Editorial: Traditional medicine

Switzerland, the banking capital of the world, is also the home of Basel, which in turn is the origin of a series of risk management norms that the global banking system has embraced over the past several years. The current generation of norms, Basel II, provides banks with benchmarks for provisions against assets of differing risks "� the higher the risk, the greater the provision. The Basel approach to risk management has been lauded for its ability to find the most efficient way to balance risk and return for banks. However, as pointed out by Gillian Tett in a recent article in Financial Times, this approach is based on the premise that banks know the risks that are inherent in their asset portfolios. As the sub-prime crisis has rather vividly demonstrated, this is not a tenable proposition, particularly as banks allocate larger proportions of their portfolios to more and more complex securities. One of the largest Swiss banks, UBS, was significantly impacted by the crisis and wrote down over $35 billion to accommodate losses. If it, along with the other banks that found themselves in the same situation, had quantified the risks of securities supported by pools of sub-prime loans, they would have either provided far greater amounts or, daunted by the provisioning requirements, limited their exposures. That is, of course, water under the bridge and it is now up to the entire financial system to work out ways in which to prevent the sequence of events from repeating itself.

The Swiss National Bank (SNB), the country's central bank, has come up with a possible solution. Accepting the limitations on banks being able to accurately quantify the risks embedded in several asset classes, it suggests that a generalised provision be made. This will not differentiate between assets based on risk; rather, it will be a fixed proportion of the banks' total assets. This "leverage ratio" is separate and distinct from the provisioning requirements already specified under Basel II. In this sense, it imposes an additional burden on banks, which therefore will resist the measure. From a risk management perspective, however, the SNB is right in seeing this as a way to pressurise banks to quantify risks more accurately, and to buffer the system by increasing the allocation to risk-free assets, which is what the provisions under the leverage ratio will be invested in.

It is too early to tell whether the measure will be implemented or not. In concept, however, it is similar to a measure that the Indian banking system still has in place "� the statutory liquidity ratio (SLR). Traditionally, this was seen as a means of ensuring that the banking system would lend to the government, thereby making the market for government borrowings less competitive and lowering the government's borrowing costs. From this perspective, reducing the SLR became an indicator of financial sector reform. The ratio was progressively lowered from a peak of 38.5 per cent to its legislated minimum of 25 per cent. Subsequently, the legislation was amended to give the Reserve Bank of India the freedom to lower it even further if deemed necessary. How ironic, then, that an instrument that was shunned because of its exploitativeness is now coming back into vogue as a risk management measure. After yoga, ayurveda and Deepak Chopra, India's next big global thing might well be bank regulation!