Capital Adequacy beyond Basel: Banking, Securities, and Insurance PDF
Preview Capital Adequacy beyond Basel: Banking, Securities, and Insurance
Capital Adequacy Beyond Basel CAPITAL ADEQUACY BEYOND BASEL Banking, Securities, and Insurance Edited by Hal S. Scott 1 2005 1 Oxford NewYork Auckland Bangkok BuenosAires CapeTown Chennai DaresSalaam Delhi HongKong Istanbul Karachi Kolkata KualaLumpur Madrid Melbourne MexicoCity Mumbai Nairobi Sa˜oPaulo Shanghai Taipei Tokyo Toronto Copyright #2005byOxford University Press, Inc. PublishedbyOxfordUniversityPress,Inc. 198MadisonAvenue,NewYork,NewYork10016 www.oup.com OxfordisaregisteredtrademarkofOxfordUniversityPress Allrightsreserved.Nopartofthispublicationmaybereproduced, storedinaretrievalsystem,ortransmitted,inanyformorbyanymeans, electronic,mechanical,photocopying,recording,orotherwise, withoutthepriorpermissionofOxfordUniversityPress. LibraryofCongressCataloging-in-PublicationData CapitaladequacybeyondBasel:banking,securities,andinsurance/ editedbyHalS.Scott. p. cm. Includesbibliographicalreferencesandindex. ISBN-13978-0-19-516971-3 ISBN0-19-516971-9 1.Bankreserves—Governmentpolicy. 2.Insurance—Reserves—Governmentpolicy. 3.Banksandbanking—Statesupervision. 4.Financialinstitutions—Statesupervision. 5.Bankloans. I.Scott,HalS. HG1656.A3C278 2005 332.1006801—dc22 2004004468 1 3 5 7 9 8 6 4 2 PrintedintheUnitedStatesofAmerica onacid-freepaper Contents Contributors ix Introduction 3 1 Capital Regulation for Position Risk in Banks, Securities Firms, and Insurance Companies 15 Richard Herring and Til Schuermann 2 Capital Adequacy in Insurance and Reinsurance 87 Scott E. Harrington 3 Consolidated Capital Regulation for Financial Conglomerates 123 Howell E. Jackson 4 Using a Mandatory Subordinated Debt Issuance Requirement to Set Regulatory Capital Requirements for Bank Credit Risks 146 Paul Kupiec 5 No Pain, No Gain? Effecting Market Discipline via ‘‘Reverse Convertible Debentures’’ 171 Mark J. Flannery 6 The Use of Internal Models: Comparison of the New Basel Credit Proposals with Available Internal Models for Credit Risk 197 Michel Crouhy, Dan Galai, and Robert Mark 7 Sizing Operational Risk and the Effect of Insurance: Implications for the Basel II Capital Accord 258 Andrew P. Kuritzkes and Hal S. Scott 8 Enforcement of Risk-Based Capital Rules 284 Philip A. Wellons Index 331 Contributors MichelCrouhyispartneratBlackDiamondConsultingandformerlySenior Vice President, Business Analytic Solutions, Treasury Balance Sheet and Risk Management Division at CIBC (Canadian Imperial Bank of Com- merce). His responsibilities included the approval of all pricing, balance sheet,risk,andcapital-relatedmodels,thedevelopmentofriskmeasurement methodologies and models for market, credit (corporate and retail), and economic capital attribution, as well as customer behavior analytics. PriortohiscurrentpositionatCIBC,MichelCrouhywasaProfessorof Finance at the HEC School of Management in Paris, where he was also Director of the M.S. HEC in International Finance. He has been a visiting professor at the Wharton School and at UCLA. Dr. Crouhy holds a Ph.D. from the Wharton School and is Doctoris Honoris Causa from the Uni- versity of Montreal. He is coauthor of Risk Management and has published extensively in academic journals in the areas of banking, options, and financial markets. He is also associate editor of the Journal of Derivatives, the Journal of Banking and Finance, and is on the editorial board of the Journal of Risk. Mark J. Flannery is the BankAmerica Eminent Scholar in Finance at the Warrington College of Business, University of Florida. Professor Flannery teachescorporatefinanceandfinancialmanagementoffinancialinstitutions in the graduate program. He has consulted with various federal banking agencies and the two housing GSEs. His published work deals primarily with the management and regulation of financial institutions, but it also includes work on asset pricing and corporate finance. Flannery’s current x Contributors research focuses on the information