about promising investment opportunities, to agents who have knowledge about the opportunities but not the funds to engage in them. This creates an agency problem between the two parties, which may be handled more or less well through the underlying financial contracts. If contracts are incomplete and negative news arrive on some of the investment projects, but information asymmetries do not allow lenders to judge whether this also affects other investment projects, funding may evaporate for all projects alike a phenomenon often referred to as adverse selection. The special propensity of financial systems to systemic risk is not simply the result of these two imperfections. Externalities and information problems are also present in other economic sectors. But there are some other features of financial systems, which render their implications much more severe and widespread. First, illiquid assets, maturity mismatches between assets and liabilities and leverage amplify the force with which problems of one financial intermediary are pushed through the complex network of exposures. Second, sizable amounts of debt relative to capital and short-term funding have more dramatic effects in situations of stress. These features in conjunction with the above imperfections lead to powerful feedback and amplification mechanisms, which may cause sudden regime changes, driving the system from a state of relative

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tranquillity to a state of turmoil (see, for example, the soaring values of the CISS in August 2007 and September 2008 in Chart 1). In the aggregate, one observes the abrupt nonlinear adjustments that are so characteristic of financial instability. A well-developed analytical apparatus for supporting policies in this area would have to fully capture all these elements. The following sections try to address some of the intellectual challenges in providing such an apparatus, using the experiences of the present and previous crises.

2| ADVANCING THE ANALYTICAL APPARATUS FOR FINANCIAL STABILITY AND SYSTEMIC RISK POLICIES 2|1 The basic functioning of financial systems and the risks they imply
The first set of intellectual challenges in advancing the analytical apparatus for financial stability and systemic risk policies relates to the deep functioning of financial systems. The crisis has shown that financial systems are much less understood than what was thought. While some important parts and implications of the DNA of financial systems are known their main components, their main functions, indicators of their efficiency or which basic risks can emerge, there are difficulties in grasping the essence of some major mutations (financial innovations) and in predicting how the overall body reacts to specific stresses; two elements that, on occasion, may be strongly related.

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The crisis has taught authorities (and market participants) that the early identification of the build-up of vulnerabilities and widespread imbalances has to become better. The analytical apparatus supporting financial stability policy needs to provide authorities with the means to understand the efficiency and risks of both new financial instruments and new business models of financial intermediaries. A second crisis lesson in this area is that not only models about the systemic risks in banking are needed but also about how nonbank financial intermediaries can contribute to the transmission of instability at the system level. Brunnermeier and Nagel (2004) found that, whilst hedge funds are technically among the most sophisticated investors, between 1998 and 2000 they were heavily invested in technology stocks rather than acting as a price correcting force towards fundamental values. More generally, the explosion of the industry of highly leveraged fi nancial institutions over the last 20 years from around 100 billion US dollars capital under management in 1990 up to 3 trillion US dollars in 2007 is not yet fully understood in its financial stability implications. Also to be noted, the credit derivative activities of some insurance companies did play a significant role in the crisis. The activities of so-called shadow banks, which were not subject to the supervisory regime of banks, played themselves a decisive role in the run up to the subprime crisis, which has been the trigger of the global financial crisis. A third lesson suggests that the image of atomistic and highly efficient financial markets needs to be revised.

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As also a growing body of financial research suggests, asset valuations, corporate financing activities and intermediation processes are subject to a range of important imperfections to which greater attention is warranted. The two examples of externalities and asymmetric information have already been mentioned. Another example is oligopolistic structures in major wholesale financial markets. Many derivatives markets are dominated by a small number of highly sophisticated and complex financial intermediaries. Their strategic behaviour is likely to have very different effects on those markets than the benchmark of perfect and atomistic markets might suggest. How this strategic, and maybe sometimes also predatory behaviour can on occasion have destabilising effects needs to be understood much better. A more radical line of work responds to analytical challenges of the crisis at a more fundamental theoretical level. It starts from the presumption that certain inherent features of the standard economic paradigms, in particular in macroeconomics prevent them from capturing crucial features of exceptional situations like the ones experienced in the last few years. Notably, analytical models based on a strong tendency to converge towards equilibrium, a high level of market efficiency and representative rational agents have great difficulties in generating the amplification effects, nonlinearities and crashes characteristic for systemic instability (see Section 1 and Chart 1).

