Jeffery Atik

Basel II and Extreme Risk Analysis

Basel II mandates the maintenance of bank capital to address three broad categories of risk: credit risk, market risk and operation risk. Basel II methodology assumes that credit risk can be reliably specified with respect to particular asset categories. These projections are based on historical experience, reflected in data sets, which are at times general and at times specific to a particular institution. Basel II may have failed, however, to identify the strong shift in the correlation of defaults that accompanied the financial crisis. Market risk assessment displays similar issues of under-anticipated correlation under extreme conditions. Of the three categories, operational risk is the least tractable. It is a catch-all category, reflecting both internal failures and external events. The character of risk shifts markedly between ‘ordinary times’ and extreme events. Consider this matrix:Credit Risk• In Ordinary Times, defaults may be predicted based on historical data; there is no strong correlation of default.• During Extreme Events, there is often inadequate data for a robust quantification of risk, where there is a strong correlation of default.Market Risk• In Ordinary Times, loss of value is linked to the performance of a particular asset.• During Extreme Events, loss of value is linked to asset type (that is, contagion).Operational Risk• In Ordinary Times, operational losses are more likely to be institution-specific.• During Extreme Events, operational losses originate from the general environment.This paper addresses the ability of Basel II to respond to extreme events. Extreme events include events thought to be extremely unlikely and events that are unimagined (and hence ex ante unimaginable). Basel II largely examines risk as faced by individual financial institutions. Yet systemic risk (contagion) is a well-recognized feature of the international financial system. The liquidity crisis, however, appears to be a novel (unanticipated) phenomenon. Cross-failure of institutions may be yet another example of unanticipated correlation of outcomes, with a peculiar magnification effect. Basel II does not ask – at least not explicitly – whether there is adequate capital across the entire banking system. The current financial crisis may be an instance where this failed to hold. A revised Basel regime might need to account for additional capital stored outside individual institutions to assure adequate capital under extreme conditions affecting the broader banking sector.

On the efficiency of health measures and the ‘appropriate level of protection’

The concept of ‘appropriate level of protection’ (ALOP) runs throughout the SPS Agreement. ALOP reflects the considerable margin of appreciation retained by WTO Members in the application of health and food safety measures and a resigned acceptance of a permanent condition of heterogeneous national regulatory approaches with their accompanying drag on international trade. Importantly, a relevant ‘appropriate level of protection’ functions in a variety of specific tests provided by the SPS Agreement. Use of a particular ALOP permits a more focused check as to whether national health measures are deemed to be violative of international trade obligations. The concept of ALOP builds on, and assumes the existence of, a workable notion of ‘level of protection.’ A level of protection (‘LOP’) can be associated with a particular measure – or with a series of measures operating in concert to address a particular SPS risk. The level of protection expresses the effectiveness of a measure within its broader context (including both physical context and legal context). At times, however, the level of protection of some regulatory alternative will be relevant; at times it is the level of protection of a measure adopted by the exporting country (for purposes of demonstrating equivalence). Finally, ‘level of protection’ may be associated with the general regulatory structure. The various tests incorporated in the SPS Agreement promise a more objective, more precise set of determinations to signal when a Member’s SPS measure must give way to trade considerations. These tests appear technical on their face, involving simple comparisons along fairly discrete dimensions. As many of the more important of these rely on the identification (if not quantification) of the concept of ‘appropriate level of protection,’ they may only be as effective (in the sense of objective, precise and predictable) as the very notion of ALOP admits. Examination of ALOP reveals significant challenges to these expectations. The contradictions and indeterminacies found within the idea of ALOP in turn renders resort to the various SPS Agreement tests problematic. At best, these tests, based on the apparent (though not real) substantiality of the notion of ALOP, permit the SPS Agreement to appear more exact and exacting that it in fact is. In the end, it is more doubtful that the SPS Agreement achieves, other than by accident, an appropriate balance between an appropriate deference to the independent and varied choices made by WTO members in their respective health policies and the maintenance of an open trade system.