Recently, a reputed training institute based in Europe sent me details of training program for Basel III. They said that their training course provides helpful details of Basel III that will be rolled out soon across financial sector of various nations across the world and will strengthen the various players in the financial sector, mainly banks.
Let us see what the first and second generations of Basel has done for the global economy. The declared aim of these systems is to bring in stability in financial system and minimize banking problems and banking collapse.
Basel 1 -first generation- was rolled out soon after the collapse of Baring Banks by the aggressive risk taking by Nick Leeson. After selling straddles on Japanese Nikkei index successful over some years, Nick Leeson licked dust the day when an earthquake hit the city of Kobe in Japan in 1992. The straddles Nick Leeson shorted in derivatives market went against Baring Bank, which witnessed massive losses. Unable to meet the obligations, the bank went bankrupt and Nick Leeson went to jail.
Then they rolled out Basel 1, which I met during my early part of the career and remember doing the Risk Weighted Asset calculation and applying the appropriate capital adequacy ratio and finding out the risk/reward pattern for each asset and portfolio in general. Several accounting firms, consulting companies and IT firms had a field day as they delivered beautiful and elegant systems that captured various risks under Basel 1 in comprehensive manner but in an incomprehensible way.
However, soon criticisms were paraded against this system and intellectuals and academicians began to devote time for an improved version. The new systems gave undue importance to risk models and opinions of rating agencies. As the new system was being formed, another near disaster hit the global economy in the form of Long-Term Capital Management or LTCM.
The collapse of LTCM in 1998 showed the weakness of the risk models which was the basis for advanced IRB models in Basel II. It is interesting to note that two co-founders of LTCM (Myron Scholes and Robert Merton) won Nobel Prize in 1997 just one year before LTCM went bankrupt. Their convergence strategy and long/short strategy that delivered excellent returns (even up to c.45% p.a) for a few years turned against the firm when Russians decided not pay its sovereign debt in 1998. Entire capital of LTCM -one of the financial giants in the Wall Street - was wiped out resulting in a financial panic. Default by LTCM loomed large giving sleepless nights to various lending banks/FIs. A default would have caused a chain reaction of defaults across US banking system and possibly in other countries which were linked to US. The fear who else is insolvent froze the financial system. Thankfully, Allan Greenspan brought together the creditor banks of LTCM who bought into the equity of LTCM and took control and avoided the crisis. Despite all the mudslinging against Allan Greenspan in the recent times, we need to praise his steadfastedness to salvage US banking system and hence the economy, without tapping into Govt support.
Despite defusing a massive financial nuclear bomb well in time, the lessons learnt in LTCM was forgotten quickly. One of the chief culprits of LTCM collapse was its reliance on financial models, especially Var (Value at Risk) which assumed normal distribution in financial markets. In fact financial and credit markets are anything but normal and there were several evidence and academic criticisms against Var and similar models. Among the leading critics was Nassim Taleb while the die-hard supporters included the Quants in JP Morgan who originally brought out this beast into the financial markets.
During the later part of career again I had to get in touch with second generation Basel and its modelling systems. I often wondered alongwith some of my colleagues that the second generation was an excellent example of making simple concepts into beautifully carved complex and complicated systems of dubious quality. Again a bunch of accounting firms, consultants and IT firms won lot of business.
As the second generation was rolled out with its heavy reliance on models, Lehman crashed spectacularly in 2008, ten years after LTCM. No one was around to save Lehman or most of its creditors and its collapse exactly did opposite what Basel-1 and Basel II was originally rolled out for. They were supposed to protect banking and financial sectors or the nations. They did everything but that. Hundreds of banks have shutdown across the world or merged with others to avoid collapse. Many banks are still alive on Govt support.
Hold your breath. Now they are rolling out the third generation!! See you in 2018 or 2019, when another spectacular financial fireworks is possible, based on the track record we just discussed.
Someone told me that Einstein had said that 'there is nothing like simplicity'. It seems that sometimes he is right!!.
Let us see what the first and second generations of Basel has done for the global economy. The declared aim of these systems is to bring in stability in financial system and minimize banking problems and banking collapse.
Basel 1 -first generation- was rolled out soon after the collapse of Baring Banks by the aggressive risk taking by Nick Leeson. After selling straddles on Japanese Nikkei index successful over some years, Nick Leeson licked dust the day when an earthquake hit the city of Kobe in Japan in 1992. The straddles Nick Leeson shorted in derivatives market went against Baring Bank, which witnessed massive losses. Unable to meet the obligations, the bank went bankrupt and Nick Leeson went to jail.
Then they rolled out Basel 1, which I met during my early part of the career and remember doing the Risk Weighted Asset calculation and applying the appropriate capital adequacy ratio and finding out the risk/reward pattern for each asset and portfolio in general. Several accounting firms, consulting companies and IT firms had a field day as they delivered beautiful and elegant systems that captured various risks under Basel 1 in comprehensive manner but in an incomprehensible way.
However, soon criticisms were paraded against this system and intellectuals and academicians began to devote time for an improved version. The new systems gave undue importance to risk models and opinions of rating agencies. As the new system was being formed, another near disaster hit the global economy in the form of Long-Term Capital Management or LTCM.
The collapse of LTCM in 1998 showed the weakness of the risk models which was the basis for advanced IRB models in Basel II. It is interesting to note that two co-founders of LTCM (Myron Scholes and Robert Merton) won Nobel Prize in 1997 just one year before LTCM went bankrupt. Their convergence strategy and long/short strategy that delivered excellent returns (even up to c.45% p.a) for a few years turned against the firm when Russians decided not pay its sovereign debt in 1998. Entire capital of LTCM -one of the financial giants in the Wall Street - was wiped out resulting in a financial panic. Default by LTCM loomed large giving sleepless nights to various lending banks/FIs. A default would have caused a chain reaction of defaults across US banking system and possibly in other countries which were linked to US. The fear who else is insolvent froze the financial system. Thankfully, Allan Greenspan brought together the creditor banks of LTCM who bought into the equity of LTCM and took control and avoided the crisis. Despite all the mudslinging against Allan Greenspan in the recent times, we need to praise his steadfastedness to salvage US banking system and hence the economy, without tapping into Govt support.
Despite defusing a massive financial nuclear bomb well in time, the lessons learnt in LTCM was forgotten quickly. One of the chief culprits of LTCM collapse was its reliance on financial models, especially Var (Value at Risk) which assumed normal distribution in financial markets. In fact financial and credit markets are anything but normal and there were several evidence and academic criticisms against Var and similar models. Among the leading critics was Nassim Taleb while the die-hard supporters included the Quants in JP Morgan who originally brought out this beast into the financial markets.
During the later part of career again I had to get in touch with second generation Basel and its modelling systems. I often wondered alongwith some of my colleagues that the second generation was an excellent example of making simple concepts into beautifully carved complex and complicated systems of dubious quality. Again a bunch of accounting firms, consultants and IT firms won lot of business.
As the second generation was rolled out with its heavy reliance on models, Lehman crashed spectacularly in 2008, ten years after LTCM. No one was around to save Lehman or most of its creditors and its collapse exactly did opposite what Basel-1 and Basel II was originally rolled out for. They were supposed to protect banking and financial sectors or the nations. They did everything but that. Hundreds of banks have shutdown across the world or merged with others to avoid collapse. Many banks are still alive on Govt support.
Hold your breath. Now they are rolling out the third generation!! See you in 2018 or 2019, when another spectacular financial fireworks is possible, based on the track record we just discussed.
Someone told me that Einstein had said that 'there is nothing like simplicity'. It seems that sometimes he is right!!.