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So-called agent-based models do not rely on strong equilibrium attractors and incorporate heterogeneous agents whose direct interactions have significant influence on overall economic outcomes. They are based on bottom-up simulations of individual behaviour rather than top-down maximisations. They have been applied successfully to a wide range of problems in different sciences, including physics, biology, computer science, traffic systems and mass panics, in particular to problems where amplification, intermittent changes and nonlinearities play a significant role.

2|2 The transition from tranquil times to crises

The second set of intellectual challenges for financial stability analysis relates to the period in which the system moves from stability to instability. One distinguishing feature of this crisis relative to previous crises is speed. While the unfolding of the sovereign debt crises in the 1980s occurred over the course of years, the Asian financial crisis developed, at its peak, over months rather than years. The major intensification of the present crisis, starting in mid-September 2008 (see Chart 1), spread around the globe in the course of half-days. In physics such phenomena are described as phase transitions. When some factors exceed a critical level, a system behaves qualitatively differently from a situation when the factors stay below this level. Building on some fundamental physics research on crackling noise and self-organised criticality, Bouchaud (2009) describes how the random field Ising model originally developed to analyse how spins order within
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a disordered magnet can be applied to the persistence and breakdowns of financial bubbles. Investors take their decisions based on slowly moving fundamental variables, such as interest rates, inflation, earnings forecasts etc. At the same time, however, they are influenced by the majority opinion of other investors. For that latter fact, the aggregate opinion can be subject to large discontinuous changes, even though dramatic changes do not necessarily happen in the fundamentals. Moreover, the physics analogy illustrates hysteresis in optimism. Much as supersaturated vapour refuses to turn into a liquid, optimism is self-consistently maintained (until a critical threshold is reached and an avalanche of opinion changes is launched). This analogy from physics illustrates how imbalances that have built up endogenously over an extended period of time can suddenly unravel. Another lesson in this area concerns the role of confidence. Ultimately fi nancial transactions rely on promises about future payments. If agents begin to doubt such promises, trust may vanish triggering sharp drops in asset valuations. Arguably, this is even more the case in a highly complex and interconnected system, such as the one that decades of financial deepening and sophistication have rendered.

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But the non-fundamental factors that also determine whether fi nancial agents have confidence in the payment promises embedded in such a complex system are hard to characterise in quantitative models. More generally in practice, it is challenging to assess how and when confidence abruptly evaporates at a very large scale, as it did for example in September 2008 after the demise of Lehman Brothers (see Chart 1). One direction is the analysis of asymmetric and imperfect information. For example, recent research has illustrated which factors generate adverse selection phenomena, so that markets dry up and instability propagates through contagion. Another direction is a greater incorporation of psychological factors in economic analyses, as actually the field of behavioural finance is starting to do. Whereas the former approach still relies on the assumption of fully rational agents, the latter approach starts from empirical evidence that contradicts this assumption. Akerlof and Shiller (2009) discuss a variety of psychological factors that played a role in the present crisis, and much more work would appear beneficial. The combination of complexity, interconnectedness, payment promises in debt contracts, limits of information and basic human behaviour animal spirits can lead to the violent feedback and amplification mechanisms that are so typical for the transition from stability to instability. For all these reasons, enhanced and deep market intelligence should continue to play a very substantial role.

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2|3 Financial crises and the macroeconomy

The third area of intellectual challenges in financial stability analysis relates to why authorities care so much about financial stability, namely to which extent financial instability affects the overall economy, notably growth and consumer welfare, and why the transmission to the real economy may sometimes be so severe. Chart 2 shows the range of GDP growth forecasts for the euro area across major forecasting institutions (dashed blue line) and the realised GDP growth rates (solid orange line) as policy makers saw them during the critical years of 2008 and 2009, respectively.

By comparing the corridor of dashed lines and the solid orange line in panel a) of Chart 2 one can see that all forecasting institutions consistently over-estimated the growth rate for 2008, even until very late the same year.

