Research Proposal: Finance; (Financial Engineering, Financial Mathematics & Risk Management)
By:Syed Asad Raza Naqvi

Index

Introduction and Background………………………………………………………………………….3
Interested areas for research and further study (Research Proposal)……………….3
Further explanation of the intended research topics………………………………………..4
Securitization…………………………………………………………………………………………………..4
Credit Derivatives…………………………………………………………………………………………….6
Hybrid Products……………………………………………………………………………………………….7
Re-Securitization……………………………………………………………………………………………..8
Contribution of these products towards Financial Crisis…………………………………..8
Improper Risk Management role in Financial Crisis………………………………………….9
Risks………………………………………………………………………………………………………………..10
Market Risk……………………………………………………………………………………………………..11
Credit Risk……………………………………………………………………………………………………….11
Liquidity Risk……………………………………………………………………………………………………11
Interest Rates and the Financial Crisis………………………………………………………………12
Relation between low interest rate and financial crisis…………………………………….12
Role of Rating Agencies……………………………………………………………………………………14
Structure Finance Products and Rating Agencies……………………………………………..14
Regulations Then and Now………………………………………………………………………………15
BASEL II……………………………………………………………………………………………………………16
Enhancements of Basel II…………………………………………………………………………………18
The Resecuritisation Exposure Using IRB Approach………………………………………….18
The Resecuritisation Exposure Using Standardized Approach…………………………..18
Operational Criteria for Credit Analysis……………………………………………………………19
Securitization Liquidity Facilities – Standardized Approach………………………………19
Conclusion……………………………………………………………………………………………………….21
SOURCES …………………………………………………………………………………………………………22

Financial Crisis and Finance

Introduction and Background:

The financial crisis which peaked in 2008 September was blamed on the government decision of letting Lehman Brothers’ fail. Just a year ago Federal Reserve oversaw the purchase of Bear Stearns by JP Morgan while providing monetary assistance in the transaction as well. Similarly in September 2008 when Freddie Mac and Fannie Mac failed they were put under the tutelage of Federal Housing Finance Agency.
Whether Lehman Brothers deserved to fail or it was a government mistake not to bail it, the result of its failure was devastating. The AIG, insurance provider, soon needed to be bailed out. AIG was unable to make the required payments. Goldman Sachs was AIG’s most prominent counterparty, and Goldman’s demands for collateral were an important part of AIG’s demise.
When the bubble burst and housing market crashed, the financial institutions with investments in mortgages came crumbling down. However, the financial crisis is not as simple to be blamed on failure of Lehman Brothers or the crash of the housing market. The recipe for the disaster was brewed for a longer time and with much more ingredients. For a whole decade the housing market saw a rise in prices and presented a good investment opportunity. Similarly post 2001 the interest rates saw a rapid decline resulting in more lending. The credit related products too played a major role in the debacle, as these innovations were profitable as the market was bullish but with the bear the brought nothing but loss. Other contributing factors that need the most reforms were the rating agencies and the regulations. Rating agencies in order to increase their business and clientele moved to more lenient and favorable rating policy while the regulators made a transition from Basel I to Basel II, the first one being less flexible. Later on the regulators further introduced IRB and Advanced IRB approaches, both of which were more flexible than the Standardized approach within Basel II.

Interested areas for research and further study (Research Proposal):
The experts have identified following as the major factors which contributed to the present financial crisis, so I intend to study these financial functions, how they contributed to the crisis, and how can they be avoided. These factors fall under banking, finance & financial engineering and these are my desired areas of research and study. I am briefly mentioning the topics here and will further explain each one of them one by one and how they are related to triggering financial crisis.
1. Structured Finance Instruments such as CDS, CDO’s and ABS.
2. Improper Risk management and wrong assumptions regarding the housing market.
3. Rating Agencies.
4. Monetary Policy (Fed and Asian Economies)
5. Regulators (Basel I, II & III)

There are numerous other factors that stem from these minor mistakes and thus each of these five factors needs to be explained in order to describe the financial crisis.

Structured Finance Instruments can be categorized into four categories: Securitization products, credit derivatives, hybrid products and re-securitization. The securitization process begins with the packaging of debt instruments and individual loans, further enclosed in to securities followed by the enhancement of their credit status or rating which is consequently sold to third party investors. The second sub-category credit derivatives, exemplifies a contract between two counterparties where a derivative instrument is utilized to transfer the risk. Moreover it is important to note that in a credit derivative the credit risk is separated from the underlying asset. Hybrid instruments possess characteristics of securitization products and credit derivatives. This is the creation of the product that securitizes assets where the transfer of the risk occurs by a credit derivative. Finally resulting from the lucrative market for securitization, re-securitization of already existing securities was created. Re-securitization comprises of repackaging an already securitized product through a collateralized debt obligation into further securities. However despite the numerous advantages of these products, ever increasing complexities of these structured instruments together with their resistance towards market changes contributed as a driving force to the 2007-2008 liquidity crises. The birth of these highly advanced credit risk instruments have enabled entities to exploit new arbitrage opportunities by transferring risky assets from their balance sheets to encompass more flexibly towards managing their risks.

