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Restoring banking balance

In August, I blogged about the notable regulatory guidance issued by the Monetary Authority of Singapore, which called for increased capital levels and – more significantly – an accelerated timeline mandated by Basel III. I also talked about the three key lessons from global financial crisis: More capital. More liquidity. Size and interconnectedness matter.

The global regulatory conversation needs to involve all three aspects. To improve upon these aspects, banks need to take a step back and understand the vulnerabilities of the external environment before deciding how to allocate capital amongst individual portfolios and the liquidity of those added buffers.

How should they do this? It’s an important question and one the Business Times, Singapore’s influential business daily, asked me to elaborate on in this weekend’s edition.

The gist: By integrating forecasts into credit risks models, banks can improve portfolio performance in changing times, therefore lending to the right customers at the right time; accurately broadening or tightening customer bases to correspond with the economic lifecycle; and continuously refining long-term portfolio and business strategies, given the new future insights.

In fact, we've found that integrating economic forecasts into models improved default projections accuracy by 25 percent. But while appropriately allocating capital is important, the liquidity of the capital that is allocated is equally as critical.

Many of you have said that you're unable to access the Business Times link, so I'm reposting my submission below. I’m sharing this because we’d like to hear your thoughts on these topics, so I encourage you post a comment. 
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Published September 17, 2011

Business Times
 
Restoring banking balance

Increased capital adequacy is only part of the solution. Greater protection is needed, given the fast and wide impact of financial crises today

Dan McConaghy
President,  FICO Asia Pacific

On Sept 12, 2010, the Basel Committee on Banking Supervision announced Basel III, a set of reform measures to fortify regulation, supervision and risk management of the banking sector. Banks would have to hold 6 per cent of Tier 1 capital, up from 4 per cent, with a supplementary conservation buffer of 2.5 per cent by Jan 1, 2015, among other requirements.

On June 28, 2011, the Monetary Authority of Singapore (MAS) took this a step further. MAS announced a Tier 1 capital adequacy requirement of 8 per cent, introduced a capital conservation buffer of 2.5 percentage points, and - more notably - accelerated compliance to meet these higher standards two years ahead of the Basel timeline.

Singapore is the first to boldly accelerate the timeline. This is a good move, especially because this standard is appropriate and achievable for Singapore's banks, which are among the highest capitalized.

But while capital adequacy is a critical piece to restoring financial stability around the world, there were three key lessons from global financial crisis: More capital. More liquidity. Size and interconnectedness matter. The global regulatory conversation needs to involve all three aspects and banks need to understand external environment vulnerabilities before deciding how to allocate capital amongst individual portfolios and the liquidity of those added buffers.

Integrating forward-looking values

Banks in Singapore, and throughout most of Asia Pacific, will not be challenged to meet these new requirements, so long as the economy keeps growing. But, if markets collectively tumble, financial institutions likely would cut lending, stalling economic growth.

Given how suddenly the global financial crisis descended upon both Wall Street and Main Street, it's important to build greater protection into the system. This demands that financial institutions be able to forecast credit risks based on projections of economic changes, enabling them to account for the amount of appropriate backing needed for stressed portfolios and suitably allocate available capital when and where required.

The issue is this: historically, lenders have relied on analytical models to assess risks, derived from patterns of customer repayment that determined whether a customer was a prime one; where given score ranges were assumed to represent immediate-future defaults. This assumption worked reasonably well if the economic environment was stable. But if external factors are changing rapidly, it would be dangerous to assume the risk levels associated with the corresponding scores will remain stable.

By integrating forecasts into credit risks models, banks can improve portfolio performance in changing times, by lending to the right customers at the right time; accurately broadening or tightening customer bases to correspond with the economic lifecycle; and continuously refining long-term portfolio and business strategies, given the new future insights.

The models must be flexible enough to take into consideration more than just the three main key economic indicators - GDP, mortgage default rates and unemployment - in periods of high stress and in environments that occur once every few decades.

We've found that integrating economic forecasts into models improved default projections accuracy by 25 per cent. But while appropriately allocating capital is important, the liquidity of the capital that is allocated is equally as critical.

Adding the liquidity criteria to capital requirements

Sept 15, 2008 is a date in history that all investors of this generation will remember. The collapse of Lehman Brothers still troubles many today. Part of the cause of their collapse was the lack of cashable liquid assets. Lehman Brothers went into bankruptcy holding over US$600 billion in assets but only had a mere US$2 billion of cashable assets.

We're seeing more and more that liquidity, not just capital allocation and adequacy, will work to lean against pro-cyclicality. While banks around the world have overall taken this lesson to heart, we believe that regulators should devote focus to ensuring liquidity guidelines are advanced and met.

The importance of liquidity is underscored at a time when the European debt crisis is looming over banks around the world. Since May this year, the Greek debt crisis and rising US unemployment has wiped off more than US$2.6 trillion worth of equities. The recent stress tests carried out at 91 banks in 21 EU countries further highlight the importance of liquidity.

While our work with the top two-thirds of Asia Pacific banks indicates that liquidity is not a big challenge for them, it's important for banks to remember that liquidity has to be a mainstay. In some instances, more liquidity than usual may be needed and regulators should remember that one size does not fit all. This fluid liquidity principle applies not only to individual countries but to large banks within key markets that are critical in the interconnected banking system.

Not all banks and markets made equal

The global financial crisis has made clear the importance of maintaining liquidity and capital adequacy. Recent guidance from the Bank of International Settlements (BIS) mandates even higher capital requirements for systemically important institutions, as well as an additional surcharge for institutions with more than US$50 billion in assets.

Singapore's role in the broader Asia Pacific and global economy - where its performance is considered an economic health indicator of the region - demands that its banks be swift and able to weather plummeting credit availability. This is why MAS' recent move is all the more welcomed.

Of all the characteristics that define economic activity, connection is the most important. Institutions considered 'too big to fail' are in reality 'too connected to fail'. The BIS and others keep coming back to this because the interdependencies that girdle the globe, linking the boardrooms of Wall Street to the kitchens of Main Street, can be the economy's greatest vulnerability or its greatest strength.

The effects of the new regulations have yet to be fully realised. That we needed better regulation is beyond debate. The crucial consideration is that we don't forget the lessons learned from the system's near-collapse.

If we resist the temptation to deny the pain of what we've just been through and take the opportunity to learn from all lessons, prosperity, confidence, and trust will grow as systemic risks diminish.

For more discussion on these issues, http://bankinganalyticsblog.fico.com/

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