Five possible polity''measuresdesigned tosimplify theBasel regulatory frameworkare:
(1) de-iayeringdie regulatorystructure,(2) emphasizingleverageindicators,(3) strengtheningsupervisory discretion andmarketdiscipline, (4) taxing complexity,and (5) reconfiguringthe financialsystem.
©2013Kaplan,Inc. Paÿ:221
Topic69
CrossReferencetoGARP AssignedReading-Haldane andMadonnas
De-Layeringthe BaselRegulatoryStructure
Introducingrisk-sensitivitymeasuresinto theregulatoryframeworkcreatedheightened degreesofcomplexityThe increasinglycomplexmodelsprovidedafalsesenseof security andtheir performancein practicewasdisappointing. Thecomplex modelsover-fit sampledata and performed poorlyinout-of-sample complexenvironments.The practice ofcalibratingthousandsof parameterswith shortsample timeperiodswill mostlikely continue to resultin poor performance.
Imposingfloorsorlimitson model parameter outputsmay provideanappropriate regulatorybackstop.Forexample, temporaryfloorsof 80%of BaselI requirementswere usedon aggregatecapitalrequirementsunderBasel El.Whilefloorsmayhe somewhat beneficial, internal modelsmusthe removed tosimplify theregulatoryprocess.Thetrend for improvementisstarting toimplement simple, standardised approachesofmeasuring credit and market riskover broadassetclasses.
Emphasizing LeverageRatios
rncernadonal regulators agreedto usealeverageratiobasedona 1/N rule(i.e.,equally weightassets) under theBaselIII framework. While thisshouldincreaserobustnessofout- of-sample results, it isonlyused asasecondarymeasure. Risk-weightedcapital ratios arestill the primaryindicators under BaselIII.
Theenvironment isverycomplexforglobalbankssuhjecttoBaselIII.Theresultsof numerousstudiessuggest thatsimplemodelsoutperform morecomplexmodelsincomplex
environments.Thus, itwould be prudent toreverse the order of importanceandemphasize leverageratiosmoredian risk-weightedcapital rados.
Thesupportfor usingrisk-weightedcapitalratios is basedon the assumption that banks will increasetheriskofassetsif leverageratios areused.Thus, perhapsthesolution isto
followtheexampleof the Bank ofEngland'sFinancialPolicyCommitteeandgive both leverageandrisk-weighted capitalradosequalimportance. Enaddition,measuring equity basedon market ratherthan historicalaccountingcosts may also improve theability to monitorabank’s health.
Lasdy, the 3%leverage ratiocurrendy in placemay nothesufficient toavoid another financialcrisis.Increasingthe 3%leverageratiosto7%underBaselIIIwould havebeen necessary toavoid the last financialcrisis with largeglobal banks. Increasing theleverage
rado to4% would significandy reduceType I and II crisiserrors.
Strengthening SupervisoryDiscretionand Market Discipline
BaselIII regulationcurrendy emphasizesregulatoryrules.However,supervisorydiscretion
andmarketdisciplineshould heallowed toplayan equallyimportant role.Simplifying rules under BaselIIIwould allow theothertwo factors tohemore useful.Forexample, ifbank supervisors would haveplacedlessemphasison the numerous smallregulatoryrules prior to thefinancialcrisisperhaps theywouldhave been able tofocus moreonthe bigindicatorsof the crisis.
©2013Kaplan,Inc.
Page222
CrassReferencetaGARPAssignedReading-Haldane andMadouros Amoreeffectivestructure wouldbe morejudgment-based rather chan rule-based.Fewer
ruleswould also reduce thecostofcompliancefor both regulatorsandbanks.However, rhesuccess under this frameworkwouldrelyonthe experience of the supervisor. The bankingenvironment becomes morecomplexwhen die numberofregulatorsandamount ofreportingincreases.Fewerexperienced supervisorsoverseeingasmaller rulebookmay be moreeffectivein preventingfuturefinancialcrises,
Eliminatingthecomplexityof banlfs internal models will alsostrengthenmarketdiscipline.
Theamountof reportingbybanksdid nothelpmarketsunderstandbank risksasimportant informationwaslostinlargecomplexreports.Simplifiedreportsmayhelp increase
transparencyandstrengthen marketdiscipline.