Further explanation of the intended research topics

i. Securitization:
The basic structure of securitization is mutual, the illiquid assets in the balance sheets of the originator are polled up and passed on to a bankrupt remote entity or a special purpose vehicle (SPV). This payment by the SPV is refinanced by the issuance of asset backed securities. The financial turmoil of 2007-2008 was exacerbated by the complex structure of risk transfer instruments; however the origination of the crisis was the subprime mortgage industry.
The subdivisions of Securitization are ABS (Asset Back Securities), CDO’s (Collatarized Debt Obligations) and ABCP (Asset Back Commercial Paper). Rather than explaining the entire ABS, the relevant division of ABS, mortgage back securities are shown in the diagram. Illiquid assets in the balance sheets of the originator are polled up and transferred to a bankrupt remote entity or a special purpose vehicle (SPV). This payment by the SPV is refinanced by the issuance of asset backed securities.
CDOs are securities that are founded on packaging types of high risk assets into new securities. The high risk assets include exposures such as mortgages, asset backed securities and other risky loans. CDOs are subordinated similarly to asset backed securities; the liabilities are separated into tranches consisting of different credit quality.

ABCP is a short term tool used to finance long term senior tranche investments, also known as a “rolling” as they constantly need to be rolled over for existence.18 Asset Backed Commercial Papers are collateralised debt instruments issued by SPVs with a maturity consisting of a few days up to two years.

ii. Credit Derivatives:
CDS and Hybrid products such as synthetic CDO have had their share of market and profit before the recession. A credit derivative is a private contract where a market participant purchases or sells a risk protection over the counter (OTC) to hedge against the credit risk associated with the reference obligation or entity. CDS cash Settlement

CDS physical settlement

iii. Hybrid Products
Infact hybrid instruments such as synthetic CDOs (which enclose an embedded option) played a very apparent role in the proliferation of the crisis. The synthetic CDO is similar to the cash flow CDO structure; however the SPV does not purchase the portfolio of underlying debt instruments, rather sells credit default swaps (CDS) over the underlying debt instruments of a cash flow CDO. The credit risk exposure that the SPV acquires relative to the underlying debt is exact to the cash flow CDO; however, the SPV does not own the asset. The credit risk is transferred to the investors.

iv. Re-Securitization:
Resecuritization was a term unknown in the finance literature and now an official terminology has been introduced in the regulatory framework as well. However, pre-financial crisis resecuritization was being carried out and covered ABS’ CDO’s and at the same time CDO’s over CDO’s.
ABS CDOs involve the securitization of structured products, derived from already existing securitization structures. Mortgage loans, consumer and credit card loans may be considered as the structured products used for these exposures.

While at the same time CDO’s were created over CDO’s i.e transactions in which the underlying portfolio consists of tranches of other CDOs.

Contribution of these products towards Financial Crisis:

In the paper The Economics of Structured Finance, Joshua D. Coval, Jakub Jurek and Erik Stafford says that these products were far riskier than shown, as these structured finance products were created using the riskier portion of the existing portfolio’s and only advertised to be safe.
“The essence of structured finance activities is the pooling of economic assets (e.g. loans, bonds, mortgages) and subsequent issuance of a prioritized capital structure of claims, known as tranches, against these collateral pools. As a result of the prioritization scheme used in structuring claims, many of the manufactured tranches are far safer than the average asset in the underlying pool. This ability of structured finance to repackage risks and create “safe” assets from otherwise risky collateral led to a dramatic expansion in the issuance of structured securities, most of which were viewed by investors to be virtually risk-free and certified as such by the rating agencies. At the core of the recent financial market crisis has been the discovery that these securities are actually far riskier than originally advertised.” (The Economics of Structured Finance by Joshua Coval, Jakub Jurek, and Erik Stafford)
The above mentioned three professors of finance in their working paper points the finger at the ratings and risk associated with these products. They are of the view that the important calculations were wrong and as a result these riskier products appeared to be safe.
Georges Dionne holds the Canada Research Chair in Risk Management, and is a Professor of Finance, HEC Montreal, in her article asserted that the structured finance products contributed less than the actual risk management. The problem which arose was not the creation of the product but rather the ratings, risks and default rate attached to these products. According to her it was these risk management errors that contributed towards the financial crisis and the solution to the problem is present in those calculations as well.
“There needs to be more transparency in the tranching of the structured products. As with any security, researchers and participants in the market must be able to replicate the composition of these products. Public data sets must be available for studying these products. The increasing complexity of structured finance creates challenges in terms of efficient management and the dissemination of information. More transparency is needed in the credit market, particularly when loans are securitized. There is also a need for more transparency regarding both the packaging of assets by trusts and the assets held by financial institutions, such as pension funds and hedge funds. The rating of these products must also be more transparent. Any good researcher or investor is able to verify the rating of any standard bond in the market because data are available and rating methods can be replicated. The same standard must apply to the rating of structured products and their pricing.” (STRUCTURED FINANCE, RISK MANAGEMENT, AND THE RECENT FINANCIAL CRISIS by Georges Dionne)
Improper Risk Management role in Financial Crisis:
Financial Crisis is linked with the assumptions used by the banks for determining the risk associated with the investments. This affected the capital required. Since banks assets on the balance sheet were considered safer, the capital requirements were less. Finally when banks such as Lehman Brother faced the problems the capital kept was not enough.
After the financial crisis risk measuring techniques and methods were challenged and criticized. VaR a single number used to evaluate risk was criticized the most. In NY Times article VaR was the first victim of the critics, who wished to challenge the bankers risk measuring methods. In his article Peter L. Bernstein, FROM THE INTRODUCTION TO ‘‘AGAINST THE GODS: THE REMARKABLE STORY OF RISK, raises the issue of poor risk management and starts his criticism from the VaR. His view is as follow:

“Risk managers use VaR to quant their firm’s risk positions to their board. In the late 1990s, as the use of derivatives was exploding, the Securities and Exchange Commission ruled that firms had to include a quantitative disclosure of market risks in their financial statements for the convenience of investors, and VaR became the main tool for doing so. Around the same time, an important international rule-making body, the Basel Committee on Banking Supervision, went even further to validate VaR by saying that firms and banks could rely on their own internal VaR calculations to set their capital requirements. So long as their VaR was reasonably low, the amount of money they had to set aside to cover risks that might go bad could also be low. Given the calamity that has since occurred, there has been a great deal of talk, even in quant circles, that this widespread institutional reliance on VaR was a terrible mistake. At the very least, the risks that VaR measured did not include the biggest risk of all: the possibility of a financial meltdown.” FROM THE INTRODUCTION TO ‘‘AGAINST THE GODS: THE REMARKABLE STORY OF RISK,’’ BY PETER L. BERNSTEIN.

In the paper, Management and the Financial Crisis (We have met the enemy and he is us …) the author, William A. Sahlman, through the example of AIG shows how improper management and common assumptions played a major role in the collapse of the Mega insurer. It was this improper management that if curbed could have saved the world from the financial crisis. AIG was bailed out by the government. The author describes the case of AIG in his own words: In the fall of 2008, the possible failure of AIG triggered a wide range of government responses that have forever changed the global financial landscape. AIG was a widely respected company that focused on insurance. In mid‐2007, AIG’s total market capitalization was almost $200 billion. By October 2008, the total market value of the company was under $10 billion and the government had invested almost $100 billion in saving the company. Real‐time history is always complicated but a clear issue at AIG was that a small group of employees (under 400) in its Financial Products group (FPG) wrote a large amount (over $500 billion) of insurance on corporate bonds and pools of asset‐backed securities, including pools of mortgage‐backed securities. Because AIG had impeccable credit, and because few people thought there was risk in any of these securities, FPG was able to write insurance with no up‐front collateral requirements. Thus, any profits represented a very high return on capital (think infinite).

Improper management of risk leads to the important question of the risks present and how they can be countered by the financial institutions.
Risks:
The financial institutions face many risks due to their role of intermediation. These risks are interest rate risk, market risk, credit risk, off balance sheet risk, technology and operational risk, foreign exchange risk, soverign risk, liquidity risk and insolvency risk. The three more important ones are
1) Market Risk
2) Credit Risk
3) Liquidity Risk
Their importance is linked with their relation with financial institutions and their role in financial crisis. The failure of Banks due to unable to meet the exposure of credit risk, while at the same time the credit crunch faced due to poor management of liquidity risk are indicators of better performance for these risks. As for Market risk, its existence is associated with other risks and during crisis, Market risk increases as the correlation of default becomes one.
The crisis started in the first half of 2007 when the credit quality of subprime residential mortgages, in particular adjustable-rate ones, started to deteriorate. Mortgage companies specializing in subprime products experienced funding pressures and many failed. Although problems were initially confined to the subprime mortgage markets, further deterioration of credit quality and increases in the delinquency rates led to a spread of the crisis to other markets and products. By mid-2007 investors started to retreat from structured credit products and risky assets more generally, as rating agencies started downgrading many mortgage-backed securities. The securitization market for subprime mortgages simply broke down. This added pressures on SPV’s, which then sought liquidity support. When the market crashed the defaults increased the institutions faced liquidity problems leading eventually to their insolvency.

