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Â Now, that we have seen how we can define the value increase and

Â the expected short fall.

Â A natural question is how did we get there?

Â In fact, we get there because of the initiative of the Basel committee.

Â So, here I will look at two questions in the session.

Â So, what are the main steps leading to the Q-hunt registration on banking?

Â And, the second question that I will address is what is the whole

Â of the Basel committee?

Â So, why do we call the Basel committee the Basel committee?

Â Well, the Basel committee is located in a very nice building in Basel,

Â which is a Swiss city.

Â And, it's located in the building of the Bank of International Settlement.

Â And, here you have a very nice picture, and

Â this is indeed the oval building of the Bank of International Settlement.

Â So, what was the goal of the Basel committee when they started to work

Â is to avoid disaster.

Â And, the disaster is known as the Herstatt bank disaster,

Â which was in fact the default of an Austrian bank.

Â And so,

Â they come up with legislation in order to avoid a second Herstatt bank event.

Â So, the Basel Committee came up with two types of ratio.

Â One, which is an adequacy ratio, and the second one which is a solvency ratio.

Â And, the solvency ratio is very well known, and

Â this is known under the name as, under the name of the Cooke ratio.

Â So, this is in fact the first initiator of the Basel committee.

Â Now, of course, the Basel committee, after the first proposal, continued to work in

Â order to try to improve the regulation of the banking sector.

Â And, what they came up with is BIS98.

Â BIS98, what do the bank had, they had the choice between what is called the internal

Â approach, and the internal approach was indeed based on the Value at Risk.

Â And, this explains why I talked in a previous session about the Value at Risk.

Â And, the second one is called the standardized approach,

Â which is in fact a static approach based on simple weights.

Â Now, the Basel committee initiative, in fact,

Â respond to what I called an external initiative, in the sense that it's

Â coming from external people to the banking sector, which are here the regulators.

Â Now, of course,

Â you have also internal initiative which are coming from the bank themself.

Â And, the most well known one is coming from Dennis Weatherstone,

Â which was the CEO of JP Morgan.

Â And, he came up with a very, very simple question.

Â So, can you give me a very simple fact sheet which will summarize

Â the risk of JP Morgan for the next 24 hours?

Â So, as you can see, this is a very simple question.

Â Bu,t this is very, very difficult to address because, as you know,

Â JP Morgan is a very large bank with a lot of positions.

Â So, what the staff of JP Morgan did is to work on a solution for that question.

Â And, they came up with what is call the RiskMetric methodology which is in fact

Â exactly the approach that I explained in a previous a session.

Â And so, using the the variance covariance approach,

Â they come up with report which is called 4:15 report.

Â Why 4:15?

Â Because it's 4 o'clock 15 minutes, and what Dennis Weatherstone

Â got in this time is a report after the market close at 4 o'clock.

Â And, that report was simply summarizing the risk for

Â JP Morgan over the next 24 hours.

Â So, now that we have seen what was going on in the banking sector,

Â another question is what is going on in the corporate sector?

Â So, were there spreading of

Â the banking regulation toward the corporate regulation.

Â And, the answer is indeed yes, because in the corporate sector,

Â there was what is called the disaster period.

Â So, the disaster period was a period where

Â corporates were playing with off-balance-sheet insurance.

Â For example, particularly options or swaps, etcetera.

Â And, they didn't know really what they were doing.

Â And so, the result was really a lot of losses, and often those losses were

Â of an amount of $1 billion, which is really a significant amount.

Â So, the regulators for the corporate sector wanted, of course,

Â to avoid those types of disaster, and

Â they come up with all sorts of regulation for corporates.

Â So, the main body of regulation for the corporate sector is the SEC.

Â So, the SEC came up with a proposal, and the proposal was that the corporates

Â sector have a choice to these three possibilities.

Â So either the usual value at risk, fair value or a sensitivity measure.

Â And, the goal was here indeed that corporates should reveal the ways that

Â they take on hedge instruments or their options, or their swaps, etcetera.

Â You remember the whole of the Basel committee in terms of banking regulations.

Â So, now with this, and this is what I call back to the future.

Â And, this is one of my favorite movies I would say.

Â So, if you look at the Basel three committee they come up with the new

Â regulation which is currently implemented in Europe.

Â And, the Basel three regulation with respect to Basel one and

Â Basel two tried to focus on two new types of risk coming,

Â of course, from the previous financial crisis.

Â Which is the risk associated to liquidity and the resource associated to leverage.

Â And, the Basel three regulation really tries to focus on those two risks.

Â What you also have in Basel three is introduction of stress tests.

Â So, stress tests will be scenarios, which would naturally complement

Â this measure which are used in standard within banks.

Â So, what you will do is look at stress scenarios corresponding to crashes,

Â for example.

Â The third innovation in Basel three is the use of

Â the expected shortfall instead of the value-at-risk.

Â So, if you remember the advantage of the expected shortfall which

Â is the possibility, and the fact that it gives you an additional information,

Â which is the average losses when my loss is above the value-at-risk.

Â They are finally recognized by the Basel committee, and

Â this is why they have chosen to use the expected shortfall in the new regulation.

Â So, let me summarize the learning outcomes of this historical session.

Â So, first of all, we saw the different main steps.

Â Yielding to the banking regulation,

Â we saw essentially the whole of the Basel Committee.

Â We see as well that the banking regulation is really an ongoing process and

Â we have new proposals coming from the Basel Committee.

Â We saw as well that the regulation, which was initially suggested for

Â the banking sector has now spread to the corporate sector.

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Â