18 April 2009

BIS report - The role of valuation and leverage in pro-cyclicality

The report sets out policy options to mitigate pro-cyclical mechanisms. These include quantitative limits on leverage, pricing of risk through the cycle, and pro-cyclical effects that mark-to-market valuation may have on incentives and decision-making.

Market practices related to market-sensitive valuation techniques appear to have contributed to an increase in the pro-cyclicality of leverage in the financial system. The report explores the link between leverage and valuation in the light of the recent experience of market stress.

 

This reports sets out a menu of policy options that could be considered to mitigate pro-cyclical mechanisms. These include quantitative limits on leverage, steps to support better measurement and pricing of risk through the cycle (in particular funding liquidity risk), and measures to mitigate pro-cyclical effects that mark-to-market valuation may have on incentives and decision-making.

 

The report discusses six market practices:

• Value-at-risk and other market-sensitive risk measures that did not capture “through-the-cycle” volatility.

• Triggers in debt or over-the-counter (OTC) derivative contracts that reduce a firm’s liquidity in times of stress when a trigger based on a market valuation or credit rating is breached.

• Strongly pro-cyclical haircuts on financing transactions and initial margins on OTC derivatives, which have a similar effect of adding liquidity to the market in a boom and draining it in times of stress.

• Upfront recognition of profits on structured products where some risks were retained.

• Use of mark-to-market valuation practices even for assets where markets have become illiquid, thereby yielding valuations that seemed too low to some and highly uncertain to many, with adverse consequences for firms reporting such valuations.

• Carrying assets and their hedges at fair value as an alternative to hedge accounting.

 

The reports sets out a menu of policy options that could be considered to mitigate these pro-cyclical mechanisms (see Annex Table 1 for an overview). These include quantitative limits on leverage, steps to support better measurement and pricing of risk through the cycle (in particular funding liquidity risk), and measures to mitigate pro-cyclical effects that mark-to-market valuation may have on incentives and decision-making.

 

Looking ahead, the pro-cyclical effects arising from the interplay between leverage and valuation need to be assessed from a macro-prudential perspective. It appears desirable for regulators and supervisors to get a clear and comprehensive picture of aggregate leverage and liquidity and have the necessary tools to trigger enhanced surveillance if necessary.

 

Suitably constructed leverage ratios may, both as indicators of potential excesses and safeguards against amplification mechanisms, play a role in a macro-prudential framework. The proper pricing of funding liquidity risk in the system could be key in preventing a build-up of leverage and maturity mismatches in the future. Valuation and risk measurement methodologies, while keeping as close as possible to market inputs and best practices, should also avoid creating incentives for excessive risk-taking through underestimating the price of risk.

 

Full report

 

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