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Moving on to panel b) of Chart 2, it can be seen that the strongly negative growth rate of 4% in 2009 the free fall in economic activity was dramatically missed until the end of 2008. In this sense, left alone with unreliable forecasts policy-makers had to act on informal information, real-time data releases and their own wisdom and judgements on how the situation was evolving. There can be many reasons for these sizable forecasting errors. One may simply be that it is particularly difficult to look into the future in extraordinary circumstances. It would, however, be too simple to just stop here. Another reason for the errors may be that standard macroeconomic models, as they tend to be used as input in projections, do not have well developed financial sectors and are mostly linear in nature. Therefore, it is not all that surprising that they were not able to predict the drastic effects of the financial meltdown on growth figures. So, a tremendous intellectual challenge is to develop aggregate models that (i) Give the central role to financial systems that they actually play in the economy by channelling funds from firms, households and governments with surpluses to the agents that need them to finance real investment and smoothen consumption and (ii) Incorporate states of widespread instability in these financial systems that feature the characteristics discussed before (bank defaults and other nonlinearities, feedback and amplification effects etc.). Although a new literature of macroeconomic models with financial frictions is emerging, we are presently still very far from a new
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generation of macroeconomic models that would fully meet the challenge described. As this fundamental research field advances, such models could also enrich the toolkit for macroeconomic forecasts. A related challenge can be identified in the very important field of macro-stress testing. A traditional stress test starts from an extreme but plausible macroeconomic scenario and considers its one-off effect on banks. Looking ahead, stress-testing frameworks could consider the two-way relationship between the financial system and the economy at large. For example, severely weakened banks have less room for lending with negative effects on consumption and investments. Again, cumulative effects and amplifications can take place in practice, which would not be captured by the traditional approaches. Therefore, the type of aggregate models described before could also enrich stress-testing toolkits.

2|4 The regulation of systemic risk

The fourth and last set of intellectual challenges addressed in this article deals with regulatory policy. How can we assess in advance whether regulatory measures have the desired stabilizing effects at the level of the financial system as a whole? This is a surprisingly new question. Most financial regulations in the past have been assessed at the microprudential level, namely for their effect on individual intermediaries or markets.
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Absent aggregate models with realistic characterizations of widespread financial instability, how can we design new macroprudential regulatory policy instruments and calibrate instruments known from the microprudential arena for the desirable effects on systemic stability and welfare? Some results from the theory of complex systems might be read in a way that those systems cannot be steered with precision. As a consequence, the efficient solution could be to ensure that agents in the system have sizable buffers in order to survive even extreme shocks rather than to try and remove or limit the risks directly. Determining how high those buffers should be is a demanding question. The view embedded into the new Basel III capital and liquidity framework is that such buffers need to be higher than was previously the case. Although the new standards foresee a multitude of micro-based regulatory measures, they also entail macroprudential elements. These regulatory measures have been developed in response to the major flaws identified during the crisis, namely the insufficient quantity and quality of the capital base of financial institutions, the underestimation of liquidity risk as well as the build-up of excessive leverage in the financial system (one of the imbalances referred to in sub-section 1|2). In addition to meeting stricter regulatory requirements with regard to the quantity and quality of regulatory capital as well as liquidity cushions, banks will need to build up additional capital buffers in good times that could be drawn down in stress periods.

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A capital conservation buffer will serve as a backstop against excessive distributions in the form of dividends and compensation payments in good times. Excessive distributions may have contributed to destabilising the financial sector as a whole in the recent past. The capital conservation buffer will be complemented with a counter-cyclical element that explicitly considers the macrofinancial environment (e.g. excess aggregate credit growth) in which financial intermediaries operate. This capital buffer regime is expected to contribute to mitigating the inherent pro-cyclicality in the financial sector (potentially constituting building-up and unraveling of widespread imbalances). Beyond pro-cyclicality refl ecting the build-up and unravelling of widespread imbalances as one form of systemic risk, regulators are increasingly concerned about the interconnectedness among systemically important financial institutions (SIFIs) and the sizable externalities that these financial intermediaries can exert on other intermediaries and the system as a whole (see Section 1). Economists have suggested recently that these intermediaries should hold higher capital or pay a tax or levy, respectively, in proportion to the risk of such externalities. They argued that if the amount of capital or the size of the tax/levy was determined by leverage, maturity mismatch and asset growth, then it would discourage intermediaries to become the source of such externalities. In practice, however, the sources and variants of such externalities are multiple and diverse.
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Recent policy debates show how complex and challenging it is to introduce such capital or liquidity surcharges in the present regulatory setup, not the least because of the difficulty to precisely and comprehensively measure all the externalities (systemic impact). Regulatory initiatives at the international level revolve around the following cornerstones: (i) Reducing the probability of the failure of SIFIs; (ii) Reducing the impact of their failure; (iii) Enhancing their supervision and (iv) Strengthening core financial infrastructures. A broad consensus has arisen about the need for SIFIs to have higher loss absorbency commensurate to their systemic importance compared to non-systemic firms. Key work is under way on the identification of SIFIs and the assessment of the magnitude of additional loss absorbency, to be achieved via a combination of equity surcharges as well as other innovative instruments, such as contingent capital and bail-in-able debt. In parallel, major efforts are ongoing to improve the resolvability of SIFIs. Prominent examples in this area are the establishment of effective resolution regimes, the development of recovery and resolution plans (living wills) and the creation of dedicated resolution funds.

