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.. continuing a ramble prompted by the Normal / Levy thread :

This deceptively simple question is at the heart of many modelling issues.

Interpreted at a shallow level, this could be a question about whether the values of some variables are within the range they have moved in historically.

At a deeper level, the question is whether models built on history will continue to be fit for purpose in future application.

Models cover a wide range from the deterministic ones of physics, that embody precise understanding of the mechanisms, through to empirical models that merely claim to capture useful patterns. It could be an interesting thread to fill in this continuum with examples; financial models, and especially econometric models, would be up the “empirical” end. There may be various nomenclatures for this kind of discussion – noting for example the von Mises (/Austrian) link provided earlier where “time invariant” is used as a descriptor of certain models.

So, sure, there is wide confidence that the models of physics will still work the same way in the future, but only qualified confidence in (especially) those models that have anything to do with human behaviour, or other complex systems.

Empirical models tend to depend heavily on the choice of the data that “calibrates” them (enough for another thread on this topic). Also, to the extent that they rely on patterns without understanding the drivers of those patterns, there may come a time when they unexpectedly perform less well – perhaps even catastrophically so – than before.

Footnote: I like Andrew’s comment “models are good tools but bad masters” and another well known one “all models are wrong, but some are useful”. Perhaps this latter one should have an addendum “…some of the time”.

I have been away from the purely banking risk area for a little while, so I had dropped my regular visits to the BIS website. Having headed over there for some stats recently I noticed how much they had beefed up their coverage.

A few interesting things have also appeared.

Deposit Insurance

The CP on deposit insurance that they issued in March has been updated into a full set of recommendations – the paper is here. Regular readers would know my opinion on deposit insurance, but in general the principles in this paper are sound. A worthwhile note is on page one:

The introduction or the reform of a deposit insurance system can be more successful when a country’s banking system is healthy and its institutional environment is sound. In order to be credible, and to avoid distortions that may result in moral hazard, a deposit insurance system needs to be part of a well-constructed financial system safety net, properly designed and well implemented. A financial safety net usually includes prudential regulation and supervision, a lender of last resort and deposit insurance. The distribution of powers and responsibilities between the financial safety-net participants is a matter of public policy choice and individual country circumstances.

Advice to our PM and Treasurer – do not do this in a hurry and in a poorly thought out manner. Nuff said.

Basel II Changes

Pillar I

The latest tweaks to the main Basel framework seem to be trying to do a little stable-door shutting on securitisation – with a fair bit of language added around understanding the risks and a few risk weights being increased.

Pillar II

The language of the amendments to Pillar II is also interesting – this places a large amount of emphasis on improved risk management at the banks, including reporting structures, concentration management and, in particular, the off-balance sheet stuff.

One recommendation in particular is interesting – the separation of the CRO’s office out of the business lines to report directly to the CEO and Board (pillar II amendments – 19).


This one is also good (pillar II, para 40):

A bank should conduct analyses of the underlying risks when investing in the structured products and must not solely rely on the external credit ratings assigned to securitisation exposures by the CRAs [credit ratings agencies]. A bank should be aware that external ratings are a useful starting point for credit analysis, but are no substitute for full and proper understanding of the underlying risk, especially where ratings for certain asset classes have a short history or have been shown to be volatile. Moreover, a bank also should conduct credit analysis of the securitisation exposure at acquisition and on an ongoing basis. It should also have in place the necessary quantitative tools, valuation models and stress tests of sufficient sophistication to reliably assess all relevant risks.

I would agree – but it should not take a regulator to tell a bank this. I wonder who is going to pay for all the extra analysts – or will banks just walk away from this market?
The whole document is worth a close read and I should get around to it soon. From my scan, though, I cannot see it having a significant impact in Australia. APRA was already doing most of this – but the changes to securitisation may cause some heartache amongst those institutions that rely on them, such as many credit unions and other smaller ADIs. I would be looking to the specialist mortgage providers and the bigger banks to benefit from these.


As expected, as well, the BCBS has boosted its look at liquidity – with almost as many mentions in the 41 pages of this as in the 400 of the Accord itself. Given much of the problems (like those at Northern Rock) at least started as liquidity issues this is not surprising. The language looks mostly drawn from the relevant Sound Practices document, but this incorporates it into the Accord itself. Again – not much to see here, as much of this is already in the relevant Australian liquidity regulation, and APRA is well across this.

Stress Testing

Brand new is a whole two pages on stress testing. As I highlighted nearly three years ago in one of the perennial favourite blog posts here – the original accord had little to say on the subject beyond telling you that it had to be done. The two pages here go some of the way to addressing that gap, but not nearly all the way. They are obviously leaving the wording fairly general here and leaving it up to national regulators still.

Pillar III

Much of this is focussed (as can be expected) on improving disclosure around the areas that have caused problems recently. Almost all of the changes to Pillar III are about increasing disclosure of securitisation exposures – with some consequential changes to the CRM stuff. None of this should cause any banks to sweat too much – these sorts of numbers have been demanded of the banks by the regulators for a while. It is just publishing the disclosures rather than sending them to the regulators.

