The risk-sensitive management of a bank therefore needs to be matched by risksensitive regulation. The risk-weighted capital ratio requirements address this, ensuring that a bank engaging in transactions with higher returns – and hence higher risk – also has to hold more capital. Accordingly, the risk weight applied to a speculative foreign investment is markedly higher than that applied to a mortgage in Switzerland. That being said, it is often difficult to estimate and model risks precisely. For this reason, a simple, non-risk-based capital ratio has now also been introduced, stipulating that a bank’s 2  3 4  These banks thus had a de facto state guarantee – their creditors could assume that the government would cover large losses and indemnify them in the event of a bankruptcy. Accordingly, they were prepared to deposit money with the banks at comparatively favourable terms. This funding advantage in turn allowed the banks to take on large risks. Overall, such a constellation is not ideal from the perspective of society as a whole as it creates a ‘moral hazard’ issue. The short-term parameter is referred to as the Liquidity Coverage Ratio, while the longer-term requirement is known as the Net Stable Funding Ratio. The risk-weighted capital requirement is referred to as the Risk-Weighted Assets Ratio, or RWA Ratio for short. Banks are permitted to use their own models for calculating RWA. However, to prevent overly low RWA figures being reported and ensure comparability between banks, the framework stipulates an ‘output floor’ for the RWA calculated by the banks.
Against the backdrop of an apparently healthy financial system, market participants report a substantial rise in transactions leverage, erosion in the use of loan covenants, more favorable financing terms for hedge fund counterparties, and especially a pressure to reduce initial margin against OTC derivatives exposure to hedge funds. But the concern is that this sustained period of very low credit losses and low volatility works to hold down measures of the underlying economic risk in these exposures. This combined with the range of factors I just discussed, raises the odds that market participants will be faced with negative surprises in the event of a more adverse macroeconomic  2  BIS Review 55/2006  environment. And this could have more negative implications for market dynamics and liquidity as market participants react to those losses and attempt to reduce their exposure to future losses. These concerns are not particularly new, and my sense is that they are widely shared among the people and institutions that are closest to these markets. They do not, in my view, challenge the overall judgment that these changes in the credit markets on balance are likely to make the financial system more resilient rather than more fragile. But they do suggest the need for greater caution by financial institutions in several important areas. First, it is very important that the major dealers make the investments necessary to improve the operational infrastructure that underpins the credit derivatives and broader OTC derivatives market.