While the nation was embroiled in the Spitzer scandal, a fire sale was in the works. JPMorgan Chase bought Bear Stearns for bupkas – $2 a share, to be exact – the latter having been hit big time by the sub-prime debacle and credit crunch. The Federal Reserve provided special financing for the deal, and cut the discount rate – on a Sunday, no less – to avoid an even larger systemic fall out. 

Credit crisis observers warn that the statistical models banks use to comply with Basel II underestimate risk exposure. The models leverage about five years of a bank’s internal loss history and use Monte Carlo simulation techniques to measure the probability of future losses over a one-year time horizon to a 99.9% confidence level.  The problem is the loss history may not be broken down into sufficient detail, making it difficult to analyse where the losses came from.

Key risk assessments are not necessarily forward looking. Banks can use their loss history to validate some of their assumptions, but a key risk may be something that has not happened in the last five years. That means the model can give the bank a fall sense of security. Moreover, Basel II advises banks to use external loss data to better predict their outlook, but that can be a bit like comparing apples with oranges. Not all banks are alike; they have different processes, technology and internal control frameworks, which could affect the probability of loss.

There have been calls for the regulators to review the Basel II rules allowing banks to use their own internal models for calculating regulatory capital. Admittedly, it’s like closing the paddock after the horse has bolted, but it is justified if future disasters can be avoided.

Filed under: Credit Crunch, risk