## Risk Management and Regulation

## Source details

**Canonical URL:** [Risk Management and Regulation](https://www.imf.org/-/media/files/publications/dp/2018/45664-dp1813-risk-management-and-regulation.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/dp/2018/45664-dp1813-risk-management-and-regulation.pdf.md)
- [Structured JSON version](/-/media/files/publications/dp/2018/45664-dp1813-risk-management-and-regulation.pdf.json)

---

### Acknowledgments and scope
- Prepared for the 20th anniversary volume of the Journal of Risk.
- Author thanks Ken Garbade and Til Schuermann for comments and Pierpaolo Grippa, Nigel Jenkinson, John Kiff, and Aditya Narain for drafting help.
- Views expressed are those of the author and do not necessarily represent the views of the International Monetary Fund, its Executive Directors, or its management.

### Abstract — evolution and regulatory response
- Evolution driven by interplay among financial crises, risk management practices, and regulatory actions.
- Key historical milestones:
  - 1970s: intellectual foundations from option-pricing breakthroughs (Black and Scholes 1973; Merton 1973).
  - 1980s: systematic implementation as bond trading grew and quants developed dynamic hedging, value-at-risk (VaR), and credit risk models.
  - 1988: Basel I required internationally active banks to maintain capital of at least 8 percent of risk-weighted assets.
  - 1996: Market Risk Amendment to Basel I (effective 1998) introduced market-risk capital rules and allowed banks to use internal VaR models for capital calculation.
  - Basel II expanded risk coverage and allowed internal models for credit risk, but was criticized as procyclical.
- Post-2008 crisis regulatory innovations dominating risk management: capital and liquidity stress testing, macroprudential surcharges, resolution regimes, and countercyclical capital requirements.

### Foundations of modern risk management — drivers and techniques
- Drivers:
  - Collapse of Bretton Woods (1971), 1973 oil shock, stagflation, and monetary tightening in late 1970s–early 1980s increased volatility and demand for risk management.
  - Technological advances enabled fast computation and real-time trading.
- Intellectual foundations and models:
  - Option pricing (Black & Scholes; Merton) underpin hedging strategies and extraction of implied distributions.
  - Term-structure and interest-rate derivative models: Cox, Ingersoll, and Ross 1985; Hull and White 1994a, 1994b; Black, Derman, and Toy 1990; Heath, Jarrow, and Morton 1992; Brace, Gatarek, and Musiela 1997.
  - Merton (1974) interpretation of debt as an option and Vašíček (1987) loan-portfolio model enabled credit-risk measurement and underpinned IRB formulas in Basel II.

### Rise of bond trading, quants, and risk-management products
- Market developments and product proliferation:
  - Chicago Board Options Exchange opened April 1973: call option contracts traded rose from 911 on day one to 20,000 by mid-1974 and 100,000 in 1975.
  - OTC derivatives and securitization markets expanded sharply.
  - Securitization timeline: Ginnie Mae pass-through RMBS (1970s), private-label RMBS (1977), collateralized mortgage obligations (1983), ABS (mid-1980s).
- Industry adoption of quantitative systems:
  - 1980s: VaR-based systems introduced by Bankers Trust, Chase Manhattan, Citibank.
  - 1994: JP Morgan launched RiskMetrics; 1997: CreditMetrics.
  - VaR embedded in internal and regulatory risk metrics; Vašíček-derived portfolio models informed Basel II IRB formulas.
- Regulatory arbitrage and structured products:
  - Basel I incentives encouraged securitization of low-risk loans and growth of CDOs and SIVs.
  - Copula-based default correlation modeling (Li 2000) facilitated explosive growth in CDO tranches but underestimated correlation increases during stress and fat tails.

### Real-world model failures and limitations
- Common shortcomings:
  - Overreliance on short-horizon volatility and continuous-trading assumptions in VaR; illiquidity undermines dynamic hedging.
  - Stressed VaR effectiveness depends critically on severity of assumed stress scenarios; historical stress windows often understated later crises.
- Notable failures:
  - LTCM (1998): misparameterized VaR inputs (low-volatility historical data, normal-return assumptions), underestimated liquidity risk.
  - AIG (pre-2005 onwards): sold massive RMBS default protection without posting collateral while rated AAA; downgrades triggered collateral calls and liquidity stress.
- Rating and model risk evidence:
  - Over three-quarters of private-label US RMBS issued 2005–2007 originally rated AAA were rated below BBB- by 2010.
  - Misestimated default correlations and flawed structured-product rating methodologies produced severe underestimation of senior-tranche risks.

### Hardwiring risk management into capital rules — trade-offs and procyclicality
- Market Risk Amendment (1996) permitted internal VaR models to feed capital requirements subject to multiplier and vetting.
- Trade-offs:
  - Cross-sectional benefit: better risk sensitivity and alignment with banks’ internal measures.
  - Time-dimension cost: procyclicality — capital requirements fall in low volatility booms and rise when volatility spikes, potentially amplifying downturns.
- Basel II credit-risk modeling (IRB):
  - Allowed banks to use internal ratings and estimates of probability of default and LGD; formulas embedded within regulation (Vašíček-based).
  - Mitigations attempted: through-the-cycle ratings and downturn LGD requirements, but enforcement and alignment with bank practices were limited.
  - Only post-crisis measures (forward-looking stress testing and a leverage ratio in Basel III) directly address procyclicality.
- Role of external ratings and accounting tensions:
  - External ratings central to standardized approaches and securitization risk weights; raised concerns about overreliance on rating agencies with conflicts of interest.
  - Basel II largely accepted local accounting rules; divergence between accounting objectives and supervisory objectives created conflicts, later addressed only after crisis through accounting reforms.

