The stress test for banks in the United States in April, with the results
released this month, was designed to ensure that these banks have sufficient
capital to withstand worst-case scenarios in an economic contraction.
Ten months earlier, on July 16, 2008, and a full year after the global credit
crunch had imploded in July 2007, the federal banking and thrift agencies (the
board of governors of the Federal Reserve System; the Federal Deposit Insurance
Corporation; the Office of the Comptroller of the Currency; and the Office of
Thrift Supervision) had issued a final guidance outlining the supervisory
review process for the banking institutions that implement the new advanced
capital adequacy framework known as Basel II, which establishes an
international standard for bank capital requirements.
Basel II is the second of the Basel Accords, which are recommendations on
banking laws and regulations issued by the Basel Committee on Banking
Supervision of the Bank of International Settlements (BIS). Basel II, initially
published in June 2004 during the global credit bubble, aims to create an
international standard that banking regulators can use when creating
regulations about how much capital banks need to put aside to guard against the
types of financial and operational risks banks face in recurring financial
I warned in two years ago, two months before the credit crisis:
historical pattern of a 10-year rhythm [1987, 1997 and 2007] of cyclical
financial crises looms as a menacing storm cloud over the financial markets.
... Now in 2007, a looming debt-driven financial crisis threatens to put an end
to the decade-long liquidity boom that has been generated by the circular flow
of trade deficits back into capital-account surpluses through the conduit of US
While the specific details of these recurring financial crises are not
congruent, the fundamental causality is similar. Highly leveraged short-term
borrowing of low-interest currencies was used to finance high-return long-term
investments in high-interest currencies through "carry trade" and currency
arbitrage, with projected future cash flow booked as current profit to push up
In all these cases, a point was reached where the scale tipped to reverse the
irrational rise in asset prices beyond market fundamentals. Market analysts
call such reversals "paradigm shifts". One such shift was a steady fall in the
exchange value of the US dollar, the main reserve currency in international
trade and finance, to cause a sudden market meltdown that quickly spread across
national borders through contagion with selling in strong markets to try to
save hopeless positions in distressed markets.
There are ominous signs that such a point is now again imminent, in fact
overdue, in globalized markets around the world. (See
Liquidity boom and looming crisis, Asia Times Online, May 9, 2007).
Under Basel II, a bank needs to provide an estimate of the exposure amount for
each transaction, commonly referred to as exposure at default (EAD), in the
bank's internal systems. All these loss estimates should seek to fully capture
the risks of an underlying exposure.
In general, EAD can be seen as an estimation of the extent to which a bank may
be exposed in the event and at the time of a counterparty default. It is a
measure of potential exposure as calculated by a Basel Credit Risk Model for
the period of one year or until maturity, whichever is sooner.
Based on Basel Guidelines, EAD for loan commitments measures the amount of the
facility that is likely to be drawn if a default occurs. The contagion effect
of a chain of EAD is a key component that makes loss estimates difficult to pin
Loss given default (LGD) is the fraction of exposure at default that will not
be recovered following default. LGD is facility-specific because such losses
are generally understood to be influenced by key transaction characteristics
such as the presence of collateral and the degree of subordination.
Theoretically, LGD is calculated in different ways, but the most common is
gross LGD, where total losses are divided by EAD. Another method is to divide
losses by the unsecured portion of a credit line where security covers a
portion of EAD. This is known as Blanco LGD. If collateral value is zero in the
last case then Blanco LGD is equivalent to gross LGD. Different types of
statistical methods can be used to do this.
Gross LGD is preferred amongst academic economists because of its simplicity
and because academics only have access to bond market data, where collateral
values often are unknown, uncalculated or irrelevant. Blanco LGD is preferred
amongst some market practitioners (banks) because banks often have many secured
facilities, and banks would like to decompose their losses between losses on
unsecured portions and losses on secured portions due to depreciation of
collateral quality. The latter calculation is also a subtle requirement of
Basel II, but most banks are not sophisticated enough in their risk management
at this time to make those types of calculations internally.
LGD is a common parameter in risk models and also a parameter used in the
calculation of economic capital or regulatory capital under Basel II for a
banking institution. This is an attribute of any exposure on the bank's client.
Under Basel II, banks and other financial institutions are recommended to
calculate downturn LGD, which reflects the losses occurring during a "downturn"
in a business cycle for regulatory purposes. Downturn LGD is interpreted in
many ways, and most financial institutions that are applying for internal
rating base (IRB) approval under BIS II often have differing definitions of
what downturn conditions are. One definition is at least two consecutive
quarters of negative growth in real gross domestic product. Often, negative
growth is also accompanied by a negative output gap in an economy (where
potential production exceeds actual demand).
The calculation of LGD or downturn LGD poses significant challenges to modelers
and practitioners. Final resolutions of defaults can take many years, and final
losses, and hence final LGD, cannot be calculated until all of this information
is ripe. Furthermore, practitioners are in want of data since BIS II
implementation is rather new and financial institutions may have only just
started collecting the information necessary for calculating the individual
elements that LGD is composed of: EAD, direct and indirect losses, security
values and potential, expected future recoveries.
Another challenge, and maybe the most significant, is the fact that the default
definitions vary between institutions. This often results in a so-called
differing cure-rates or percentage of defaults without losses. Calculation of
LGD (average) is often composed of defaults with losses and defaults without.
Naturally, when more defaults without losses are added to a sample pool of
observations, LGD becomes lower. This is often the case when default
definitions become more "sensitive" to credit deterioration or "early" signs of
defaults. When institutions use different definitions, LGD parameters therefore
Mark-to-market as crisis detonator
The central issue over capital adequacy related to risk exposure centers around
the controversy of asset values mark-to-model against that market-to-market.
Basel II was instituted because mark-to-model value was considered inoperative,
devoid of reality. Thus mark-to-market value was required at the close of each
trading day. Yet mark-to-market is generally recognized as the detonator of the
current credit crisis. Now, the Federal Reserve's stress tests for banks have
switched back to mark-to-model to calculate the capital adequacy of banks.
The differential between the two values in a market failure can be more than
the total for assets to become "toxic" because of the interconnectedness of
structured finance instruments. In other words, a bank exposed to counter-party
default on one single credit instrument can affect the mark-to-market value of
all other credit instruments in its possession and also those held by other
institutions, even those to which it had no direct counter-party exposure.
The seeming innocuous rise in default rate of the riskier unbundled tranches of
an inverted credit pyramid can affect the credit ratings of the upper "safe"
tranches so as to cause the whole credit superstructure to crumble, much like
the way the dead weight of falling upper floors of the collapsing World Trade
Towers in lower Manhattan caused the collapse of the lower floors in an
unstoppable cascade of mounting structural failures.
Credit default swaps
The banking system in recent decades has morphed into one that is inherently
risk-infested on account of its precarious dependence on unimpaired
counterparty credibility. The shadow banking system has deviously evaded the
reserve requirements of the traditional regulated banking regime and
institutions and has promoted a chain-letter-like inverted pyramid scheme of
escalating leverage, based in many cases on a non-existent reserve cushion.
This was revealed by the AIG collapse in 2008, caused by its insurance on
financial derivatives known as credit default swaps (CDS).