Taxing Complexity
Under thecurrentBaselframework,allowing bankstouse internal models gives them a taxsubsidyforcomplexity. Risk is moredifficulttomonitor andmanagewhen non-
standardizedcomplexinternal bank modelsareused.Radier than subsidizecomplexity,
acapitalsurchargeshould be leviedonlarge globalinstitutionsbased on their levelof systemic connectivitywithodier banks and complexity. Currentlycross-systemcomplexity isnottaxedandisnot recognized byregulators.
Reconfiguringthe Financial System
Thecurrent financialcrisisincreasedsupportforquantity-based regulatorysolutions. The Volcker ruleis anexampleofaquantity-basedrule thatstatesbankswill notengagein
proprietarytrading.The U.K.proposedasimilarquantity-basedrule thatforbids banks
tocomingleretaildeposit takingandinvestmentbanking. However, even thesesimple rules maybecomecomplex. Forexample,the Volcker ruleisaccompanied bya29-page consultationdocument.Limitingbanksizeandseparatingcommercial and investment
bankingatetwo majorstructuralchangesthatarebeing debated.Currently,market
pressuresrather than regulatorypressuresareencouraginglargehanks toseparateand reduce thesizeof their balance sheets.
©2013Kaplan,Inc. Page 223
Topic63
CrossReferencetoGARPAssigned Reading-Haldaneand Madouros
KEY CONCEPTS
AIM69.J
Heuristicsare basedon the assumption that human behavior followssimple rules. Research studiessuggestsimple modelsare moresuccessfulthan complex modelsbecause there is greater uncertainty ofparameter estimateswithcomplexmodels.
AIM69.2
Simple heuristics are moreeffective than complex models incomplexenvironmentswhere one of thefollowingconditionsexist:information iscosdy, toomuch informationcreates noise,equal-weightingstrategiesareused,samplesizes aresmall,and complexrulesare presentleading todefensivebehavior.
AIM69.3
Simple modelsare moreeffective thancomplexmodelsin thefollowing complex
environments:
• Sportingoutcomesand heart attack predictionare moreeffective when LOOmuch informationcreatesnoise.
* Equal-weighted modeLsare moreeffectivein predictingavalanches andasset prices.
* Simplemodelsare moreeffectiveintrackingserial criminals andinvestmentstrategies whensamplesizes aresmall.
* Complexrulesfor physiciansencouragedefensive hehaviors toavoidmalpractice lawsuits.
AIM69.4
Overdine,bankregulationsfrom Basell to Basel III have becomeincreasingly more
complex.This requiresasubstantialincreasein diecompliancerequirements of banksand a substantialincreasein die numberof regulators requiredtoexamine bankperformance.
AIM69.5
Astudyoflarge globalbanksfindsthatasimple leverage modeloutperformsmorecomplex BaselTier1 risk-weightedcapital ratios in predictingthemost recentfinancialcrisis.A studyof smaller regional U.S.banks using FDICdata confirms thateveninlesscomplex environmentsout-of-sampleperformanceofasimple liquidityindicatoroutperforms mote
complex muldpleCAMEL indicatormodelsin predictingbank failure.
AIM69.6
An experimentconducted where theGARCH(3,3) model wasdie truemodelfora hypotheticalfinancialasset revealedthat theGARCH(1,1) was the moreeffectivein
predictingassetprices. Enaddition,asimpleMA modelhadaVaRviolation ratio,defined asthe ratioof actual fosses toexpected losses,closest toonein historical tests,which indicateda hetter performingmodel.
Page 224 ©2013Kaplan,Inc.
CrossReferencetoGARPAssignedReading-Haldane andMadouros AIM69.7
Five proposedchanges tosimplifydieregulatoryframeworkinclude thefollowing;
• De-layeringtheregulatorystructure.
• Emphasizing leverageindicators.
• Strengtheningsupervisory discretion and market discipline.
* Taxing complexity.
• Reconfiguringdie financialsystem.