Market Risk:
It is the risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates and other asset prices. Market risk is closely related to interest rate risk, equity return, and foreign exchange risk. Thus it is volatile and in extreme cases market risk can be fatal to Financial Institutions, which was observed in the recent crisis. Another reason Market risk is important to monitor is its relation to structure finance products.
Credit Risk:
The risk that the promised cash flows from loans and securities held by financial institutions may not be paid in full. Credit Risk is of two types. The first is firm specific associated with risk related projects of the firm. The second is systematic credit risk which affects the entire economy. The firm specific risk was seen in the recession through the types of investment, especially through the structured products while the systematic risk was observed after the collapse of Lehman Brothers when the entire economy was rattled and default rates rose.
Liquidity Risk:
The risk that sudden demand of cash by the creditors would not be met in the short term, thus leading to default of the financial institution. If we look at the collapse of Lehman Brothers, AIG and many others bank that defaulted in 2008, we observe the liquidity to be fatal for them. The housing market crashed and due to investment in the market, the financial institutions suddenly faced a credit crunch, unable to meet their financial liabilities and unable to raise more cash due to the investment positions.
The three risks played a hand in hand part but market risk and credit risk led to abnormal liquidity risk that was not estimated and thus not prepared for, which thrust the economy into the recession.

Interest Rates and the Financial Crisis:
Background:
One aspect that seems to stand out as a key contributor to the markets collapse is the interest rate. Low interest rates enticed people to borrow money with little regard for how they would repay it. When interest rates are low the cost of borrowing money is low because there is less interest to pay back over the course of the loan. This encourages people to borrow money to buy things they could not normally afford and should probably not own in the first place. The banks were more than happy to right these loans until they realized they had no more money to pay investors. The solution to this is to take high performing loans, package them up and sell them off to other inventors and get cash to now. So the bank gets its money now rather than latter and the investors have secure investments that produce steady payments every month, everyone wins. After seeing how well this work banks decided to try less desirable or "sub-prime" loans. Although there were some anticipated defaults, the actual number of loans that defaulted was unprecedented. Now the investors make no money and the banks are forced to take back houses that they wrote mortgages for that people could not afford to pay.

Relation between low interest rate and financial crisis:
In his paper, U.S. Monetary Policy, ‘Imbalances’ and the Financial Crisis, Pierre Olivier Gurrinchas explains how monetary policy of US post dot com bubble bust and September 11 terrorist attack contributed to financial crisis. He agrees with the argument that 2-3 years of low interest rate contributed to boom in housing market. “Many voices are now arguing that the extended period of low policy interest rates between June 2003 and June 2004, followed by a period of “measured” rate hikes is directly or indirectly responsible for the crisis: policy rates were too low, for too long, fueling the housing boom and ultimately destabilizing the U.S. economy.”
He presents his own answer with the following argument: “The more sensible argument is that low (although not necessarily negative) real interest rates can be a source of financial instability. The relevant observation here is that low real interest rates can be a problem especially in periods of robust growth, like the one the world economy, and the U.S., experienced in the years preceding the crisis. Low real rates can be dangerous in a rapidly expanding economic environment because they relax long term budget constraints, allowing households, governments and firms to be lulled into a false sense of financial security and leading to dangerous increases in leverage and potential misallocation of capital.”
The argument that financial crisis is somehow linked or caused by low interest rates is presented thorough a chain of assertions:

• The 2001 dotcom crash and the 9/11 attacks led to a reallocation of capital towards safe assets as the world came to realize that there was substantial risk in U.S. assets.

• As the demand for safe assets outstripped supply (constituted of triple-A corporate bonds, government securities and agency debt backed by the securitized mortgages of low-risk borrowers), this created an irresistible profit opportunity for the U.S. financial system.

• This allowed the U.S. financial system to transfer part of the demand for safe liquid debt instruments onto ultimately higher risk assets, fueling increases in asset prices across the board and allowing more borrowing.

• Creating synthetic supposedly triple-A assets on such large scale allowed supply to meet demand, at the cost of making the financial system vulnerable to systemic risk.

• When the crisis reached the systemic stage, the only bona-fide safe debt instruments left were U.S. Treasuries. By then, even triple-A corporate bonds and agency debt faced significant liquidity and counterparty risk. (U.S. Monetary Policy, ‘Imbalances’ and the Financial Crisis, Pierre Olivier Gurrinchas)

So while establishing the relational coefficient between low interest rate and financial crisis, the conclusion that is derived is that the economy is susceptible to bubbles when the interest rates are low. This is possible as for each investor there is an opportunity to make money, but considering this opportunity over the entire economy one finds that all the investors can’t be in the same situation, even though the picture presents it to them. This rosy picture is the bubble, like the housing bubble in the recent crisis. The low interest rates contributed to making real estate profitable. The investment in that sector grew as each investor saw profits and gain, however, the real picture was that there was over pricing and overvaluing of the assets, resulting in a bubble that had to bust.

