Assessing Financial StabilityConceptual and organisational challengesIstanbul, 18 May 2005

Peter PRAET

Executive Director, National Bank of Belgium

Member of the Board, Banking, Finance and Insurance Commission

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I. The building blocks

Prevention

design of rules, regulation, standards...

Surveillance

micro / macro

Crisis management

"orderly exit"

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II. Challenges (1/2)

Traditional bank

illiquid assets, originated & held to maturity

liquid liabilities

uninformed depositors

Highly powered incentive structure

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Changing borders of banks risk profile can change rapidly / more dynamic

balance sheet

cross-sector: from narrow banks to financial conglomerates

size: firms as market infrastructures

cross-border

perimeter of control / outsourcing issues

fiduciary role?

II. Challenges (2/2)

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III. Three horizontal questions

What is risk? "Just a probabilistic concept"?

What financial structure carries the risks?

Understanding leverage

What governance setting takes and

manages the risks?

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IV. Illustration: credit risk

Major changes over the past 10/15 years

in the management of credit risk and in

the nature of market participants

Regulation tries to be as close as possible

to "Market best practices"

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Value-at-risk (VaR) approach

Amount capital >= VaR

VaR measures the maximum loss in value that can occur at a given

confidence level and in a specified time period

Example: if confidence interval = 99.9% and time period = 1 year, then

there is 1 chance in a 1000 that the loss in 1 year is greater than the VaR.

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VaR approach

Realised losses over time gives loss frequency distribution

Unexpected losses

Expected losses

Time

Los

ses

Frequency losses

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Credit VaR

Example of losses distribution: the EL and UL parts

0

0,05

0,1

0,15

0,2

0,25

0,3

Expected losses Unexpected losses

Losses

Average

Loss frequency distribution

Credit Value-at-Risk

A

0.07%

AA

0.03%

AAA

0.01%

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Credit VaR: risk parameters

Risk parameters loss distribution

PD (probability of default)

LGD (loss given default)

EAD (exposure at default)

Maturity

Correlation

Additional parameter Credit -VaR: confidence interval

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Credit VaR: risk parameters Illustration maturity

(in %) AAA A BBB BB

PD 1 year 0.02 0.14 0.75 2

PD 3 year 0.03 0.24 0.99 6.14

PD 5 year 0.1 0.57 2.16 10.59

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Credit - VaR: risk parameters Illustration: Impact correlation on loss distribution

Correlation = 0 % Correlation = 50 % Correlation = 100 %

Loss LossLoss

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VaR in credit institutions: economic capital / rating agencies' capital / supervisory capital

Convergence? "Same business same rules?"

Credit - VaR parameters: market participants and supervisors

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Outlook: banks / non-banksE

quit

yJu

nior

Mez

zani

ne

Sen

ior

Sup

er

seni

or

Losses

Los

s pr

obab

ilit

y

Illustration: CDO tranching loss distributionVolume

Equity 2%

Junior 1%

Mezz. 4%

Senior 8%

Super senior

85%

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Main issues

The increasing difficulty to track the circulation

of credit risk (for authorities and markets)

Possible excessive reliance on the output of

models that have not been tested sufficiently

Lack of risk management tools that consider the

interlinkages between market risk, credit risk,

operational risk ("silo" approach to risk)

How to deal with "tail risks"?