2 Financial Stability Review: December 2002 – Financial stability themes and issues
Financial stability
themes and issues
During the past six months, financial systems around the world have withstood sharp declines in equity markets,
higher market volatility, and a deterioration in the macroeconomic outlook. In this uncertain environment, there
have been occasional signs of fragility and a retreat from risk-taking. This issue of the Bank of England’s Financial
Stability Review explores the factors contributing to changing appraisals of risk, and considers various public and
private sector initiatives designed to strengthen risk management.
The Bank’s regular assessment of The financial stability conjuncture
and outlook is complemented for the first time by a separate
article reviewing developments Strengthening financial
infrastructure. Perhaps the most important of these in the past
six months has been the successful launch of continuous linked
settlement (CLS) in foreign exchange markets, which can greatly
reduce foreign exchange settlement risk. The article considers
efforts generally to make financial systems more robust and
initiatives to improve crisis management – two of the three key
aspects of the Bank of England’s financial stability work, along
with the surveillance of risks.
The greater resilience of banks in most industrial countries is
attributable partly to larger buffers of capital compared with the
1980s and early 1990s. Encouraging internationally active banks
to hold more capital was one of the objectives of the
original (1988) Basel Accord. Central banks and supervisors have
been working to amend the Accord to make it more sensitive to
risk. The article by Patricia Jackson, Bank capital: Basel II
developments, describes the current state of play. The Basel
Committee on Banking Supervision set out its latest proposals on
1 October. These modified earlier proposals in the light of
comments, the results of quantitative impact studies which
sought to assess the likely effect of the proposals on minimum
capital, and concerns about the potential procyclicality of the
new approach. The latest proposals are currently being tested in
a third quantitative impact study.
One concern has been that, if Basel II increased capital
requirements for loans to certain classes of borrower, it could
increase their cost of funds. In The impact of the new Basel Accord
on the supply of capital to emerging market economies, Simon Hayes,
Victoria Saporta, and David Lodge consider whether emerging
market (EME) borrowers are likely to be materially affected. The
Financial stability themes and issues – Financial Stability Review: December 2002 3
Financial stability authors argue that the regulatory capital charge will not rise –
and may indeed fall – for lending to a number of emerging
themes markets. In any case, banks seem already to price their loans to
reflect the perceived creditworthiness of their customers rather
than being based on regulatory capital requirements; Basel II is
and issues simply likely to bring the regulatory charge more into line with
existing practice. The authors also point out that bank finance is
only one of several sources of credit for EMEs, and that the new
Accord will not apply to the others.
Another concern about Basel II has been that the adoption of
risk-based requirements could amplify market volatility at times
of financial crisis. In an invited article, Fallacies about the effects of
market risk management systems, Professor Philippe Jorion
investigates whether value-at-risk (VaR) methods of risk
Financial Stability Review measurement for trading books do in fact increase market
December 2002
volatility in crisis periods. His answer is reassuring. He finds that
asset price volatility over the 1990s, when the techniques were
introduced, was lower than previously, not higher as is sometimes
suggested. Also, rather surprisingly, the markets which in 1987
used portfolio insurance – another risk management tool –
declined less than the markets in which it was not used. Jorion
also notes that the existing Basel VaR capital requirements are
calculated in such a way as to react slowly to changing market
conditions.
Basel II is designed to make regulatory capital requirements more
responsive to risk. Similarly, there have been proposals to make
accounting frameworks reflect more clearly the risky nature of
banks’ lending. Fiona Mann and Ian Michael explore one such
proposal in Dynamic provisioning: issues and application. The
advocates of dynamic provisioning argue that it would encourage
the build-up of a buffer, in the form of an ‘expected loss reserve’,
against potential losses. It might also reduce a distortion in the
measurement of banks’ income over time which arises because
margins set to cover expected losses are treated as profit. The
approach would reduce both profits in times of boom (when
many riskier loans are taken on) and losses in recessions (when
the losses inherent in holding a portfolio of loans tend to
crystallise). But the authors point out that all of the various
ways in which a dynamic provisioning approach might be
implemented in practice raise practical issues which would need
to be overcome.
The interaction between accounting practices and assessments of
risk and return has also been prominent in the recent debate
about deficiencies in financial reporting in the corporate sector.