Role of Rating Agencies:

Background:

In 1996, Thomas Friedman, the New York Times columnist, remarked on The News Hour that there were two superpowers in the world , the United States and Moody’s bond-rating service and it was sometimes unclear which was more powerful. Their power and influence was related to the business of rating securities available in the market. A favorable rating would calm the investor’s fear, who would rely that such rating agencies have probably done their homework. However, the market collapsed and the financial products with good ratings became worthless reducing investors’ asset and investor’s confidence.
Thus these rating agencies have been blamed for the financial crisis, as investors rely on the ratings before investing. Many believe that Rating Agencies have overlooked their responsibility for more profits. The competition for customers between these agencies led to more lenient policies and more favorable ratings. Furthermore most criticism comes on the ratings assigned by these agencies on structured finance products, as it is now known that agencies didn’t have complete information on the products they were rating.
In the NY Times article, the ratings game, Roger Lowenstein describes the power and influence of these rating agencies before the crisis. “Obscure and dry-seeming as it was, this business offered a certain magic. The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans. To get why this is impressive, you have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody’s, then the investor could forget about the underlying mortgages. He wouldn’t need to know what properties were in the pool, only that the pool was triple-A — it was just as safe, in theory, as other triple-A securities. Nothing sent the agencies into high gear as much as the development of structured finance. As Wall Street bankers designed ever more securitized products — using mortgages, credit-card debt, car loans, corporate debt, every type of paper imaginable — the agencies became truly powerful. ”
Structure Finance Products and Rating Agencies:
Structured finance institutions and investors relied immensely on rating agencies and hence the valuation of adequate ratings was the foundation to a prudent investment decision. Here two important and relevant examples would be of mortgages and CDO’s. The probabilities of default inherent within the mortgages industry were not accurate and aligned with realistic occurrences. Mortgages usually have high recovery rates; however, despite the high debt-to-value ratios together with diminishing underwriting standards increasingly evident during the subprime boom, the originators passed on inaccurate information on the credit quality of their borrowers to issuers and arrangers. As the rating agency did not cross check if due diligence was conducted among originators and mortgage borrowers, there was larger susceptibility for false ratings. Collateral debt obligations (CDO) and mortgage backed securities (MBS) markets are characterized by fragile AAA rating structures, where the originators depended on AAA ratings for a successful issuing. Here both parties required favorable treatment to reap profits. While the one needed AAA rating the rating agencies too were caught up in the process of reaping inevitable profit margins for their services, and thus failed to prudently manage these finance instruments. Many institutions required AAA rated securities for their investments, which incentivised rating agencies to improve their marketing by illustrating that the two types of categories entail the exact risk measurements and furthermore there was a competition between the agencies for more market share, which too compromised their judgment and their assigned ratings, especially in structured finance products.
However, the one major criticism on Rating agencies is on different rating interpretations. There ratings implied differently for corporate bonds and structure finance products. Investors believed that rating agencies would use the same rating methodologies bonds as this was what these agencies propogated:
“Our ratings represent a uniform measure of credit quality globally and across all types of debt instruments. In other words, an „AAA‟ rated corporate bond should exhibit the same degree of credit quality as an „AAA‟ rated securitized issue.”109
Thus, investors believed that an AAA rated corporate bond entailed the exact risk like securitized assets - even though over 60% of all structured finance products in 2006 were AAA rated relative to merely 1% of AAA rated corporate bonds.

Regulations Then and Now:

Two types of framework are important. The first is the accounting framework and how the change or the shift to fair value accounting contributed to the financial crisis. The second is Basel framework which would enable to understand that how the new approaches introduced played a part in recession.
Fair value accounting
Fair value accounting was introduced in 1993 by the Financial Accounting Standards Board (FASB) with the intention to facilitate comparison of balance sheets across companies, industries and countries on the one hand and insightfully represent real values of the corporation on the other. The two main purposes of fair value accounting are based on two perceptions. Firstly, given that there is a market for an asset, the value should be stated on the balance sheet representing the current price. Secondly, the valuation of assets should be constantly applied among corporations to facilitate a cohesive comparison methodology across industries. Under IFRS and GAAP, disclosure of securities held as financial assets must be categorized under three categories relative to their underlying motive. The three categories represent: held to maturity, held for trading and availability for sale. The latter two categories are valued at fair value and assets held to maturity are valued at amortized cost. The problem with the fair value accounting was that during lucrative economic conditions banks through mark to market and fair value accounting could provide almost unlimited credits, since their assets directly reflected surges in equity or profits. However as economic conditions changed, the mark to market accounting regulations induced firms to reduce their highly credit exposures as deteriorating asset values directly affected profits or equity.

