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2.5 REGULATORY INITIATIVES FOR MARKET RISKS AND VALUE AT RISK
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Alan Greenspan has made it very clear that the assumptions and conditions must be fully discussed and understood when applying quantitative models such as value at risk (VaR):
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Probability distributions estimated largely, or exclusively, over cycles that do not include periods of panic will underestimate the likelihood of extreme price movements because they fail to capture a secondary peak at the extreme negative tail that reflects the probability of occurrence of a panic. Furthermore, joint distributions estimated over periods that do not include panics will underestimate correlations between asset returns during panics. Under these circumstances, fear and disengagement on the part of investors holdings net long positions often lead to simultaneously declines in the values of private obligations, as investors no longer realistically differentiate
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among degrees of risk and liquidity, and to increase in the values of riskless government securities. Consequently, the benefits of portfolio diversification will tend to be overestimated when the rare panic periods are not taken into account.67
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The 1988 Basel accord provided the first step toward tighter risk management and enforceable international regulation with similar structural conditions for financial supervision.68 The Basel accord set minimum capital requirements that must be met by banks to guard against credit risk. This agreement led to a still-evolving framework to impose capital adequacy requirements to guard against market risks. The reasoning behind regulation is multilayered and complex. One could ask why regulations are necessary. In a free market, investors should be free to invest in firms that they believe to be profitable, and as owners of an institution, they should be free to define the risk profile within which the institution should be free to act and evolve. Essentially, this is what happened to Barings, where complacent shareholders failed to monitor the firm s management (see Section 6.6). Poor control over traders led to increasingly risky activities and, ultimately, bankruptcy. In freely functioning capital markets, badly managed institutions should be allowed to fail. Such failures also serve as powerful object lessons in risk management. Nevertheless, supervision is generally viewed as necessary when free markets appear to be unable, themselves, to allocate resources efficiently. For financial institutions, this is the rationale behind regulations to protect against systemic risk (externalities) and to protect client assets (i.e., deposit insurance). Systemic risk arises when an institution s failure affects other participants in the market. Here the fear is that a default by one institution will have a cascading effect on other institutions, thus threatening to destabilize the entire financial system. Systemic risk is rather difficult to evaluate, because it involves situations of extreme instability, which happen infrequently. In addition, regulators tend to take preventive measures to protect the system before real systemic damage is caused.69 Deposit insurance also provides a rationale for regulative measures. By nature, bank deposits have destabilizing potential. Depositors are promised that the full face value of their investments will be repaid on demand. If customers fear that a bank s assets have fallen behind its liabilities, they may then rationally trigger a run on the bank. Given that banks invest in illiquid assets, including securities and real estate, the demand for repayment will force liquidation at great cost. One solution to this problem is government guarantees on bank deposits, which reduce the risk of bank runs. These guarantees are also viewed as necessary to protect small depositors who have limited financial experience and cannot efficiently monitor their banks.
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There is an ongoing argument that deposit insurance could be provided by the private sector instead of the government. Realistically, however, private financial organizations may not be able to provide financial transfers to investors if large macroeconomic shocks or sector collapses occur, such as the U.S. savings and loan crisis of the 1980s. On the other hand, applying Darwinism to capital markets, it should be possible to eliminate failing institutions from the market and replace them with fitter organizations.70 This government guarantee is no panacea, for it creates a host of other problems, generally described under the rubric of moral hazard (see Section 1.4). Given government guarantees, there is even less incentive for depositors to monitor their banks. As long as the cost of the deposit insurance is not related to the risk-profile of the activities, there will be perverse incentives to take additional risks. The moral hazard problem, due to deposit insurance, is a rationale behind regulatory attempts to supervise risk-taking activities. This is achieved by regulating the bank s minimum levels of capital, providing a reserve for failures of the institution or systemic risks. Capital adequacy requirements can also serve as a deterrent to unusual risk taking if the amount of capital set aside is tied to the amount of risk undertaken. Alan Greenspan stated in 1999 that the current regulatory standards had been misused due to inconsistent and arbitrary treatment:
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The current international standards for bank capital had encouraged bank transactions that reduce regulatory requirements more than they reduce a bank s risk position. The fundamental credibility of regulatory capital standards as a tool for prudential oversight and prompt corrective action at the largest banking organizations has been seriously undermined.71
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