### The Crisis of 2008 — systemic drivers and mechanics
- Market size and growth statistics:
  - BIS: outstanding value of interest rate swaps and other derivatives reached almost $600 trillion by end-2007, about 11 times annual global GDP; 10 years earlier value was about $75 trillion (2½ times global GDP).
  - CDS market by end-2007: more than five times the outstanding principal of global corporate bonds (three years earlier: about 85 percent of corporate bond market).
  - Global ABS issuance: $1,460 billion in first half of 2007, up from $425 billion nine years before.
  - CDO market expanded from $75 billion in first half of 2005 to $200 billion in first half of 2007.
- Originate-to-distribute model effects:
  - Securitization transferred credit risk to capital markets but often re-concentrated risk via performance guarantees and vendor-sponsored funding structures.
  - Example: capital requirement on senior tranche of a typical subprime MBS could be less than 1 percent of nominal value; under Basel II standardized approach top-rated securitization tranche risk weight = 20 percent versus 35 percent or higher on underlying mortgage loans; under IRB risk weight could be as low as 7 percent, leading to a capital charge as low as 0.56 percent.
- Intermediation chain lengthening and funding fragility:
  - Securitization, SPEs, ABCP conduits, CDOs, and SIVs lengthened intermediation chains and increased interconnectedness.
  - Short-term funding reliance (ABCP, repo, MMMFs) created rollover and run vulnerabilities; repo capacity depended on collateral values and haircut levels.
  - Opacity and data gaps impeded supervisory assessment; OTC derivative trade reporting was voluntary and incomplete.
- Trigger and escalation:
  - US housing price flattening and collapse in mortgage securitization market led to rising delinquencies and defaults.
  - August 9, 2007: BNP Paribas suspended redemptions in three mutual funds, signaling freeze and triggering ABCP rollovers collapse.
  - Mark-to-market valuation conventions and lack of pricing led to forced asset sales, higher volatility, larger haircuts, and funding strains.
- Systemic failures and notable institutions:
  - Bank failures/near-failures: Northern Rock (UK), Bear Stearns (US), Lehman Brothers (US).
  - AIG: ultimate losses included $30 billion from selling credit protection on CDOs and $21 billion from securities-lending/repo activities tied to CDOs and RMBS.

### Post-crisis regulatory reform agenda — objectives and elements
- Overarching aim: build a more robust and resilient global financial system to support the real economy in stress.
- Global coordination led by: Financial Stability Board, BCBS, IAIS, IOSCO, CPMI.
- Reform program grouped into four main elements (document cuts off before listing them in full).

### 1. Measures to strengthen the system-wide focus of financial policymaking
- System-wide focus and supervisory implications:
  - Major lesson: focus on the financial sector as a system, recognizing collective behavior and close interconnections and interactions across the financial network.
  - Policy implication: complement strong supervision of individual banks with system-wide risk assessment and regulation to contain system-wide risk and limit externalities and spillovers.
- Containment of risk buildup:
  - Countercyclical buffer introduced by the Basel Committee: supervisory authorities require banks to hold additional capital at times of excessive credit growth that can be released in a subsequent downswing.
  - Other tools: loan-to-value and debt-to-income constraints in real estate markets; risk weighting in corporate lending.
  - Capital conservation buffer that can be run down during times of stress.
  - Forward-looking stress tests condition on severe stress scenarios many months into the future; IMF pioneered these starting with the first Financial Sector Assessment Program in 2000.
- Cross-sectional tools and measures:
  - New analytical tools to assess institution contribution to systemic risk (for example, CoVaR).
  - Regulatory measures: systemic capital surcharges for global and domestic systemically important banks; more intrusive supervision; tougher large exposure rules; measures to mitigate spillovers between banking and shadow banking sectors.
  - Measures to address misaligned incentives:
    - FSB compensation principles (2009a, 2009b): require compensation packages for principal risk takers to contain a high, variable component that is deferred and remains at risk depending on realized performance.
    - New securitization guidelines (IOSCO 2012): require originator to retain a proportion of the risk.
    - Steps to reduce mechanistic reliance on rating agencies (FSB 2012).

### 3. Policies to improve the resilience of the financial system in the event of stress
- Core reforms:
  - Basel III: raise the quality and quantity of bank capital and provide a stronger, more resilient sector in stress (BCBS 2011).
  - Leverage ratio as a backstop to counteract procyclicality of risk-based capital requirements.
  - Work ongoing to address excessive variability of risk weights.
  - New international standards for liquidity risk; enhanced approaches for market risk and operational risk.
  - Requirement for a higher proportion of loss-absorbing common equity compared with Basel II.
- Stress testing and market infrastructures:
  - Enhanced supervisory reliance on stress tests to assess capital and liquidity plans; stress tests identify vulnerabilities and support remedial plans.
  - Stress-testing techniques improved via better models and data; extended to sectoral contributions to systemic risk, nonbank resilience, and financial network robustness.
  - Supervisory trend: stress tests sometimes becoming an effective constraint on regulatory capital; movement to transform stress test outcomes into capital surcharges in several countries.
  - Policies to support central clearing of standardized derivative contracts through central counterparties (CCPs) to lower bilateral counterparty credit risk.
  - Ongoing work to support robustness, recovery, and resolution of CCPs to ensure continued market functioning.
- Shadow banking:
  - Objective to “transform shadow banking into resilient market-based finance” (FSB 2015).
  - Progress: strengthening money market funds, improving securitization markets, lowering interconnectedness between banking and nonbank sectors, improving securities financing markets.
  - Ongoing work: address liquidity and leverage risks in asset management; continuous monitoring of nonbank sector and adaptation beyond the regulatory frontier.