Wrap Up

All of these comments, though, are fairly preliminary. I will need to go through this in a bit more detail and give it some thought. If I have missed anything, feel free to point it out in comments.

Some contributions on the Normal vs Levy thread suggest that wider musings on modelling issues may be fruitful.

By the standards set by one poster as the minimum “to understand financial modelling”, my score looks to be 1/5, so readers need not expect breakthroughs on particular questions in this field.

While not disputing that Levy is likely to be more correct than Normal (in the modelling contexts cited) I wonder how much of the problem with the model can be attributed to this choice.

Doesn’t this issue segue into deeper issues concerning the complex systems that drive the processes whose outputs are finally observed as univariate distributions?

I plan a couple of exploratory posts.

This one was pointed to by financialart. Well worth a look. The full show is an almost hour-long show on a London analyst who gives up the City and heads bush to do some “real world” trading.

Money quote (on entering Sudan) “Stratightaway I can tell I am going to have to adjust to a different way of doing things. I’ve already been ripped off, I’ve been lied to, I’ve been taxed, I’ve been fined – and that’s just getting my passport stamped.

Anyway – enjoy. The other four episodes are on youtube – starting here.

The paper from the IASB on the changes to IAS 39 are both more and less interesting than they first appeared. There are a lot of possible changes in there, but at the moment (and as you would expect) they are heavily hedged with questions and possibilities.

First – a word about the process from here. This part of the draft covers only the classification and measurement of financial instruments – so nothing on impairment or hedging, but perhaps there are some hints on the way they are headed. Comments on the draft are due by September 14 and they seem to be hoping to have a finalised new IFRS on this area only by the end of the year. Ambitious, perhaps, but given the relatively focussed nature of the questions in here, possible.

The other sections of IAS 39 will then be progressively deleted as the relevant sections of it are replaced by the new IFRS. The Board expects to have all this finished, with a shiny brand new IFRS that completely replaces IAS 39 to be mandatorily adopted by January 2012, with early adoption permitted. Given work has been progressing for years on this having a further 2 and a half years to bed down the transition is probably enough.
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I will be going through the exposure draft of the revised IAS 39 (AASB 139 in Australia) and the relevant Basis for Conclusions over the next day or so, but on first impressions it is a distinct improvement on the old, unduly complex, standard. Those who like their accounting updates a little shorter and sweeter, try the Snapshot version.

The cut in the number of categories from four (fair value through income statement, fair value through equity, held to maturity and amortised cost) to two (fair value through income statement and amortised cost) should reduce complexity. The use of the holder’s intent as the basis for accounting for the holding should also be a good step.

As they say, though, the devil is in the detail, so I will read through it. Unlike the old one (at close to 200 pages) this one is only short, at 37 pages plus the BC at 27, so I hope to have a measured response in a day or so.

While I am sure there are many out there that will join in a chorus of condemnation of Goldman Sachs, unless there is something really odd hidden in the numbers, I will not be one of them. Having banks turn decent profits under trading conditions like these is a challenge, one that Goldman’s appear to be meeting.

Having been, in essence, unwillingly forced to take taxpayers funds they were paid back at the earliest opportunity, with interest, and then continued good trading have delivered a great result. They did not join in on the rush into dodgy assets and appear to have been actively trading against the stream on these.

If more banks acted like this we may have a better system overall. That said, if more acted like this then there would be less profits for any individual player. And that would be a good thing.

The difficulty for them now is to manage the political fallout. I am glad I am not going to have to do that. Of course, with average pay per employee of about USD770,000 I would be happy to try…

A piece in the AFR today (page 59 – no link if you are not a subscriber, if you are it is here) is, I think, a little premature. The NAB has for some time been supporting a charitable scheme run by a part of the Roman Catholic Church that is aimed at low income earners, helping them to borrow enough to get things like fridges and washing machines and then pay the money back over time without interest. The recent media release where they announced an expansion to the scheme seems to have been taken as an announcement that the NAB is serious about Islamic finance.

The thing to note about this scheme is that it is not an Islamic finance initiative – it is charitable giving. The NAB should be applauded for that charity (and I would like to see more of it from the other banks) but this cannot be taken, as the piece in the AFR seems to be saying, as a start in the Islamic finance area. It will not give them any experience in Islamic finance. Islamic Finance is a serious business, with profitability still expected from conducting it.

The way the scheme works is that the NAB hands money to the Good Shepherd Youth and Family Service who then lend it out. There is no return to the NAB so this is not a business.

That said, perhaps some good will be done as this gets through the NAB media reporting system. You can guarantee that a piece in the AFR reporting a possible new business initiative will have been seen by some very senior people in the NAB.

If it does get anywhere perhaps they will consider it. OTOH, one of the other banks may decide to take up the baton and give this a try. In the mean time, if you are looking to get this underway in Australia, there is already a mechanism in Australian law that would allow the Muslim community here to do it for themselves – the religious charitable fund, as I suggested nearly 3 years ago. If you (the Muslim community) want to do it I would be happy to be what help I can.

If NAB or one of the others want to do it, I would also be happy to help. Contact details are on the “Authors” page.

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