INSIDE BRIEFING Snapshot: C&I asset quality—a few cautionary signals p.

8 "Then & Now," a yearlong review of banking history during ABA Banking Joumat's 100th Anniversary. This month: "In support of the Greatest Generation" p. l o Award-winning "event concept" ABA Resources p. 12 p. 15

Searching for new paradigms at BIS
Market turmoil has thrown VaR, and Basel II, a curve
Bank for Internatioiidl

o fcntral bankers, the implementation of the volatility was deceptively low. As a result, the VaR Basel 11 Capital Accord was planned as a stimu^m techniques "should be complemented by stress testlant to improve banks' risk management pracily ing and by basic judgment and simple indicators," tices, as well as to formulate appropriate, risk-sensithe deputy general manager of the Bank for Internaiive capital levels for the global banking system. tional Settlements, Herve Hannoun, tt>ld a group of Now, after building up very high expectations and central bankers meeting in Ottawa on May 8. investing enormous intellectual capital in the reforAmong the "simple indicators" to be considered, mulation of Basel II, many bankers and regulators, Hannoun proposed maximum loan-to-value ratios not to mention bank investors, have fallen disapfor mortgage loans, capital charges on structured pointed at the unexpected deficiencies in banking investment vehicles, leverage ratios, and dynamic L-.ipit.il, especially for complex global financial instiprovisioning. Each of these has a precedent in one or tutions, that have been exposed by the recent market turmoil. more national regulatory structures, he pointed out. Even the improved risk management systems of these large Three weeks later, his boss at BIS, general manager Malcolm banks—as stimulated by Basel II —have become orphaned by Knight, told a meeting of international securities regulators in their erstwhile supporters. Paris on May 29 that "risk managers must rely on a wider range of Consider that, for the past dozen years or so, the most popu- tools to capture the multi-dimensionality of risk," because "tail l.ir risk paradigm has been VaR, or, value at risk. Central risk exposures —including the risk of illiquidity —are not well bankers seem to have concluded that banks that relied on VaR measured by simple tools such as value at risk." Despite the relatended to operate in ways which exaggerated the banking sys- tive rarity of losses out on the "tails" of a risk distribution, in icms' natural "proeyclicality." That is, banks using VaR made some cases the bell-curve-shaped distribution is so flat that the loo many loans into the credit boom economy, resulting in an actual value of losses can bankrupt banks and threaten financial overstimulation of the business cycle. VaR failed to prevent par- markets. The bottom line on VaR is that it is so reliant on volatiliticipants from building excess leverage, especially when market ty as a measure of risk, that VaR adherents missed the entire accumulation of risky positions since there was very low volatility. By Ed Blount, contributing editor and executive director, Knight recommended several corrective actions in order to Center for the Study of Financiai Market Evolution, reduce the risks in today's market-dependent financial system. www.csfme.org To begin, he emphasized the need for less complexity and more

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ABA BANKING JOURNAL/JULY 2008 7