### 4. Reforms to contain moral hazard and lower the costs of handling failure
- Containing moral hazard and managing failure:
  - Regulatory objective: eliminate need for taxpayer support because firms are seen as too big, too complex, or too interconnected to fail.
  - Crisis management reforms:
    - Introduction/enhancement of special resolution regimes in line with FSB Key Attributes (2011, updated in 2014).
    - Toughened regulation for institutions perceived as too big to fail: capital surcharges, more intensive supervision.
    - Major financial institutions required to prepare recovery and resolution plans (“living wills”) subject to supervisory scrutiny.
    - Requirements for globally systemically important banks to hold “total loss absorbent capacity” instruments that can be written down or converted into equity under stress to sustain critical functions without taxpayer support.
    - Parallel work on recovery and resolution of central counterparties.

### Implementation, evaluation, and changes in regulatory approach
- Reform status and evaluation:
  - Major program of regulatory reform is nearing completion and has strengthened the financial system.
  - Evidence suggests a well-capitalized banking system supports sustainable credit growth (Cohen and Scatigna 2014).
  - Authorities should evaluate impacts of large regulatory changes and amend policies if major adverse unintended consequences emerge.
- Rethinking complexity, simplicity, and internal models:
  - Crisis exposed limitations of sophisticated quantitative techniques and excessive reliance on banks’ internal models.
  - Basel Committee’s effort to simplify regulatory framework: balance simplicity, risk sensitivity, and comparability; simplicity now viewed as desirable and linked to proportionality for non-systemic firms.
  - Trans-Atlantic discord over proposed floor based on supervisory parameters to limit capital relief from internal models and reduce variability of risk-weighted assets; variability partly due to national differences and evidence of active gaming of internal models (Plosser and Santos 2014).
  - Some complex approaches revised or abandoned: regulatory approval for the Advanced Measurement Approaches to Operational Risk on verge of withdrawal; market risk approach overhauled (stressed VaR, Fundamental Review of the Trading Book replacing VaR with expected shortfall).
- Supervisory trends:
  - Erosion of supervisory faith in banks’ internal models for regulatory purposes, even as diversity in approaches can counter herding.
  - Stress testing has become central: combination of bottom-up and top-down, detailed bank and trading-book information.
  - Streamlining stress tests by converting outcomes into capital surcharges is being implemented in several countries.

### Persistent and emerging challenges
- Sovereign exposures:
  - Treatment of sovereign exposures remains an area where regulation often treats sovereigns as risk free, skewing bank behavior and potentially putting capital at risk.
  - Work on sovereign exposure treatment gained ground after peripheral European sovereign debt losses but has gone on the back burner.
- Preparing for future threats and technological change:
  - Debate: regulators criticized for “fighting the last war” vs. view that fixing past flaws is critical to assure system soundness and allow sufficient implementation time.
  - Rise of FinTech may redraw regulatory boundaries; benefits include efficiency and innovation, risks include failures, scams, and financial crime.
  - RegTech and SupTech can support risk management, compliance, monitoring, identity management, and data analysis using AI, machine learning, and big data analytics.
- Operational, automated trading, and cyber risks:
  - Automated trading can cause large losses and market-wide disruptions (examples: Knight Capital loss of several hundred million dollars within minutes; March 2010 equity flash crash; October 2014 Treasury flash rally).
  - Cyber-risk event with systemic impact is a major threat: could affect market infrastructures (clearing, payment, settlement), cause liquidity freezes, and undermine trust in financial channels.
  - Challenges: macro-consequences poorly understood; data collection and sharing hampered by privacy and reputation concerns; cross-border cooperation complicated by national security suspicions.
  - Responses: banks incorporate cyber and operational risks into stress-testing scenarios as single-factor sensitivity shocks; supervisors simulate cyberattacks in supervisory frameworks.
  - Estimating buffers for cyber-risk losses remains a work in progress due to paucity of event data and rapid technology evolution.
- Research and analytics:
  - Rapid technological progress generates new threats (cyber risks, high-frequency trading, FinTech) that are not yet quantifiable in a meaningful manner.
  - Ample room for researchers to contribute to the nexus of risk management and regulation in a world of radically reshaped financial technologies.

*Risk Management and Regulation (selected chapters and bibliography), IMF PDF content unit.*

### Bibliography �����������������������������������������������������������������������������������������������������������

### Risk Management and Regulation

### Acknowledgments and scope
- Prepared for the 20th anniversary volume of the Journal of Risk.
- Author thanks Ken Garbade and Til Schuermann for comments and Pierpaolo Grippa, Nigel Jenkinson, John Kiff, and Aditya Narain for drafting help.
- Views expressed are those of the author and do not necessarily represent the views of the International Monetary Fund, its Executive Directors, or its management.

### Abstract — evolution and regulatory response
- The evolution of risk management resulted from interplay among financial crises, risk management practices, and regulatory actions.
- Key historical milestones:
  - 1970s: intellectual foundations from option-pricing breakthroughs (Black and Scholes 1973; Merton 1973).
  - 1980s: systematic implementation as bond trading grew and quants developed dynamic hedging, value-at-risk (VaR), and credit risk models.
  - 1988: Basel I created a level playing field; required internationally active banks to maintain capital of at least 8 percent of risk-weighted assets.
  - 1996: Market Risk Amendment to Basel I (effective 1998) introduced market-risk capital rules and allowed banks to use internal VaR models for capital calculation.
  - Basel II expanded risk coverage and allowed internal models for credit risk, but was criticized as procyclical.
- Post-2008 crisis regulatory innovations dominated risk management: capital and liquidity stress testing, macroprudential surcharges, resolution regimes, and countercyclical capital requirements.

### Foundations of modern risk management — drivers and techniques
- Drivers:
  - Collapse of Bretton Woods (1971), 1973 oil shock, stagflation, and monetary tightening in late 1970s–early 1980s increased volatility and demand for risk management.
  - Technological advances enabled fast computation and real-time trading.
- Intellectual foundations and models:
  - Option pricing (Black & Scholes; Merton) underpin hedging strategies and extraction of implied distributions.
  - Interest-rate derivative modeling required term-structure models (Cox, Ingersoll, and Ross 1985; Hull and White 1994a, 1994b; Black, Derman, and Toy 1990; Heath, Jarrow, and Morton 1992; Brace, Gatarek, and Musiela 1997).
  - Merton (1974) interpretation of debt as an option and Vašíček (1987) loan-portfolio model enabled credit-risk measurement and underpinned IRB formulas in Basel II.

### Rise of bond trading, quants, and risk-management products
- Market developments:
  - Chicago Board Options Exchange opened April 1973: call option contracts traded rose from 911 on day one to 20,000 by mid-1974 and 100,000 in 1975.
  - OTC derivatives and securitization markets expanded sharply.
- Quantitative systems and industry adoption:
  - 1980s: VaR-based systems introduced by Bankers Trust, Chase Manhattan, Citibank.
  - 1994: JP Morgan launched RiskMetrics; 1997: CreditMetrics.
  - VaR became embedded in internal and regulatory risk metrics; Vašíček-derived portfolio models informed Basel II IRB formulas.
- Product proliferation and securitization:
  - Securitization timeline highlights: Ginnie Mae pass-through RMBS (1970s), private-label RMBS (1977), collateralized mortgage obligations (1983), ABS (mid-1980s).
  - Regulatory arbitrage under Basel I incentivized securitization of low-risk loans and created incentives for CDOs and SIVs.
  - Copula-based default correlation modeling (Li 2000) facilitated explosive growth in CDO tranches but underestimated correlation increases during stress and fat tails.

### Real-world model failures and limitations
- Common model shortcomings observed in crises:
  - Overreliance on short-horizon volatility and continuous-trading assumptions in VaR; illiquidity undermines dynamic hedging.
  - Stressed VaR effectiveness depends critically on severity of assumed stress scenarios; historical stress windows often understated later crises.
  - LTCM (1998): misparameterized VaR inputs (low-volatility historical data, normal-return assumptions), underestimated liquidity risk.
  - AIG (pre-2005 onwards): sold massive RMBS default protection without posting collateral while rated AAA; downgrades triggered collateral calls and liquidity stress.
- Rating and model risk:
  - Figure 3.3 evidence: over three-quarters of private-label US RMBS issued 2005–2007 originally rated AAA were rated below BBB- by 2010.
  - Misestimated default correlations and flawed structured-product rating methodologies produced severe underestimation of senior-tranche risks.

### Hardwiring risk management into capital rules — trade-offs and procyclicality
- Market Risk Amendment (1996) allowed internal VaR models to feed capital requirements (subject to multiplier and vetting).
- Trade-off identified:
  - Cross-sectional benefit: better risk sensitivity and alignment with banks’ internal measures.
  - Time-dimension cost: procyclicality — capital requirements fall in low volatility booms and rise when volatility spikes, potentially amplifying downturns.
- Credit-risk modeling under Basel II:
  - IRB approach allowed banks to use internal ratings and estimates of probability of default and LGD; formulas embedded within regulation (Vašíček-based).
  - Attempted mitigation: through-the-cycle ratings and downturn LGD requirements, but enforcement and alignment with bank practices were limited.
  - Only post-crisis measures (forward-looking stress testing and a leverage ratio in Basel III) directly address procyclicality.
- Role of external ratings:
  - External ratings became central to standardized approaches and securitization risk weights, raising concerns about overreliance on rating agencies with conflicts of interest.
- Accounting and prudential tensions:
  - Basel II largely accepted local accounting rules; divergence between accounting objectives (objectivity, comparability) and supervisory objectives (prudence over credit cycle) created conflicts, later addressed only after crisis through accounting reforms.

### The Crisis of 2008 — systemic drivers and mechanics
- Macro and market statistics:
  - BIS: outstanding value of interest rate swaps and other derivatives reached almost $600 trillion by end-2007, about 11 times annual global GDP; 10 years earlier value was about $75 trillion (2½ times global GDP).
  - CDS market by end-2007: more than five times the outstanding principal of global corporate bonds (three years earlier: about 85 percent of corporate bond market).
  - Global ABS issuance: $1,460 billion in first half of 2007, up from $425 billion nine years before.
  - CDO market expanded from $75 billion in first half of 2005 to $200 billion in first half of 2007.
- Originate-to-distribute model effects:
  - Securitization transferred credit risk to capital markets but often re-concentrated risk via performance guarantees and vendor-sponsored funding structures.
  - Example: capital requirement on senior tranche of a typical subprime MBS could be less than 1 percent of nominal value; under Basel II standardized approach top-rated securitization tranche risk weight = 20 percent versus 35 percent or higher on underlying mortgage loans; under IRB risk weight could be as low as 7 percent, leading to a capital charge as low as 0.56 percent.
- Intermediation chain lengthening and funding fragility:
  - Securitization, SPEs, ABCP conduits, CDOs, and SIVs lengthened intermediation chains and increased interconnectedness (Figure 5.1).
  - Short-term funding reliance (ABCP, repo, MMMFs) created rollover and run vulnerabilities; repo capacity depended on collateral values and haircut levels.
  - Opacity and data gaps impeded supervisory assessment of exposures and contagion pathways; OTC derivative trade reporting was voluntary and incomplete.
- Trigger and escalation:
  - US housing price flattening and collapse in mortgage securitization market led to rising mortgage delinquencies and defaults.
  - August 9, 2007: BNP Paribas suspended redemptions in three mutual funds, signaling freeze and triggering ABCP rollovers collapse.
  - Mark-to-market valuation conventions and lack of pricing led to forced asset sales, higher volatility, larger haircuts, and funding strains (Table 5.1 shows typical haircut escalation across 2007–2009).
- Systemic failures and notable institutions:
  - Bank failures/near-failures: Northern Rock (UK), Bear Stearns (US), Lehman Brothers (US).
  - AIG: ultimate losses included $30 billion from selling credit protection on CDOs and $21 billion from securities-lending/repo activities tied to CDOs and RMBS.

### Post-crisis regulatory reform agenda — objectives and elements
- Overarching aim: build a more robust and resilient global financial system to support the real economy in stress.
- Global coordination led by: Financial Stability Board, BCBS, IAIS, IOSCO, CPMI.
- Reform program grouped into four main elements (document cuts off before listing them in full).

*Italicized source attribution: Risk Management and Regulation (selected chapters and bibliography), IMF PDF content unit.*

### 1. Measures to strengthen the system-wide focus of financial policymaking

### 1. Measures to strengthen the system-wide focus of financial policymaking

### System-wide focus of financial policymaking and supervision
- 1. Measures to strengthen the system-wide focus of financial policymaking and supervision;

### Containment of risk buildup
- 2. Initiatives designed to contain the buildup of risks in the financial system;

### Improving financial system resilience
- 3. Policies to improve the resilience of the financial system in the event of stress;

*45664-dp1813-risk-management-and-regulation - 1. Measures to strengthen the system-wide focus of financial policymaking*

### 4. Reforms to contain moral hazard and lower the costs of handling failure.

### 4. Reforms to contain moral hazard and lower the costs of handling failure

### Strengthening the system-wide dimension
- Major lesson: focus on the financial sector as a system, recognizing collective behavior and close interconnections and interactions across the financial network.
- Illustrative failures of system perspective:
  - Investors in complex structured products mistook benign market conditions as an indicator of quick exit, failing to recognize concentrated risk and likely simultaneous exits by other investors, causing evaporation of market liquidity.
  - Bank liquidity contingency plans (liquefying illiquid assets, bidding for additional deposits, restricting balance sheet size) that work in single-firm stress can fail and exacerbate system-wide stress when many banks are strained.
  - Reliance of many European banks on steady rollover of short-term wholesale dollar funding from US money market funds motivated creation of the Term Auction Facility, where foreign banks were major borrowers of term money at the Federal Reserve’s discount window.
- Policy implication: complement strong supervision of individual banks with system-wide risk assessment and regulation to contain system-wide risk and limit externalities and spillovers.

### Initiatives to contain the buildup of risks (longitudinal and cross-sectional)
- Longitudinal dimension (counteracting procyclicality):
  - Countercyclical buffer introduced by the Basel Committee: supervisory authorities require banks to hold additional capital at times of excessive credit growth that can be released in a subsequent downswing.
  - Other tools used more actively: loan-to-value and debt-to-income constraints in real estate markets; risk weighting in corporate lending.
  - Capital conservation buffer that can be run down during times of stress to counteract procyclicality.
  - Forward-looking stress tests condition on severe stress scenarios many months into the future; IMF pioneered these starting with the first Financial Sector Assessment Program in 2000.
- Cross-sectional dimension (containing spillovers and contagion):
  - New analytical tools to assess institution contribution to systemic risk (for example, CoVaR).
  - Regulatory measures: systemic capital surcharges for global and domestic systemically important banks; more intrusive supervision; tougher large exposure rules; measures to mitigate spillovers between banking and shadow banking sectors.
  - Measures to address misaligned incentives:
    - FSB compensation principles (2009a, 2009b): require compensation packages for principal risk takers to contain a high, variable component that is deferred and remains at risk depending on realized performance.
    - New securitization guidelines (IOSCO 2012): require originator to retain a proportion of the risk.
    - Steps to reduce mechanistic reliance on rating agencies (FSB 2012).

### Policies to improve resilience to stress
- Core reforms:
  - Basel III: raise the quality and quantity of bank capital and provide a stronger, more resilient sector in stress (BCBS 2011).
  - Leverage ratio as a backstop to counteract procyclicality of risk-based capital requirements.
  - Work ongoing to address excessive variability of risk weights.
  - New international standards for liquidity risk; enhanced approaches for market risk and operational risk.
  - Requirement for a higher proportion of loss-absorbing common equity compared with Basel II.
- Stress testing:
  - Enhanced supervisory reliance on stress tests to assess capital and liquidity plans; stress tests identify vulnerabilities and support remedial plans.
  - Stress-testing techniques improved via better models and data; extended to sectoral contributions to systemic risk, nonbank resilience, and financial network robustness.
  - Trend: supervisory stress tests sometimes becoming effective constraint on regulatory capital; movement to transform stress test outcomes into capital surcharges in several countries.
- Financial market infrastructures and central clearing:
  - Policies to support central clearing of standardized derivative contracts through central counterparties (CCPs) to lower bilateral counterparty credit risk.
  - Ongoing work to support robustness, recovery, and resolution of CCPs to ensure continued market functioning.
- Shadow banking:
  - Objective to “transform shadow banking into resilient market-based finance” (FSB 2015).
  - Progress: strengthening money market funds, improving securitization markets, lowering interconnectedness between banking and nonbank sectors, improving securities financing markets.
  - Ongoing work: address liquidity and leverage risks in asset management; continuous monitoring of nonbank sector and adaptation beyond the regulatory frontier.

### Containing moral hazard and managing failure
- Regulatory objective: eliminate need for taxpayer support because firms are seen as too big, too complex, or too interconnected to fail.
- Crisis management reforms:
  - Introduction/enhancement of special resolution regimes in line with FSB Key Attributes (2011, updated in 2014).
  - Toughened regulation for institutions perceived as too big to fail: capital surcharges, more intensive supervision.
  - Major financial institutions required to prepare recovery and resolution plans (“living wills”) subject to supervisory scrutiny.
  - Requirements for globally systemically important banks to hold “total loss absorbent capacity” instruments that can be written down or converted into equity under stress to sustain critical functions without taxpayer support.
  - Parallel work on recovery and resolution of central counterparties.

### Implementation, evaluation, and changes in regulatory approach
- Reform status and evaluation:
  - Major program of regulatory reform is nearing completion and has strengthened the financial system.
  - Evidence suggests a well-capitalized banking system supports sustainable credit growth (Cohen and Scatigna 2014).
  - Authorities should evaluate impacts of large regulatory changes and amend policies if major adverse unintended consequences emerge.
- Rethinking complexity, simplicity, and internal models:
  - Crisis exposed limitations of sophisticated quantitative techniques and excessive reliance on banks’ internal models.
  - Basel Committee’s effort to simplify regulatory framework: balance simplicity, risk sensitivity, and comparability; simplicity now viewed as desirable and linked to proportionality for non-systemic firms.
  - Trans-Atlantic discord over proposed floor based on supervisory parameters to limit capital relief from internal models and reduce variability of risk-weighted assets; variability partly due to national differences and evidence of active gaming of internal models (Plosser and Santos 2014).
  - Some complex approaches revised or abandoned: regulatory approval for the Advanced Measurement Approaches to Operational Risk on verge of withdrawal; market risk approach overhauled (stressed VaR, Fundamental Review of the Trading Book replacing VaR with expected shortfall).
- Supervisory trends:
  - Erosion of supervisory faith in banks’ internal models for regulatory purposes, even as diversity in approaches can counter herding.
  - Stress testing has become central: combination of bottom-up and top-down, detailed bank and trading-book information.
  - Streamlining stress tests by converting outcomes into capital surcharges is being implemented in several countries.

### Persistent and emerging challenges
- Sovereign exposures:
  - Treatment of sovereign exposures remains an area where regulation often treats sovereigns as risk free, skewing bank behavior and potentially putting capital at risk.
  - Work on sovereign exposure treatment gained ground after peripheral European sovereign debt losses but has gone on the back burner.
- Preparing for future threats and technological change:
  - Debate: regulators criticized for “fighting the last war” vs. view that fixing past flaws is critical to assure system soundness and allow sufficient implementation time.
  - Rise of FinTech may redraw regulatory boundaries; benefits include efficiency and innovation, risks include failures, scams, and financial crime.
  - RegTech and SupTech can support risk management, compliance, monitoring, identity management, and data analysis using AI, machine learning, and big data analytics.
- Operational, automated trading, and cyber risks:
  - Automated trading strengths (speed, operator absence) can cause large losses and market-wide disruptions (examples cited: Knight Capital loss of several hundred million dollars within minutes; March 2010 equity flash crash; October 2014 Treasury flash rally).
  - Cyber-risk event with systemic impact is a major threat: could affect market infrastructures (clearing, payment, settlement), cause liquidity freezes, and undermine trust in financial channels.
  - Challenges in responding to cyber risk: macro-consequences poorly understood; data collection and sharing hampered by privacy and reputation concerns; cross-border cooperation complicated by national security suspicions.
  - Responses in practice: major banks incorporate cyber and operational risks into stress-testing scenarios as single-factor sensitivity shocks; supervisors simulate cyberattacks in supervisory frameworks.
  - Estimating buffers for cyber-risk losses is a work in progress due to paucity of event data and rapid technology evolution making historical data a weak predictor.
  - Recommended focus: stronger business continuity planning, greater prominence to technology function in risk management architecture, closer international and cross-sectoral supervisory cooperation for information sharing and global risk management approaches.
- Research and analytics:
  - Today’s risk management challenges differ from past decades; rapid technological progress generates new threats (cyber risks, high-frequency trading, FinTech) that are not yet quantifiable in a meaningful manner.
  - Ample room for researchers to contribute to the nexus of risk management and regulation in a world of radically reshaped financial technologies.

*Italic: Chapter 4 — Reforms to contain moral hazard and lower the costs of handling failure (from Risk Management and Regulation).*

### Bibliography

### Bibliography

### Basel, regulatory, and supervisory publications
- ———. 2009. “Enhancements to the Basel II Framework.” Basel. July.
- ———. 2011. “Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems.” Basel.
- ———. 2012. “Prudential Supervision of Netting, Market Risks and Interest Rate Risk - Preface to Consultative Proposal.” Basel.
- Financial Stability Board (FSB). 2009a. “Principles for Sound Compensation Practices.” Basel. April.
- ———. 2009b. “Implementation Standards for the FSB Principles for Sound Compensation Practices.” Basel.
- ———. 2010. “Principles for Reducing Reliance on CRAs.” Basel.
- ———. 2011. “Key Attributes of Effective Resolution Regimes for Financial Institutions.” Basel.
- ———. 2012. “Roadmap for Reducing Reliance on CRA Ratings.” Basel.
- ———. 2015. “Transforming Shadow Banking into Resilient Market-based Finance.” Basel. November.
- International Organization of Securities Commissions (IOSCO). 2012. “Global Developments in Securitisation Regulation: Final Report.” Madrid, November.
- International Monetary Fund (IMF). 2006. Global Financial Stability Report. Washington, DC, April.
- ———. 2009. “Restarting Securitization Markets: Proposals and Pitfalls” In Global Financial Stability Report, Chapter 2, Washington, DC, October.
- ———. 2011. “Towards Operationalizing Macroprudential Policies: When to Act?” In Global Financial Stability Report, Chapter 3, Washington, DC, October.
- ———. 2013. “Key Aspects of Macroprudential Policy.” IMF Policy Paper, Washington, DC, June.
- ———. 2014. “IMF Staff Guidance Note on Macroprudential Policy.” Washington, DC, November.
- ———, Financial Stability Board (FSB), and Bank for International Settlements (BIS). 2016. “Elements of Effective Macroprudential Polices: Lessons from International Experience.” August.

### Credit risk, default prediction, and bank capital
- Bharath, S., and T. Shumway. 2008. “Forecasting Default with the Merton Distance to Default Model.” Review of Financial Studies 21: 1339–69.
- Duffie, Darrell, Leandro Saita, and Ke Wang. 2007. “Multi-Period Corporate Default Prediction with Stochastic Covariates.” Journal of Financial Economics 83 (3): 635–65.
- Duffie, Darrell, and Kenneth Singleton. 1999. “Modeling Term Structures of Default-able Bonds.” Review of Financial Studies 12: 687–720.
- ———. 2003. Credit Risk: Pricing, Measurement, and Management. Princeton University Press.
- Gordy, Michael. 2003. “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules.” Journal of Financial Intermediation 12: 199–232.
- ———, and B. Howells. 2006. “Procyclicality in Basel II: Can We Treat the Disease without Killing the Patient?” Journal of Financial Intermediation 15 (3): 395–417.
- Dagher, Jihad, Giovanni Dell’Ariccia, Luc Laeven, Lev Ratnovski, and Hui Tong. 2016. “Benefits and Costs of Bank Capital.” IMF Staff Discussion Note 16/04, International Monetary Fund, Washington, DC.
- Cohen, Benjamin, and Michela Scatigna. 2014. “Banks and Capital Requirements: Channels of Adjustment.” Working Paper 443, Bank for International Settlements.
- Repullo, Rafael, and Javier Suarez. 2008. “The Procyclical Effects of Basel II.” CEPR Discussion Paper 6862.
- Kapan, Tumer, and Camelia Minoiu. 2017. “Balance Sheet Strength and Bank Lending: Evidence from the Global Financial Crisis.” Unpublished, April 5.
- Plosser, Matthew, and João Santos. 2014. “Banks’ Incentives and the Quality of Internal Risk Models.” Federal Reserve Bank of New York Staff Reports 704.
- Gupton, Greg, Christopher Finger, and Mickey Bhatia. 1997. CreditMetrics – Technical Document. New York: JP Morgan.
- Morgan Guaranty. 1994. RiskMetrics. Technical Document, 1st ed. New York.
- McGuinness, John. 1969. “Is Probable Maximum Loss (PML) a Useful Concept?” Proceedings of the Casualty Actuarial Society 56 (105).

### Interest rates, term structure, and volatility modeling
- Black, Fischer, Emanuel Derman, and William Toy. 1990. “A One-Factor Model of Interest Rates and Its Application to Treasury Bond Options.” Financial Analysts Journal 46 (1): 33–39.
- Brace, Alan, Dariusz Gatarek, and Marek Musiela. 1997. “The Market Model of Interest Dynamics.” Mathematical Finance 7 (2): 127–55.
- Cox, John, Jonathan Ingersoll Jr., and Stephen Ross. 1985. “A Theory of the Term Structure of Interest Rates.” Econometrica: 385–407.
- Heath, David, Robert Jarrow, and Andrew Morton. 1992. “Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation.” Econometrica: 77–105.
- Hull, John, and Alan White. 1994a. “Numerical Procedures for Implementing Term Structure Models I: Single-Factor Models.” Journal of Derivatives 2 (1): 7–16.
- ———. 1994b. “Numerical Procedures for Implementing Term Structure Models II: Two-Factor Models.” Journal of Derivatives 2 (2): 37–48.
- Fisher, Lawrence, and Roman Weil. 1971. “Coping with the Risk of Interest-Rate Fluctuations: Returns to Bondholders from Naïve and Optimal Strategies.” Journal of Business 44 (4): 408–31.
- Fong, H. Gifford, and Oldřich Vašíček. 1984. “A Risk Minimizing Strategy for Portfolio Immunization.” Journal of Finance 39: 1541–46.
- Vašíček, Oldřich. 1977. “An Equilibrium Characterization of the Term Structure.” Journal of Financial Economics 5: 177–88.
- Vašíček, Oldřich. 1987. “Probability of Loss on Loan Portfolio.” Unpublished, KMV Corporation.
- Vašíček, Oldřich. 2002. “Loan Portfolio Value.” Risk 15: 160–62.
- Homer, Sidney, and Martin Leibowitz. 1972. Inside the Yield Book. Englewood Cliffs, NJ: Prentice-Hall Inc.
- Macaulay, Frederick. 1938. Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields and Stock Prices in the United States since 1856. NBER Books.

### Econometric methods, volatility, and hazard models
- Bollerslev, Tim. 1986. “Generalized Autoregressive Conditional Heteroskedasticity.” Journal of Econometrics 31: 307–27.
- Engle, Robert. 1982. “Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation.” Econometrica 50 (4): 987–1007.
- Jorion, Philippe. 2006. Value at Risk: The Benchmark for Managing Financial Risk. 3rd ed. New York: McGraw Hill.
- Pesaran, M. Hashem, Til Schuermann, Björn-Jakob Treutler, and Scott Weiner. 2006. “Macroeconomic Dynamics and Credit Risk: A Global Perspective.” Journal of Money, Credit and Banking 38 (5): 1211–61.
- Shumway, Tyler. 2001. “Forecasting Bankruptcy More Accurately: A Simple Hazard Model.” Journal of Business 74: 101–24.
- Duffie, Darrell, Leandro Saita, and Ke Wang. 2007. “Multi-Period Corporate Default Prediction with Stochastic Covariates.” Journal of Financial Economics 83 (3): 635–65.

### Financial history, market structure, securitization, and institutions
- Bernanke, Ben. 2005. “The Global Savings Glut and the U.S. Current Account Deficit.” Sandridge Lecture at the Virginia Association of Economists, March 10.
- Bernstein, Peter. 2012. Capital Ideas: The Improbable Origins of Modern Wall Street. Wiley.
- Goetzmann, William, and K. Geert Rouwenhorst. 2008. “The History of Financial Innovation.” In Carbon Finance: Environmental Market Solutions to Climate Change, edited by B. Garcia and E. Roberts. Yale School of Forestry & Environmental Studies.
- Gorton, Gary, and Andrew Metrick. 2012. “Securitized Banking and the Run on Repo.” Journal of Financial Economics 104: 425–51.
- Mills, Paul, and John Kiff. 2007. “Money for Nothing and Checks for Free : Recent Developments in U.S. Subprime Mortgage Markets.” IMF Working Paper 07/188. Washington, IMF.
- McDonald, Robert, and Anna Paulson. 2015. “AIG in Hindsight.” Journal of Economic Perspectives 29 (2): 81–106.
- McLean, Bethany. 2012. “The Meltdown Explanation that Melts Away.” Reuters. March 19 (http://blogs.reuters.com/bethany-mclean/2012/03/19/the-meltdown-explanation-that-melts-away/).
- Snowden, Kenneth. 2007. “Mortgage Companies and Mortgage Securitization in the Late Nineteenth Century.” Unpublished, University of North Carolina.
- White, Eugene. 2009. “Lessons from the Great American Real Estate Boom and Bust of the 1920s.” NBER Working Paper 15573.
- Paech, Philipp. 2016. “The Value of Financial Market Insolvency Safe Harbours.” Oxford Journal of Legal Studies 36 (4): 855–84.
- Garbade, Kenneth. 1986. “Assessing Risk and Capital Adequacy for Treasury Securities.” Bankers Trust Company Money Market Center.

### Foundational theory and conceptual works
- Black, Fischer, and Myron Scholes. 1973. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy 81 (3): 637–54.
- Merton, Robert. 1973. “Theory of Rational Option Pricing.” Bell Journal of Economics and Management Science: 141–83.
- ———. 1974. “On the Pricing of Corporate Debt: The Risk Structure of Interest Rates.” Journal of Finance 29: 449–70.
- Roy, Arthur. 1952. “Safety First and the Holding of Assets.” Econometrica: 431–49.
- Hardy, Charles. 1923. Risk and Risk-Bearing. Chicago: University of Chicago Press.
- Hicks, John. 1935. “A Suggestion for Simplifying the Theory of Money.” Economica 2 (5): 1–19.
- Garbade, Kenneth. 1986. “Assessing Risk and Capital Adequacy for Treasury Securities.” Bankers Trust Company Money Market Center.
- Geithner, Timothy. 2006. “Risk Management Challenges in the U.S. Financial System.” Speech delivered to the Global Association of Risk Professionals, 7th Annual Risk Management Convention and Exhibition, New York, February 28.
- Carney, John. 2012. “The SEC Rule That Broke Wall Street.” CBNC, March 21. https://www.cnbc.com/id/46808453.

*Source: Bibliography (chapter/section) from 45664-dp1813-risk-management-and-regulation PDF.*

---


_Source: https://www.imf.org/-/media/files/publications/dp/2018/45664-dp1813-risk-management-and-regulation.pdf_