PrefBlog

American corporates were on fire today amidst a dramatic steepening in Treasuries; the 2-30 spread widened 26bp. Canadian 2-30s steepened as well, but only by 12bp; a mere bagatelle.

Jon Danielsson has an interesting essay on VoxEU : The myth of the riskometer:

There is a widely held belief that financial risk is easily measured – that we can stick some sort of riskometer deep into the bowels of the financial system and get an accurate measurement of the risk of complex financial instruments. Such misguided belief in this riskometer played a key role in getting the financial system into the mess it is in.
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One of the biggest problems leading up to the crisis was the twin belief that risk could be modelled and that complexity was good. Certainly the regulators who made risk sensitivity the centrepiece of the Basel 2 Accord believed this.

Under Basel 2, bank capital is risk-sensitive. What that means is that a financial institution is required to measure the riskiness of its assets, and the riskier the assets the more capital it has to hold. At a first glance, this is a sensible idea, after all why should we not want capital to reflect riskiness? But there are at least three main problems: the measurement of risk, procyclicality (see Danielsson et. al 2001), and the determination of capital.

To have risk-sensitive capital we need to measure risk, i.e. apply the riskometer. In the absence of accurate risk measurements, risk-sensitive bank capital is at best meaningless and at worst dangerous.

Risk-sensitive capital can be dangerous because it gives a false sense of security.
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The unreliability of capital calculations becomes especially visible when we compare standard capital calculations under international standards with the American leverage ratio. The leverage ratio limits the capital to assets ratio of banks and is therefore a much more conservative measure of capital than the risk-based capital of Basel 2. Because it is more conservative, it is much harder to manipulate.
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As Philipp Hildebrand (2008) of the Swiss National Bank recently observed “Looking at risk-based capital measures, the two large Swiss banks were among the best-capitalised large international banks in the world. Looking at simple leverage, however, these institutions were among the worst-capitalised banks”

I take issue with the description of the leverage ratio as inherently conservative. Its virtue is simplicity, full stop.

Another glorious day for preferreds amidst continued heavy volume. It’s nice to see.

This entry was posted on Monday, January 5th, 2009 at 8:56 pm and is filed under Market Action. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.