content of security prices. He is an Editor of the Journal of Money, Credit and Banking, and the outside Di- rectoroftheFDIC’sCenterforFinancialResearch.ProfessorFlanneryhas servedonthefacultyoftheUniversityofPennsylvaniaandtheUniversityof North Carolina, and as a visiting professor at the London Business School and the University of New South Wales. Dan Galai is the Abe Gray Professor of Finance and Business Adminis- tration at the Hebrew University School of Business Administration in Jerusalem. He was a visiting professor of finance at INSEAD and at the UniversityofCalifornia,LosAngeles,andhasalsotaughtattheUniversity of Chicago and at the University of California, Berkeley. Dr. Galai holds a Ph.D. from the University of Chicago and undergraduate and graduate degrees from the Hebrew University. He has served as a consultant for the Chicago Board of Options Exchange and the American Stock Exchange as well as for major banks. He has published numerous articles in leading business and finance journals, on options, risk management, financial markets and institutions, and corporate finance. He is a coauthor of Risk Management. He was a winner of the first annual Pomeranze Prize for excellence in options research presented by the CBOE. Dr. Galai is a principal in Sigma P.C.M., which is engaged in portfolio management and corporate finance. Scott E. Harrington is the W. Frank Hipp Professor of Insurance and Pro- fessorofFinanceintheMooreSchoolofBusinessattheUniversityofSouth Carolina. During 1978–1988, he was on the faculty of the Wharton School attheUniversityofPennsylvania.AformerPresidentofboththeAmerican Risk and Insurance Association and the Risk Theory Society, he has pub- lished articles in numerous academic and policy journals, including the Journal of Business, the Journal of Law and Economics, the Review of Eco- nomicsandStatistics,theJournalofRiskandInsurance,theJournalofBank- ingandFinance,theJournalofFinancialIntermediation,theJournal ofRisk and Uncertainty, the Journal of Insurance Regulation, and Science. He has contributedarticlestobookspublishedbytheAmericanEnterpriseInstitute, theBrookingsInstitution,theFederalReserveBankofBoston,theFederal ReserveBankofChicago,OxfordUniversityPress,W.W.Norton,andother publishers. He is coauthor or coeditor of numerous scholarly books, in- cluding Cycles and Crises in Property/Casualty Insurance and Rate Regula- tionofWorkers’CompensationInsurance:HowPriceControlsIncreaseCosts, and coauthor of the textbook Risk Management and Insurance. Dr. Har- ringtoncurrentlyservesontheShadowFinancialRegulatoryCommittee.He isanAssociateEditoroftheJournalofRiskandInsuranceandamemberof theeditorial advisory board for Regulation magazine. RichardHerringisJacobSafraProfessorofInternationalBanking,Director of The Lauder Institute of Management & International Studies, and Contributors xi Co-Director of the Wharton Financial Institutions Center. He served as Undergraduate Dean of the Wharton School from 1995–2000. Dr. Herring is an expert on financial institutions and international fi- nance. He has advised numerous U.S. government agencies as well as sev- eral multilaterallendinginstitutions andinternationalfinancial institutions. He is cochair of the Shadow Financial Regulatory Committee and the Bi- ennial Multinational Banking Seminar, and has been a fellow of the World EconomicForuminDavos,Switzerland.Dr.Herringistheauthorofmore than 80 articles and books. He serves on the editorial boards of several leading journals and is coeditor of The Brookings-Wharton Papers on Fi- nancial Services. His current research interests include financial conglom- erates, liquidity and financial regulation. Before coming to Wharton in 1972, Dr. Herring taught at Princeton University. He received his AB from Oberlin College (1968) and his MA (1970) and Ph.D. (1973) from Princeton University. Howell E. Jackson is Associate Dean for Research and the Finn M.W. Caspersen and Household International Professor at Harvard Law School, where he teaches courses on the