©2013Kaplan,Inc. Pagjc225
Topic69
CrossReferencetoGARP AssignedReading—Ilaldane and Madouros
CONCEPT CHECKERS
Whichofthefollowingstatementsbestdescribes theuseof heuristicsindecisionơ
making models?
A. Research studiessuggestsimple models basedonheuristicsare moresuccessful indecision makingthan morecomplex models,unless the environmentis complex*
B. Heuristics aresimplerulesof thumb char areusedindecision making.
C. Modelsbasedonheuristics tendtohavemore parameterassumptions.
D. Adrawbackofheuristicmodelsisdiatthey tend toover-fit sampledata and perform poorlyin predictingfutureoutcomes.
Allof thefollowingitems areadvantagesof heuristicsinmodeling uncertainty in complexenvironmentsexcept:
A. information required forcomplexmodelsiscosdy.
B. toomuch informationcreatesuselessnoiseincomplex models.
C. equal-weightingstrategiesunderperform complex weightingstrategies.
D. smallersamplesixesresultingreatermodel uncertainty.
Whichof thefollowing predictionsisthe hestexampleofa situationwheresimple modelsoutperform complexmodels whensamplesizesaresmall?
A. Avalanche prediction.
B. Heartattackprediction.
C. Serialkiller prediction.
D. Sportsprediction.
Supposeanexperimentisconductedinwhich theGARCH(3,3) stochasticprocess isusedtogenerate randomsamplesofdaily hypotheticalasset returns.Whichof thefollowingstochasticprocesses ismostlikely tohave thehighest predictivepower withsmallsamplesixes?
A. GARCH(U).
B. GARCH(2,2).
C. GARCH(3,3).
D. GARCH(5,5).
1.
2.
3.
4.
Whichof thefollowingstatementsmostaccurately describesthe roleofleverage ratiosaccording toBasel III?
A. Leverageratios aredieprimaryindicators under BaselIII.
B. The Bank ofEngland's FinancialPolicyCommitteegives leverageratios lower importancein regulation thanrisk-weightedcapitalratios.
C. Theleverageratio iscurrentlysetat4% underBaselTIL
D. Internationalregulators agreed to usealeverageratiobasedonequally-weighted
assetsunder the Basel111framework.
Foradditional Book 4, Topic 69practice questionssee:
5.
SelfTestQuestions;#9(page255)
©2013Kaplan,Inc.
Page226
CrossReferencetoGARPAssignedReading—Haldane andMadouros
CONCEPT CHECKER ANSWERS
Heuristicsatesimplerules ofthumbthatateused indecision making. Research studiesfind that simple modelsbasedon heuristicsoftenarcmotesuccessfulin decision makingthan
morecomplexmodels.Simple modelshavefewerparameterassumptions.Morecomplex models tendtoover-fit sampledataandperformpoorly inpredicting futureoutcomes.
1. B
2L C Advantagesof heuristicsin modelinguncertainty incomplexenvironmentsarerelated tothe following findings:
* Information required forcomplexmodels iscostly.
Toomuch information createsuseless noise.
• Equal-weighting strategicsoutperform complexweighting strategies,
• iSmailcrsainpiesizes resultingreater model uncertainty.
Complexruleslead todefensive behavior in individuals.
C When the numberof crimes committed is inthesingledigits,simple modelsarc more effectiveattrackingserial killersthancomplexmodels.
4. A Thefindingsofastudysuggestsimplermodelsoutperformmorecomplexmodelswhen samplesizesarcsmaller.100,001)sample dayswrcrcrequired when asimitarhypothetical studyvtasconducted before thetrueGARCTT(3,3) modeloutperformeda much simplerone.
5L D Internationalregulatorsagreed tousealeverage ratiobasedona1/N rule(he.,equallyweight assets) underthe Basel Tilframework. Risk-weighted capitalratiosarctheprimary indicators underBaselIIL
TheBankofEngland’sFinancial PolicyCommitteegives both leverage and risk-weighted capital ratiosequal importance.Theleverage ratio iscurrently3%.
©2013Kaplan,Tnc. Page 227
TheItJIuwutgis±reviewa(theCurranIssues inFinuirh]MitktisprinciplesJr-siÿnedLuaddress the AIMstaiemetiLSsetforth \iyGARP®.This topicis also covered in: