Understanding Basel III: June, July, August 2013

Did you know that "Economics is a highly sophisticated field of thought that is superb at explaining to policymakers precisely why the choices they made in the past were wrong.

About the future, not so much."

Who said that?

Chairman Ben S. Bernanke, at the Baccalaureate Ceremony at Princeton University.

The title of his speech: The Ten Suggestions

His speech is interesting. We can even find more about meritocracy:

"A meritocracy is a system in which the people who are the luckiest in their health and genetic endowment; luckiest in terms of family support, encouragement, and, probably, income; luckiest in their educational and career opportunities; and luckiest in so many other ways difficult to enumerate—these are the folks who reap the largest rewards.

The only way for even a putative meritocracy to hope to pass ethical muster, to be considered fair, is if those who are the luckiest in all of those respects also have the greatest responsibility to work hard, to contribute to the betterment of the world, and to share their luck with others."

Well, I will spend the weekend thinking about it, especially the methodology, how they will "share their luck with others".

As a consultant, I must develop a step by step luck-sharing methodology (well, I think it is better to make it "principles-based" instead of "rules-based").

I already have some ideas. The process will have 3 Pillars.

Pillar 1: Luck Quantification.
Pillar 2: Internal Luck Adequacy Assessment Process, and luck stress-testing.
Pillar 3: Luck Transparency.

It looks a bit like Basel iii ... I know ...

According to the "if all you have is a hammer, everything looks like a nail" principle, we can use a Basel iii approach almost everywhere.

We will use a Monte Carlo simulation to quantify the "luckiest in so many other ways difficult to enumerate" part, as Mr. Bernanke said.
We will generate luck scenarios, we will find a probability weigted luck average, and we will calculate the LVaR ( Luck Value at Risk).

Almost done.

The following morning, I received an email.

Title: "Forecasting is the art of saying what will happen, and then explaining why it didn't "

Message: I hate you. Our boss is following your stress testing recommendations. Lao Tzu has said that those who have knowledge don't predict. Those who predict, don't have knowledge.

Signature: Terminator

Terminator?
Arnold Schwarzenegger, did you send this email?

I replied!

"Dear Arnold (or other Terminator),
It is not me! It is Basel iii that asks for a forward-looking perspective! Basel iii requires stress testing. And, we have a crystal ball in risk management: The recommendations of the Financial Stability Board (FSB)."

The recommendations...

Who reads these recommendations? So important ... I have led some classes since January, nobody reads FSB.

They laugh when I say read FSB every morning, before reading FT or WSJ!

It is time to read the recommendations of the FSB carefully. It is about the board, senior management, risk officers, compliance officers, internal and external auditors.

Another interesting development...

I have reasons to love and reasons to hate internal models.

I love them, because I started my career as a mathematician, and mathematicians usually love models, not people.

(After that, I studied risk management, and later I continued with international law, so I am more social now. Way more social).

I hate them only when I have to explain to the board of directors what their model does, and how it works.

Board members are like kids, so I start with "not advanced" (high school) mathematics.

We have similar models in both, Basel iii (3 pillars in banking) and Solvency ii (3 pillars in insurance).

This is the phrase that ruined my day:

"The estimation noise can be significant"

To make things worse, this is a phrase from Mr. Jaime Caruana, General Manager of the Bank for International Settlements.

(2013 International Monetary Conference, Shanghai ...