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To address the issue of linkages and contagion, there is also a general drive towards directing trades to Central Clearing Counterparties (CCPs) whenever possible. This way counterparty risk can be managed more effi ciently and policies on haircuts can be more effective. The growth of CCPs into highly systemic institutions, however, calls for their tight supervision. Finally, the recognition that the quality, quantity and timeliness of information are crucial for a sound and stable financial system is driving efforts to improve data collection, develop stress tests into a truly macroprudential tool that fits into a policy framework aimed at advancing the systems resilience, and work on the harmonisation of accounting standards that reflect as closely as possible the economic value of contracts. Another reminder of the present crisis is the danger of excessive debt and leverage. For example, we know that the debt financing of a wide range of economic agents (from households to large and complex intermediaries) without enough income, equity or collateral was a major cause of the instability. Since one locus of this problem was the heavy flow of credit into mortgage markets in a number of important countries, one should not neglect tools such as loan-to-value ratios and debt-to-income limits. Some Asian emerging countries have some interesting experiences with the use of such demand-side oriented macroprudential policy instruments.

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We should reflect on whether the positive experiences of those countries with tightening limits would justify generalising them as fully countercyclical instruments (also relaxing them in downturns). And whether these experiences in emerging economies of relatively moderate size would be fully valid for sizable industrial countries with highly developed financial systems. From an institutional perspective, Europe has pushed ahead with the creation of the ESRB, a body responsible for the macroprudential oversight of the financial system within the European Union. The ESRB will monitor systemic risk and, when necessary, issue warnings and policy recommendations both about the current situation and the medium-long term, starting with the toolbox described above and working on new instruments suited to industry developments. The strength of this new institution comes from its membership, which comprises all the EU central banks and financial supervision authorities plus the Commission and a representative of the Councils structures. This should ensure that micro- and macroprudential concerns are tackled in a harmonised way and that its recommendations carry due weight. The ESRB starts at a time that calls both for crisis management and for prevention. It was the right time to put in place such a building block of a truly stable and efficient financial system. The issue of adequate policy responses to emerging systemic risks becomes even more challenging in the international arena. Lately, global imbalances have been reconfirmed and could further widen in the future.
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While a detailed discussion of this specific issue is more the topic of other papers in this volume and goes beyond the scope of this article, we need to think more about how to make the international monetary system more resilient to such imbalances and policy structures more flexible in addressing them more effectively than the case in the past. Identifying and mitigating systemic risk is the key challenge for policy makers in the era of macroprudential oversight, which has just started. This requires analytical frameworks and tools to understand and counter it. Authorities need to deepen their understanding of the fundamental working of financial systems and the risks they generate. They need to develop a better assessment of when and how systems migrate from stability to instability. They need to develop models that truly capture the interactions between widespread financial instability, aggregate consumption, investment and growth. And, they need to further extend the latter to be able to assess the effectiveness and efficiency of regulatory policies in containing systemic risks. Meeting this tall agenda will be challenging in the years ahead. It will require reorienting significant resources in academia, central banks and supervisory authorities in these directions. It will also require enriching the way of thinking in economics and finance.

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New approaches should be considered that do not necessarily rely only on the notions of equilibrium, universal rationality and efficiency, but go beyond those concepts. Approaches that have been used successfully in other fields, such as the natural sciences, may be a helpful source of inspiration. The ESCB has launched a large research effort in order to extend the analytical apparatus available in our central banks. We call it the MaRs, for Macroprudential Research network. Many researchers from all EU central banks are contributing to it, following three work areas: 1) Macrofinancial models linking financial stability and the performance of the economy; 2) Early warning systems and systemic risk indicators; and 3) Assessing contagion risks.

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