94 4.neimg transparency in the securitization chain. these surprises seem also to have given bankers a reason to reconsider a situation in wbicb years of their invested energies may give rise to a reformed capital regime which is still inadequate for tbe modern banking system. event risk in trading books should be framed more carefully in bank capital requirements. The next generation of risk management systems for banks and capital adequacy systems lor their regulators must operate in syne if the goal is to prevent tbe kind of unpleasant surprises that have recently undermined confidence in tbe global banking and credit markets.63 1. so the uptiek was large indeed. the state had previously run at around 1% to 1.S.h^'Vn.86 2. the reality is that modern financial crises are simply too complex for any one country or central bank to solve alone.78 loans defined as nonazcrual loans plus loans 90 or more days past due 8 JULY 2008/ABA BANKING JOURNAL Subscribe at www.64 5.84 1.98 0.34 0.S. go to ababj.21 2.33 1.49 3. The Southwest was represented with both Arizona and New Mexico showing up on the top-ten list. This reduces tbe perceived order of magnitude of risk exposures and gives a false sense of comfort. SNL HKiiricw/jmccune@snl. are advocating tbe benefits ot a paradigm called the "macropnidential. the central banks. by saying that. as an alternative to the serial bubbles that we have experienced over the past ten years: tbe dot-com equity bubble. Similarly. a new regulatory paradigm. In summation.25 1. Ultimately.34 1.97 1.irters. "The recent turmoil has highlighted the need for better coordination of financial regulation and supervision across institutions. commercial hanit aggregates. Knight advanced.com Asset Quality Trends: C&I Lending U.ababj.52 0. suggest an uptick in problem loans in the segment with the first-quarter 2008 ratio of noncurrcnt C&I loans to total C&I loans increasing by 14 basis points at the national level as compared to the fourthquarter of 2007.19 1.32 1." He added that tbe recent turmoil was a reminder tbat "nominal and notional amounts do matter when looking at risk exposures.56 1.09 1.57 1. and jurisdictions. —John McCune." or macro-financial regulatory approach. despite the apparent success of the Federal Reserve in monetizing the systemic liquidity crisis and avoiding catastrophic fallout from the Bear Stearns crisis.55 1. Losses in the C&I category tend to have a longer tail than 1-4 family loans and upticks in the latter are generally a precursor to upticks in the former. SNL took a look at state-level commercial bank data aggregated from the call reports.71 3.59 1. the commodity price bubble.31 1.41 0. markets. Recent trends. through their BIS consortium. Herve Hannoun posited that "it might be useful for the central banking community to consider developing a macrofinancial stability framework in supervisory and monetary pohcyniaking.. 10 worst-performing states in QI 2008 Noncurrent C & I Loans / Totai C & I Loans (%)* state aggregates 20O7Q1 2007q2 2007Q3 2007Q4 2008Q1 New Hampshire Puerto Rico Aiaska Deiaware Minnesota New Mexico Arizona Michigan Iowa Nebraska U. 'Noncurrent Source: SML Financial 1.13 1.46 1. BIS officials and their central bank members appear to have come to the conclusion that. the housing bubble.42 1. as well as for liquidity facilities associated with off-balance-sheet vehicles.64 1. Delaware and Minnesota also made the top of the list with increases in the 40 basis point range on a linked-quarter basis.61 0.03 0.52 0. up from the prior period." The evolving BIS perspective is not only a backlash from the market turmoil.5%.06 0. Capital support should be boosted for certain products.21 1.com and look under ABABJ Biogs "''" Snapshot C&I asset quality—a few cautionary signals A midst all of the credit-related turmoil of the last few qu.61 1.com .29 0.40 1. The outlook for the C&I lending segment for the rest of the year is largely mixed following geographic lines.67 1.41 1. the commercial and industrial {C&I} lending segment has been largely untouched.45 1.00 0. as an overarching consideration. According to Hannoun: "economic capital and VaR techniques amount to transforming large nominal amounts into very small values at risk." Indeed. whiie not technically a state. especially for tranche-based instruments.06 0. BJ For more on Basel II. explaining that their views should be supplemented with analyses of liquidity and of events that could trigger sudden ratings changes.12%. it is also a new call for evolving risk and regulatory benchmarks to support future reforms. To get a sense for the geographic concentration of the problem loans. Look for noncurrent loans for the nation as a whole to creep upward. NL'W Hampshire stood out with a noncurrent ratio in the C&I segment of 5. was near the top of the list with a ratio of A.12 4.63 1.06 0.68 2.37 1.90 1. Therefore.94 0. The table shows the states with the highest numbers. the credit bubble and perhaps the latest one.37 0. Regionally look for concentrations in areas that have experienced higher levels of losses in the 1 -4 family loans segments as those woes spread into the genera! economy of the region. he said.10 0.60 1. Puerto Rico.57 1. but largely in-line with prior behavior. however.28 1.74 0. He criticized mechanistic reliance on ratings agencies." The justification for new paradigms is rooted in widespread disappointment in the VaR-based models.

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