From Berlin to Basel: what can 1930s Germany teach us about banking regulation?

Tobias Neumann.

Two of the country’s largest banks collapse. The subsequent panic brings the banking system to its knees and only a costly government bail-out prevents even greater catastrophe. A radical re-think of regulation is needed. No, it’s not London or New York in 2008. It is Berlin in the 1930s. It’s when risk-weighted capital regulation was born, notably to be used alongside a range of other tools; for example, liquidity requirements and such modern ideas as bonus deferrals and capital conservation. But the idea that no single regulatory measure is likely to be sufficient on its own was forgotten. In 2008 it had to be painfully re-learned making this episode a striking example of the importance of studying past financial crises.

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Fixing bankers’ pay: punish bad risk management, not bad risk outcomes

Misa Tanaka and John Thanassoulis.

Post-crisis, a number of jurisdictions have introduced remuneration regulations in order to reduce bankers’ incentives to take excessive risks. The UK is pioneering the use of bonus clawbacks under which bankers are asked to pay back their bonuses if certain circumstances materialise at a future date. In our latest paper, we show that clawback can encourage better incentives as long as bankers believe that they will be held liable for failures of risk management, and not simply for poor outcomes. Having a transparent mechanism in place to apply clawbacks is therefore critical. If bankers fear that clawback will be wielded too generally upon bad business outcomes, then it could end up making them excessively risk averse.

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The “question” or the “answer”? Market reaction to UK stress tests

Matthieu Chavaz, Jeremy Chiu and Evarist Stoja.

How might banks fare in stressful macroeconomic conditions? Are they strong enough to withstand the stress and survive or will they fall like dominoes? Stress tests offer insights into such questions.

Regulators are not only making a growing usage of such tests, they are also increasingly inclined to communicate openly about them. This is a remarkable evolution. Throughout history, regulators have typically followed some form of Hippocratic Oath and refrained from disclosing their detailed diagnostics of individual banks’ health. Regulators are now increasingly keen to release both the “answer” to stress tests (the results) and the “question” – the stress scenario regulators confront banks with. This column suggests that the disclosure of the scenario can be as important as – if not more than – the disclosure of the results.

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Bringing together stress testing and capital models – a Bayesian approach

Dan Georgescu & Manuel Sales.

Capital requirements for financial institutions are typically calculated using a statistical model and a risk measure such as VaR, whereas stress tests designed by regulators and risk managers are often based on subjective scenarios with no associated probability level. The stress test cannot therefore be easily linked to the capital measure. Taking insurance as an example, we show how to establish the link using intuitive tools which (i) respect the stress test designer’s intuition about causal direction, (ii) can be calibrated to pre-determined parameters such as correlations between risks, and (iii) can be easily communicated to and challenged by non-technical audiences.

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It’s a model – but is it looking good? When banks’ internal models may be more style than substance.

Tobias Neumann.

Most large banks assess the capital they need for regulatory purposes using ‘internal models’. The idea is that banks are in a better position to judge the risks on their own balance sheets. But there are two fundamental problems that can arise when it comes to modelling. The first is complexity. We live in a complex world, but does that mean a complex model is always the best way of dealing with it? Probably not. The second problem is a lack of ‘events’ (eg defaults). If we cannot observe an event, it is difficult to model it credibly, so internal models may not work well.

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Are mortgages like potatoes? Unintended consequences in a world of many constraints

Authors: Renzo Corrias and Tobias Neumann.

When banks are subject to both a leverage and a risk-weighted constraint they may violate a fundamental law of economics: that of demand. In our theoretical model, some banks constrained by the leverage ratio react to an increase in capital requirements by investing more in the asset. This so-called ‘Giffen’ behaviour is very counterintuitive. One would assume the opposite to be the case: higher capital requirements should discourage lending. In our theoretical model, Giffen behaviour is likely to occur for firms that hold predominantly low-risk weighted asset and are therefore bound by the leverage ratio. The real-world equivalent in the context of mortgages would be building societies and, in the future, ring-fenced banks.
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Driverless Cars: Insurers Cannot be Asleep at the Wheel

Neha Jain, James O’Reilly & Nicholas Silk

In 2020 Google plans to launch a self-driving car which has already driven nearly one million miles without causing an accident; it doesn’t get tired and irritable, swerve into lamp posts or require a driving test. The in-built chauffeur comes in the form of a rotating LIDAR laser taking 1.3 million recordings per second, and it’s a better driver than you. By eliminating the element of human blunders, driverless cars are forecast to reduce motor accidents by up to 90% in the US according to McKinsey. That might imply a substantial impact on the insurance industry, with liability potentially shifting to car manufacturers. Such developments would pose challenging questions for the PRA in regulating UK insurance firms.

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