regulation of financial institutions, secu- rities regulation, pensionlaw, internationalfinance, andanalytical methods forlawyers.Hisresearchcurrentlydealswiththeregulationofinternational securities market, reform of the social security system, problems in con- sumer finance, and comparative cost-benefit analyses of financial reg- ulation. He is coauthor of the Regulation of Financial Institutions and Analytical Methods for Lawyers and author of numerous scholarly articles. Professor Jackson has served as a consultant to the U.S. Treasury De- partment in connection with the Gramm-Leach-Bliley Act and also as an adviser to the United Nations Development Programme, the World Bank/ International Monetary Fund, and the Harvard Institute for International Development in connection with various projects involving the reform of financial systems in other countries. Prior to joining the Harvard Law School faculty in 1989, Professor Jackson served as a law clerk to U.S. Supreme Court Justice Thurgood Marshall and practiced law in Washington, D.C. PaulKupiecisAssociateDirectoroftheDivisionofInsuranceandResearch attheFederalDepositInsuranceCorporationinWashington,D.C.Former positionsinclude:DeputyChiefoftheBankingSupervisionandRegulation Division in the Monetary and Exchange Affairs Department of the Inter- nationalMonetaryFund;DirectorintheFinanceDivisionatFreddieMac; Vice-President at J.P. Morgan’s RiskMetrics group, and Senior Economist in Trading Risk Analysis and Capital Markets sections at the Federal Re- serve Board. He has also served as a visiting Economist at the Bank for International Settlements, an Assistant Professor of Finance at North CarolinaStateUniversity,andasaconsultantonfinancialmarketissuesfor the OECD. xii Contributors Andrew P. Kuritzkes is a Managing Director at Mercer Oliver Wyman. He joinedOliver,Wyman&Companyin1988,wasaManagingDirectorinthe firm’s London office from 1993 to 1997, and served as Vice Chairman of Oliver, Wyman & Company globally from 2000 until the firm’s acquisition by Mercer, Inc. (a division of Marsh & McLennan Companies) in 2003. Mr. Kuritzkes has consulted on a broad range of strategy, risk man- agement,regulatory,andorganizationalissuesforfinancialinstitutionsand regulatorsintheUnitedStates,Canada,theUnitedKingdom,Switzerland, Germany, the Netherlands, Hong Kong, and Singapore. He has worked extensivelywithorganizations,attheBoardandseniorexecutivelevels,ona numberofissuesrelatingtocorporatebankingstrategyandfinanceandrisk management,includingthelinkbetweenriskmeasurementandstrategy,the impact of regulation, active portfolio management, and the evolution of wholesale lending. Mr. Kuritzkes has written and spoken widely on a broad range of risk, financial structuring, and regulatory topics. His articles have appeared in Strategic Finance, Risk, Die Bank, Banking Strategies, Journal of Applied Corporate Finance, Journal of Risk Finance, and the Brookings-Wharton Papers on Financial Services. BeforejoiningOliver, Wyman&Company,Mr.Kuritzkesworkedasan economistandlawyerfortheFederalReserveBankofNewYorkfrom1986 to 1988. Robert M. Mark is the CEO of Black Diamond, which provides corporate governance, risk management consulting, and transaction services. He serves on several boards and is the Chairperson of The Professional Risk Managers’ International Association’s Blue Ribbon Panel. In 1998, he was awardedtheFinancialRiskManageroftheYearbytheGlobalAssociation of Risk Professionals. Priortohiscurrentposition,hewastheSeniorExecutiveVice-President, Chief Risk Officer, and a member of the Management Committee at the Canadian Imperial Bank of Commerce (CIBC). Dr. Mark’s global re- sponsibilitycoveredcredit,market,andoperatingrisksforallofCIBCand its subsidiaries. Prior to CIBC, he was the partner in charge of the Financial Risk Management Consulting practice at Coopers & Lybrand. Prior to his po- sitionatC&L,hewasamanagingdirectorintheAsia,Europe,andCapital MarketsGroupatChemicalBank.BeforehejoinedChemicalBank,hewas aseniorofficeratMarineMidlandBank/HongKongShanghaiBankwhere he headed the technical analysis trading group within the Capital Markets Sector. He earned his Ph.D. from NYU’s Graduate School of Engineering and Science. Subsequently, he received an Advanced Professional Certificate in accounting from NYU’s Stern Graduate School of Business, and is a graduate of Harvard Business School’s Advanced Management Program. He is an Adjunct Professor and coauthor of Risk Management. Contributors xiii TilSchuermanniscurrentlyaSeniorEconomistattheFederalReserveBank ofNewYork’sResearchDepartmentwherehefocusesonriskmeasurement and management in financial institutions and capital markets. He is also a Sloan Research Fellow at the Wharton Financial Institution Center and teachesatColumbiaUniversity.PriortojoiningtheNewYorkFedinMay of2001hespentfiveyearsatthemanagementconsultingfirmOliver,Wyman &Company,wherehewasaDirectorandHeadofResearch.Tilspent1993 to1996atBellLaboratoriesworkingoncombiningtechniquesfromstatistics and artificial intelligence to build models for bad debt prediction as well as developing risk-basedmanagement decision supporttools. Tilhas numerous publications in the area of risk modeling and applied econometrics and has edited Simulation-Based Inference in Econometrics. He received his Ph.D. in economics in 1993 from the University of Pennsylvania. Hal S. Scott is the Nomura Professor of International Financial Systems and the Director of the Program on International Financial Systems at HarvardLawSchool.HeteachescoursesonBankingRegulation,Securities Regulation, International Finance, and the Payment System. He joined the Harvardfacultyin1975afterservingforayearasaclerktoSupremeCourt Justice Byron R. White. Professor Scott served as Reporter to the 3-4-8 Committee of the Permanent Editorial Board of the Uniform Commercial Code from 1978–1983 to revise the law for payment systems. His books include International Finance: Transactions, Policy and Reg- ulation(11thed.)andAsianMoneyMarkets(Oxford1995).Hehasservedas a consultant to financial institutions, foreign governments, and the World Bank and OECD. He is past President of the International Academy of ConsumerandCommercialLawandiscurrentlyamemberoftheBoardof Governors of the American Stock Exchange and a member of the Shadow Financial Regulatory Committee. Philip A. Wellons was Associate Director of the Program on International Financial Systems at Harvard Law School. He joined the Harvard Uni- versityfacultyin1976,teachingfirstatHarvardBusinessSchool,inbusiness strategy and comparative political economy, specializing in global finance. In 1987, he moved to Harvard Law School, where he taught courses about the world debt crisis and international finance. His fields are comparative government policy and financial markets, as wellaslawandfinancialreformindevelopingandtransitioncountries.The work involves research, consulting, and training, in Asia, Europe, North America, and Africa. He coauthored a textbook with Hal S. Scott on in- ternational finance and law, in its tenth edition. He has consulted for gov- ernments, major banks, the OECD, the World Bank, the International Legal Center, various agencies of the United Nations, the USAID, the European Bank for Reconstruction and Development, and the Asian De- velopment Bank. He has testified before Congress. Acknowledgments The opinions shared in this book are those of the authors and not neces- sarily those of the institutions for which they work. The contributors would like to thank Swiss Reinsurance Company, without whose financial support this research project would not have been possible; Jens Drolshammer, for helping to formulate the idea for this pro- ject; Jenepher Moseley, for her amazing editing skills and dedication; Paul DonnellyandKarenCapriaatOxfordUniversityPressforseeingthebook through to production; and from the Program on International Financial Systems, Melissa Greven, our in-house editor, and J Weinstein, who man- aged this project every step of the way.
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