Basel II and Extreme Risk Analysis

Abstract

Basel II mandates the maintenance of bank capital to address three broad categories of risk: credit risk, market risk and operation risk. Basel II methodology assumes that credit risk can be reliably specified with respect to particular asset categories. These projections are based on historical experience, reflected in data sets, which are at times general and at times specific to a particular institution. Basel II may have failed, however, to identify the strong shift in the correlation of defaults that accompanied the financial crisis. Market risk assessment displays similar issues of under-anticipated correlation under extreme conditions. Of the three categories, operational risk is the least tractable. It is a catch-all category, reflecting both internal failures and external events. The character of risk shifts markedly between ‘ordinary times’ and extreme events.

Consider this matrix:

Credit Risk

• In Ordinary Times, defaults may be predicted based on historical data; there is no strong correlation of default. • During Extreme Events, there is often inadequate data for a robust quantification of risk, where there is a strong correlation of default.

Market Risk

• In Ordinary Times, loss of value is linked to the performance of a particular asset. • During Extreme Events, loss of value is linked to asset type (that is, contagion).

Operational Risk

• In Ordinary Times, operational losses are more likely to be institution-specific. • During Extreme Events, operational losses originate from the general environment.

This paper addresses the ability of Basel II to respond to extreme events. Extreme events include events thought to be extremely unlikely and events that are unimagined (and hence ex ante unimaginable). Basel II largely examines risk as faced by individual financial institutions. Yet systemic risk (contagion) is a well-recognized feature of the international financial system. The liquidity crisis, however, appears to be a novel (unanticipated) phenomenon. Cross-failure of institutions may be yet another example of unanticipated correlation of outcomes, with a peculiar magnification effect. Basel II does not ask – at least not explicitly – whether there is adequate capital across the entire banking system. The current financial crisis may be an instance where this failed to hold. A revised Basel regime might need to account for additional capital stored outside individual institutions to assure adequate capital under extreme conditions affecting the broader banking sector.