In the second invited article in this issue, Renewing confidence in
the markets, Sir David Tweedie, Chairman of the International
Accounting Standards Board (IASB) sets out his view of the issues
at stake. He argues that fears about the quality of financial
reporting have undermined investor confidence, in turn
4 Financial Stability Review: December 2002 – Financial stability themes and issues
damaging economic prospects. Good financial reporting requires
clarity of accounting standards, sound auditing practices and an
effective enforcement framework. Accounting standards must be
based on clear principles, rather than detailed guidance, to avoid
manipulation and a ‘rule-book mentality’. There is growing
international consensus around this view, and the IASB has
agreed with the US Financial Accounting Standards Board to
work to remove major differences between international and US
standards. New standards need to be developed too, to reflect
how a modern economy works. Reported earnings are likely to
become more volatile as a result, but it is better to confront
investors with the reality that the financial performance of
complex companies in today’s environment is bound to fluctuate.
In the same area, but focusing more on how accounts are used
by investors and analysts to assess firms’ earnings prospects,
Fabio Cortes, Ian Marsh, and Michael Lyon ask, Is there still magic
in corporate earnings? It had often been suggested, in the
United States in particular, that audited reported earnings were
not necessarily the best basis for equity valuation. However,
alternative measures – for example, pro forma earnings – appear
to have excluded systematically certain recurring expenses, so
exaggerating earnings and sometimes giving an excessively rosy
view of likely future cash-flows. The authors review some of the
academic analysis of this subject, which indicates that items
often excluded from pro forma earnings statements do in fact
contain information useful in forecasting cash flows. They also
explore the use of national-accounts-based measures of
aggregate corporate earnings as a way of checking the
implications of firm-level accounting data.
The accounting framework used in the corporate sector is a vital
part of the ‘infrastructure’ on which companies – and those who
invest in or lend to them – depend. Clear principles and an
understanding of the economic significance of accounting data
enable better assessments of likely risks and returns. But,
however good the accounting framework, occasionally some firms
will still face insolvency. In these circumstances, insolvency and
bankruptcy law are important, as they affect both the stability
and the efficiency of the financial system. To explore the
Economics of insolvency law further, the Bank held a conference on
27 September, reported here by Bethany Blowers. As well as the
Bank’s general interest in promoting effective management of
financial problems, to avoid them having systemic implications, it
has had a long-standing practical involvement in pre-insolvency
workouts via its role in the ‘London Approach’.
Some of the same risk management issues arise in an
international context. There has been an active debate for some
time about the best means of resolving international financial
crises. In Fixing financial crises, Andrew Haldane reports a
conference hosted by the Bank on 23-24 July on the subject of
Financial stability themes and issues – Financial Stability Review: December 2002 5
Financial stability the role of the official and private sectors in resolving sovereign
debt crises. Amongst the specific topics discussed were the role
themes of the IMF, and the pros and cons of collective action clauses
and the IMF’s proposal for a sovereign debt restructuring
mechanism (SDRM).
and issues The articles outlined above are primarily about how to improve
the resilience of the framework within which financial
intermediaries operate. Market-driven initiatives along these lines
include the development of central counterparties (CCPs) in
financial markets. In Modelling risk in central counterparty clearing
houses: a review, Raymond Knott and Alastair Mills consider what
academic studies have revealed about risks in this key part of the
financial infrastructure. CCPs originally arose to protect market
participants from counterparty risk in exchange-traded
Financial Stability Review derivatives markets, but they also now have an important
December 2002
presence in cash and OTC derivatives markets. In helping to
manage counterparty risk for market participants, CCPs are
themselves exposed to various risks – and their position at the
centre of a web of financial exposures raises issues about
possible contagion. The article notes that margins alone may not
be sufficient to protect CCPs from extreme, but rare, events. As a
consequence, the level of additional default resources needs to
be carefully considered.
CCPs raise questions about the systemic significance of different
networks of exposures. So do interbank wholesale markets. In
UK interbank exposures: systemic risk implications, Simon Wells
explores a possible approach to measuring the direct impact on
other banks of the sudden and unexpected failure of a single
institution, in the unlikely event that such a failure were to
occur. Data limitations make it impossible to put together a
complete map of interactions between banks; but, using a stylised
framework, some progress can be made in investigating the
patterns of potential spill-overs. The article is part of the Bank’s
continuing work to understand more fully the links between
financial institutions and the systemic risk they pose.
6 Financial Stability Review: December 2002 – Financial stability themes and issues