BASEL II:
With Basel II the flexibility awarded the financial institutions was far more than with Basel I, as in Basel I, the framework provided mostly the relevant figures to determine the risk weighted assets and the capital required. The standardized approach was not different from Basel I as the risk measures are not obtained by bank themselves but rather provided by the framework or the external agencies. The Basel II however allowed IRB approach and the internal rating approach allowed the banks to use their own measures and figures. Advanced IRB approach allowed even more flexibility and reduced the role of external agencies completely. This flexibility of the Basel II coupled at the same time with new products such as structured finance products, not covered in the Basel framework were the main criticism faced by the Basel Committee. It was believed that the regulators set capital requirement was not enough and the Bankers circumvented the regulators.

Basel II pillar I deals with three different kinds of risks:
i) Credit risk ii) Market risk iii) Operational risk
Credit risk is due to a credit position of the bank or FI’s. The credit position shows how much capital does a bank need to counter for this risk. Now Basel II gives risk weights for the securitisation exposures of the banks along with the Credit Conversion Factors allowed to be used to determine the risk weights of their commitments. Banks determine the joint probability of default for their securitisation exposures and commitments and using the Basel II framework they calculate their minimum capital requirements. Operational risk and Market risk have been included in the Basel II pillar one as well for the first time. Before Basel II both these risks were not incorporated and were not deterministic in minimum capital requirements.
Following illustration from Shin and Adrian provides a great illustration of the combined effect of fair value accounting and Basel II.
Consider a financial institution with securities worth a $100, and the bank finances this exposure with debt (D) worth $90. The bank upholds a constant minimum leverage ratio of 8%.
Assets Liabilities Securities 100 Equity 10 Debt 90 Assets Liabilities Securities 105 Equity 15 Debt 90
Assume that the prices of the assets increased by 5% to $105.Increasing equity to $15 (Assume that debt remains stable for small changes in assets). The leverage has fallen to 7%).
L= 105/15 (105-90)
L= 7%
As the minimum capital requirement lies at 8%, the bank can further take debt to purchase respective securities (assets) to bring the leverage ratio to 8% , this is the case when leverage is pro-cyclical, which was evident with mark to market fair value accounting.
A/E = 105+ D/15 = 8
D = $15
The financial intermediary takes a further $15 worth of debt and with the proceeds buys securities worth $15, bringing the leverage ratio back to 8%. An increase in the price of assets by 5% causes an increased holding capacity of $15.
Assets Liabilities Securities 120 Equity 15 Debt 105 Assets Liabilities Securities 118 Equity 13 Debt 105
Conversely, let us consider a fall in the price of securities to $118. The equity component of the balance sheet withstands the burden (assume that liabilities remain constant for small changes in the asset prices).Consequent to the constant leverage, banks tend to reduce leverage ratios as prices of assets fall.
L= A/ (A-D)
L= 118/13 (118-105)
L= 9%
As the minimum capital requirement lies at 8%, to bring the leverage ratio back to this target the bank can either sell securities that are worth $14, or pay off $14 worth of debt. A fall in the price by $2 requires the sale of assets worth $14. The leverage ratio is back to 8%. This was the outcome of fair value accounting during depressed economic conditions. Thus, a fall in the price of securities results in the sale of assets.
A/E = 118+ D/13 = 8
D = (14)
Assets Liabilities Securities 104 Equity 13 Debt 91

There was no immediate response by the Accounting Boards such as IFRS or GAAP but only one by the Basel committee which introduced changes in the Basel II framework, enhancements. However, the solutions are being sought after both by accounting and Banking regulations in the form of replacement of fair value accounting and introduction of Basel III.
Enhancements of Basel II:
After the implementation of Basel II accords the Basel committee was quite contended with the fact that the implemented Basel II accords are capable enough to coop with the financial demands. But the recent financial turmoil proved them wrong and made them to reconcile their regulatory material. After a number of tedious sessions, the board proposed some enhancements to all the three pillars of the Basel II accords. The three pillars to which enhancements were proposed deal with minimum capital requirement (allocating risk), supervisory review and market discipline respectively.
Enhancements came into effect on January 1 2010, however, these enhancements are a temporary solution. The framing of Basel III is underway, and it is hoped that it would provide a long term solution to the crisis and a regulatory framework for the banks. However, no comments can be said about Basel III, rather only the enhancements can be discussed in particular the pillar 1 which deals with minimum capital requirements as all the seven changes introduced are considered to be a response of financial crisis.

