Bank for International Settlements Studies Current Status of Global Credit Risks

In 2013, the Bank for International Settlements (BIS) did a survey to try and get a feel for the current status of credit risk management. Here is a link to a recent press release about the survey. Here is a link to the much more in-depth and detailed consultative document. The BIS is still in the process of getting feedback comments on the survey.

They surveyed supervisors and firms in banking, securities, and insurance around the world. The survey defined credit risk as "the risk that a counterparty will fail to perform its financial obligations." They go on to give some examples. "For example, credit risk could arise from the risk of default on a loan or bond obligation, or from the risk of a guarantor, credit enhancement provider, or a derivative counterparty failing to meet its obligations."  

The survey participants came from North America, Europe, and Asia. The goal of the survey was to find out the current status of credit risk management and how it may have changed since the 2008 financial crisis. The survey produced four main recommendations. Below we will post those and then add a few comments.

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The text of the press release linked above lists four recommendations based on results from the survey. Here is the actual full text of the press release:

Significant market and regulatory developments since the 2008 financial crisis have led to changes in how banks, insurers and securities firms measure credit risk. The Joint Forum surveyed supervisors and firms in the banking, securities and insurance sectors globally in order to understand how credit risk supervision and management have changed. Fifteen supervisors and 23 firms from Europe, North America and Asia responded to the survey.

This survey provides insight into the state of credit risk management and the implications for regulatory and supervisory frameworks. It updates the Joint Forum's 2006 review: Regulatory and market differences: issues and observations. Based on its analysis of the responses and subsequent discussions with firms, the Joint Forum makes the following recommendations for consideration by supervisors.

Recommendation 1:  Supervisors should be cautious against over-reliance on internal models for credit risk management and regulatory capital. Where appropriate, simple measures could be evaluated in conjunction with sophisticated modelling to provide a more complete picture.

Recommendation 2:  With the current low interest rate environment possibly generating a "search for yield" through a variety of mechanisms, supervisors should be cognisant of the growth of such risk-taking behaviours and the resulting need for firms to have appropriate risk management processes.

Recommendation 3:  Supervisors should be aware of the growing need for high-quality liquid collateral to meet margin requirements for OTC derivatives sectors, and if any issues arise in this regard they should respond appropriately. The Joint Forum's Parent Committees (BCBS, IAIS and IOSCO) should consider taking appropriate steps to monitor and evaluate the availability of such collateral in their future work while also considering the objective of reducing systemic risk and promoting central clearing through collateralisation of counterparty credit risk exposures that stems from non-centrally cleared OTC derivatives.

Recommendation 4:  Supervisors should consider whether firms are accurately capturing central counterparty exposures as part of their credit risk management.

Comments on this consultative document should be uploaded here by Wednesday 4 March 2015. Comments will be published on the website of the Bank for International Settlements unless a respondent specifically requests confidential treatment.

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My additional comments:

There is a lot of meat in this report. The consultative document goes into a lot more detail about the various forms of credit risk that exist today and why these four recommendations are being made. You can read the whole document here.  Below is a bullet point summary I made after reading through the document. 

- in general firms have made serious attempts to improve their ability to manage credit risks since the 2008 financial crisis, but there are still substantial risks in the the system

- firms have worked on improving the internal models they use to assess their risk, but there are still concerns that these internal models may not be conservative enough. Also, firms should not rely only on internal models. 

- the low interest rate yield environment is putting pressure on firms to take more risks to try and improve their returns

- OTC (over the counter) derivatives in all forms are still a very large risk to the system. Derivatives contracts related to interest rate changes are an enormous dollar amount.

- firms have taken some steps to reduce derivative risk such as requiring daily margin from counterparties and also requiring higher quality collateral from counterparties

- firms also do more upfront evaluation of potential counterparties and ongoing monitoring of their financial viability over the life of any contracts they may have with the counterparty

- firms expressed concerns that evaluating the true market value of collateral may be too optimistic, especially where non liquid assets are involved (like an airplane for example)

- firms expressed concerns that risk models cannot really fully account for sudden rapid volatility in any assets used for collateral such as real estate, stocks, commodities, etc.

- some of the global regulations that will try to reduce risk and improve management of credit risks are not yet implemented. One in Europe (cited in the report) for example does not become effective until December 2015

- the report mentions that the use of a central clearing exchange for derivatives trading helps reduce risk, but notes that the central clearing exchange itself is vulnerable to risk of failure in the event of a sudden market volatility event, especially with derivatives contracts

Conclusion/Summary:

If you read through the detailed consultative document, you will see that credit risk management is very much still a concern for the BIS. The report notes some improvements since the 2008 financial crisis which are good. However, it is clear that reduction of systemic risk is still very much  a work-in-progress. There are concerns that sudden market volatility could render the risk model a firm uses worthless. For example, if you own a derivative based on the market value of real estate, the risk model used for this derivative cannot anticipate something that causes a rapid plunge in the value of that real estate. A better recent example might be oil. Risk models for loans and derivatives on oil would not have predicted a 50% drop in the price in just a few months. We still don't know what the impact of that may be on the system right now.

On top of all the risks that existing risk models cannot fully account for, there is the "shadow banking" risk that the IMF recently warned about. Here we have unregulated investment activity that we covered earlier in this blog post. These deals and contracts may not even be disclosed to the public anywhere. Let's think about that problem. Say Bank A wants to take on a derivative contract with Bank B. Bank A works hard upfront to assess how viable Bank B is financially. They hope to reduce the risk of Bank B defaulting on the deal. 

But what if Bank B has some high risk, unregulated, and undisclosed investments? How can Bank A possibly account for that risk? They can't. Neither can regulators or the IMF or the BIS.

These kinds of problems still exist all throughout the current system which is why the BIS and the IMF are concerned. They are trying to implement regulatory reforms to reduce some of these risks. But obviously, risks that are not even disclosed are impossible to assess.

If we lived in a world where those who take on these higher risk investments were the only losers if the investments go bad, most of us could ignore this problem. Only those who were directly involved with the bad investment or the bank that made the bad investment would be impacted. Unfortunately, that world no longer exists. Because some of these high risk investments are held by the biggest (too big to fail) banks in the world, the whole system is at risk of failure. 

Country after country is in the process of considering or implementing new banking rules endorsed at the last G20 summit. According to attorney Ellen Brown, the rules could put ordinary bank deposits at risk of a so called "bail-in" if the system were at risk of failure. (added note: a reader pointed out that current legislation still protects insured amounts of bank deposits). The rules are not easy to interpret. We covered that issue more in depth in this earlier blog article. 

This BIS report clearly shows that despite efforts to improve the situation since the 2008 crisis, the problem is still out there. It's just another area we have to understand and be alert to in the coming months and years. The mainstream media does not cover BIS reports like this very much. We do here because we think they are important to understand, even if they are difficult to read for most of us.

Update 2-19-15: A new government report on systemic risk from the biggest banks is out. We cover it here in this blog article.