Chapter 39

Managing Institutional Default Risk and Safety and Soundness

In 2003, the Basel Committee on Banking Supervision proposed the New Capital Accords as a way to insure the safety and soundness of financial institutions around the world. Since then, such a volume of documents has poured forth from the Basel Committee that few risk managers known to the authors admit to having read every page of even one Basel Committee document. Insiders at the Bank for International Settlements (BIS) have revealed an indirect confirmation of why the Basel II and III regulations have evoked such a yawn from real risk managers: inside the BIS, as of this writing, there is not a single piece of evidence that the Basel ratios (in any variation) are statistically significant in predicting financial institution failure. For that reason, we focus on methods for controlling default risk in this chapter in which both the statistical evidence and economic logic are strongly supportive of the risk “levers” we discuss.

In Chapters 36 through 38, we showed how modern risk management technology allows a much different approach to ensuring the safety and soundness of financial institutions. In this chapter, we discuss the implications of a more modern approach to risk management for the safety and soundness of a given institution from both a shareholder value perspective and from a regulatory perspective.

STEP 1: ADMITTING THE POSSIBILITY OF FAILURE

Step 1 in using a more modern approach to risk management ...

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