Pillar 1—(Minimum Capital Requirement)
Introduction:
Pillar 1 comprises of regulations regarding the capital requirements. It clarifies the financial institutions about the capital requirements which they need to fulfill in order to stay in business. This capital requirement also includes the assessment of risk associated with each asset that is within possession of the financial institutions.

The Resecuritisation Exposure Using IRB Approach:
Internal Rating Based Approach says that the financial institutions have to rate their assets on the base of their internal assessment techniques which mean that they have a choice to follow that set of asset rating which suits their organizational framework. Therefore the financial institutions got rid of the approach when they have to rely on external ratings. The IRB approach is flexible to an extent that it gives the FIs more liberty than the approach which relies on the external ratings. It is the only reason why most of the financial institutions are adopting the IRB approach for rating their assets.
This part of enhancement to pillar 1 emphasizes the fact that the risk weights of the resecuritized assets should be enhanced from the position they had when they were treated as the securitized assets.
Following this approach the assets were divided into following categories. These were the senior and the junior categories. The resecuritized asset of senior category is defined as the resecuritized asset which (a) has the exposure of the senior position and (b) none of the underlying exposures are themselves the Resecuritisation exposures. Similarly the junior category was defined as the asset having the exposure of junior position and the second condition is same as that of senior category.

The Resecuritisation Exposure Using Standardized Approach:
In addition to the IRB approach, the financial institutions are also given the option to use the Standardized approach of measuring the risk of the resecuritized asset.

Ratings Resulting from Self-Guarantees:
During the recent turmoil, several banks that provided the Liquidity Facilities to the Asset Backed Commercial Paper Programs chose to purchase the Commercial Paper and used the external rating of these Commercial Papers. Therefore their asset side of the Balance Sheets boosted up as a result of the excellent external ratings of these Commercial Papers.
The Basel Committee has added language to the Basel II framework so that a bank cannot recognize ratings – either in the SA or in the IRB Approach – that are based on guarantees or similar support provided by the bank itself. In other words, the Committee concluded that banks should not be allowed to recognize external ratings when those ratings are based on support provided by the same bank.

Operational Criteria for Credit Analysis:
Operational requirements for securitization exposures have increased as well. No along with requirements of Basel II with regard to securitization and use of Standardized Approach and IRB Approach (Internal Rated Based), banks are required to perform operational requirements with regard to credit analysis of securitization exposure.
The three additional operational requirements are:
• They are required to first understand the risk and its characteristics of both Balance Sheet and off-Balance Sheet exposures.
• They are required to evaluate the performance of the securitization exposures on timely basis.
• They also must have a thorough understanding of structural features of the securitization transactions that would impact the performance of the bank’s exposures to the transactions.

