The Great Leap Forward From Basel II to Basel III Dr. Michael Zerbs President and COO April 2011

© 2010 Algorithmics Incorporated. All rights reserved.2 The main point What is the long term impact of Basel III on …? Can be translated into … What are the implications of outcome oriented supervision ascertaining the sustainability of business models?

© 2010 Algorithmics Incorporated. All rights reserved / 2009 Key challenges Banks’ capital in the US and Europe was critically eroded Many actual losses were caused by events that were out of model scope Systemic interdependencies were poorly understood Source: Bank of England, 2011 Trading Book Losses 2H 2007 – 1H 2009 compared to Regulatory Capital YE 2007

© 2010 Algorithmics Incorporated. All rights reserved / 2009 Key challenges Banks’ capital in the US and Europe was critically eroded Many actual losses were caused by events that were out of model scope Systemic interdependencies were poorly understood Source: FSA, 2010

© 2010 Algorithmics Incorporated. All rights reserved.5 In response Basel III Fundamental changes in supervisory approach (e.g. FSA) However – we need to watch for unintended consequences Source: BIS, 2010

© 2010 Algorithmics Incorporated. All rights reserved.6 Unintended consequences The pervasive view that “this time is different” is precisely why it usually isn’t different, and catastrophe eventually strikes again. Reinhart and Rogoff (2008)

© 2010 Algorithmics Incorporated. All rights reserved.7 Funding liquidity risk Unintended consequences We may exchange known risks for new unknown risks or new tail risk Potential future exposure (one scenario through time) Potential future exposure with daily collateral calls (one scenario through time) Counterparty credit risk

© 2010 Algorithmics Incorporated. All rights reserved.8 Unintended consequences We may exchange known risks for new unknown risks or new tail risks Intervention creates new risks and economic distortions Foreign exchange reserves as a percentage of M2 Banks’ holdings of central bank and government paper expanded as a result of sterilization measures Source: BIS, 2010

© 2010 Algorithmics Incorporated. All rights reserved.9 Unintended consequences Over 1,000 pages and counting … We may exchange known risks for new unknown risks or new tail risks Intervention creates new risks and economic distortions Risk by a different name is still risk

© 2010 Algorithmics Incorporated. All rights reserved.10 Unintended consequences We may exchange known risks for new unknown risks or new tail risks Intervention creates new risks and economic distortions Risk by a different name is still risk Crowded trades don’t make good hedges

© 2010 Algorithmics Incorporated. All rights reserved.11 Unintended consequences Lucas critique We cannot predict the effect of a change in policy based on relationships observed historically Therefore Supervision requires an element of “predictable unpredictability” Multi-step approach – e.g. “judgments on judgments”

© 2010 Algorithmics Incorporated. All rights reserved.12 Mitigating unintended consequences Imaginative stress testing is fundamental Basel III, supervisors and banks share stress scenarios as the “Language of Risk:”

© 2010 Algorithmics Incorporated. All rights reserved.13 What if … Resurgent capital inflows to emerging markets reverse, having obscured flaws in banks’ business models? Imaginative stress testing Source: IMF, 2010

© 2010 Algorithmics Incorporated. All rights reserved.14 What if … Resurgent capital inflows to emerging markets reverse, having obscured flaws in banks’ business models? New asset price bubbles form and, eventually, are pricked or burst? Imaginative stress testing Source: IMF, 2010

© 2010 Algorithmics Incorporated. All rights reserved.15 What if … Resurgent capital inflows to emerging markets reverse, having obscured flaws in banks’ business models? New asset price bubbles form and, eventually, are pricked or burst? Rising inflation causes a major shift in monetary policy? Imaginative stress testing Source: IMF, 2010

© 2010 Algorithmics Incorporated. All rights reserved.16 Requires a comprehensive risk architecture that … Supports dialogue Provides coherence Differentiates among stakeholder Allows for unorthodox scenarios Stress tests business models Stress Testing: Effective Implementation Source: CEBS, 2010

© 2010 Algorithmics Incorporated. All rights reserved.17 Requires a comprehensive risk architecture that … Supports dialogue Provides coherence Differentiates among stakeholder Allows for unorthodox scenarios Stress tests business models Credit Risk Market Risk Liquidity Risk Stress Testing: Effective Implementation

© 2010 Algorithmics Incorporated. All rights reserved.18 Requires a comprehensive risk architecture that … Supports dialogue Provides coherence Differentiates among stakeholder Allows for unorthodox scenarios Stress tests business models Source: IMF, 2010 Stress Testing: Effective Implementation

© 2010 Algorithmics Incorporated. All rights reserved.19 Requires a comprehensive risk architecture that … Supports dialogue Provides coherence Differentiates among stakeholder Allows for unorthodox scenarios Stress tests business models Source: IMF, 2010 Stress Testing: Effective Implementation

© 2010 Algorithmics Incorporated. All rights reserved.20 Conclusion 1.Basel III is a major step forward. It applies key “lessons learnt” 2.However, unintended consequences are a serious challenge 3.Supervision and banks’ own risk management both require an element of unpredictability to maintain their effectiveness 4.This makes imaginative stress testing a key part of Basel III and sound risk management practice 5.It can only be done within a comprehensive risk architecture