Securitization Liquidity Facilities – Standardized Approach
Basel II as Basel I for credit risk allowed a 20% Credit Conversion Factor (CCF) for short term commitments of the banks while 50% for long term.
Those commitments which were neither of the above two, but were securitization exposures, received a CCF of 100%. For such commitment enhancements propose no charge.
However for short term commitments of the bank the CCF has been charged to 50%. Enhancements treat both long term and short term commitments in the same manner unlike Basel I and Basel II. Now this measure is a proactive measure, as it has been taken after recession considering the factors that led to recession but its roots are not found in recession unlike for the concepts of re-securitization and self guarantees issues.
Securitization Liquidity Facilities – IRB Approach
Whether the liquidity facilities provided by the banks to commercial paper etc are short term or long term their treatment under the IRB Approach is the same.
All liquidity facilities are treated as a securitization exposures and CCF of 10% is used.
Now Basel II and enhancements don’t offer different method for determination of credit risk. In fact enhancements in this case accentuates only on the operational requirements for securitization exposures including the three additional charges for continuous and timely basis credit analysis.
Furthermore the enhancements under the IRB Approach clarifies which liquidity facilities would be placed under senior granular the securities with less risk, early settlement rights and priority in terms of payment.
Market Disruption Lines:
Basel II in paragraph 580 & 638 allowed preferential treatment i.e. a smaller CCF using both Standardized Approach and IRB Approach for specific liquidity facilities. The reason was that there liquidity facilities were liable to be drawn only in case of Market Disruption. Thus banks were allowed a 0% CCF under Standardized Approach for short term commitments of that type. While for other exposures of the kind 20% CCF was allowed, even under IRB Approach.
Due to this preferential treatment banks allowed capital was not sufficient to meet the requirements in the recent recession, when such liquidity facility were drawn on the bank. As a result enhancements have changed the treatment for such liquidity facilities. They shall be treated in the same manner as ordinary liquidity facilities.
Implication of Pillar I:
The enhancements to the Basel II accords, Pillar 1 can have a number of significant effects on the business environment of the financial institutions, some of which are listed below:
First of all, adding risk weights to the Resecuritisation exposure can make the asset less favorable to invest in. Therefore we can see a risk return trade off between the riskiness of the resecuritized asset and the attraction of investors to invest in that asset.
Secondly, by introducing IRB approach of rating the resecuritized assets, the Basel committee has granted the financial organizations, an additional and flexible approach with which they can rate their Resecuritisation exposures. Hence the financial institutions can rate their resecuritized assets according to their organizational framework. Here one thing should be kept in mind, that the IRB approach is not an arbitrary value of riskiness that can be assigned by any financial institution; rather it is a set of values that different financial institutions apply on their resecuritized assets according to their own organizational framework and even these set of values are strictly monitored by the Basel Committee. Therefore there is very rare chance of finding a loop hole.
Thirdly the enhancement, in which there is prohibition of usage of ratings resulting from self guarantee, is a good signal towards the trust of the investor in the market because in the absence of this self guaranteed asset ratings, there will be lesser chance of any trick which financial institutions can play in order to attract the investors. Hence it will promote transparency in the market which will eventually lead to trust building in the investor’s mind.
Another impact of enhancement is that the credit risk calculation has been changed with regard to credit conversion factors. Now for financial institutions, credit facilities for short term or long term maturities are given equal risk weights. This would have a negative impact on the business and this step is the least justified. The recession image, looming as a backdrop, is the only cause of the committee’s decision to change the credit conversion factor, which now has made liquidity facilities a riskier undertaking in general. Enhancements with regard to Pillar-I introduces reactive measures keeping in view the factors that led to recession. Introducing the concept of re-securitization, prohibiting the use of ratings due to self guarantee, changing the CCF of off-Balance Sheet liabilities are all just exercising of the hard learned lesson. Financial Institution’s business might be affected due to such changes but the regulators can justify it by pointing them as the cause of such unappreciated changes. But what is more important is the next step the regulators taken with regard to credit risk, market risk and operation risk. Manipulation of the regulations has always been possible and regulators must keep in mind and must evolve before the others do. Regulators should beware of dormancy as manipulation of enhancements would eventually start as well.

Conclusion:

Financial Innovation and Financial Crisis:

Financial innovation is the creation of new products. The standard finance products are both limited and restricted use. The investment banks need derivatives to hedge the risks attached and thus they look to financial engineering when the market cannot provide. Structured finance products are a result of financial engineering too and with hindsight one sees that they had a link with the crisis. These credit products were developed and were result of innovation. They yielded heavy profits for the innovators, however, when the market crashed the reality was exposed. They were found to be riskier than shown and the result was financial crisis. In a NY Times article Innovating Our Way to Financial Crisis by Paul Krugman, the author blames the bankers and the innovation for the financial crisis: the innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized.

No factor responsible for financial crisis can be separated from financial innovation as the main cause was somehow these structured finance products, engineered to make money. And it is this part that needs regulation. Engineering should not stop but infact should be coupled with regulation. Introducing regulations only afterwards is no solution as witnessed. Barry Eichengreen in the paper, The Crisis in Financial Innovation, asserts this view. He doesn’t regard engineering or the innovation to be evil just mismanaged and misunderstood. “I continue to believe that many financial innovations, including more complex financial instruments, are in principle good. They can be used to shift risk to those best able to hold it. They can provide insurance for those with limited risk-bearing capacity. They can reduce financing costs for those engaged in production, investment and innovation. But given the number of unsophisticated users in the marketplace and the extent of asymmetric information, nothing ensures that a specific innovation will have these positive effects.”

SOURCES:
• The Squam Lake Report Fixing the Financial System
• The Crisis in Financial Innovation
• The Economics of Structured Finance, Joshua D. Coval, Jakub Jurek and Erik Stafford
• STRUCTURED FINANCE, RISK MANAGEMENT, AND THE RECENT FINANCIAL CRISIS by Georges Dionne
• Management and the Financial Crisis
• FROM THE INTRODUCTION TO ‘‘AGAINST THE GODS: THE REMARKABLE STORY OF RISK,’’ BY PETER L. BERNSTEIN.
• Restoring Financial Stability, Viral V. Acharya, Lasse Pedersen, Thomas Philippon and Matthew Richardson
• U.S. Monetary Policy, ‘Imbalances’ and the Financial Crisis, Pierre Olivier Gurrinchas
• NY Times:
• Innovating Our Way to Financial Crisis by Paul Krugman
• Thomas Friedman
• Roger Lowenstein
• Illustrations and Diagrams:
• Shin and Adrian
• Sarai and Van Rixtel
• IFRS