FSF: Valuation techniques and leverage aggravate pro-cyclicality

Financial regulators have widely accepted that reform of Basel II capital adequacy rules needs to address pro-cyclicality, but the FSF identifies valuation and leverage as another source of pro-cyclicality to be tackled.

"The pro-cyclical effects arising from the interplay between leverage and valuation needs to be addressed from a macro-prudential perspective," the FSF wrote in a report earlier this month. "Regulators and supervisors should obtain a clear and comprehensive picture of aggregate leverage and liquidity, and have the necessary tools to trigger enhanced surveillance if necessary."

The Basel Committee on Banking Supervision has confirmed it will introduce a minimum leverage ratio, but a joint working group of the FSF and the Committee on the Global Financial System has made a number of alternative suggestions on how supervisors might tackle the pro-cyclicality in leverage and valuations.

The joint working group identified embedded pro-cyclicality in practices such as value at risk, upfront recognition of profits on structured products and mark-to-market valuation of assets where markets have become illiquid during the financial crisis.

The group's suggestions include the requirement for a minimum initial margin for all over-the-counter derivatives and securities financing transactions to restrict the degree of leverage that can be taken on; promoting through-the-cycle measures of market risk; the use of stress tests for new risks and products with limited historical data; and the restriction of the use of contractual triggers that kick in when firms are under stress.

It also suggests supervisors should introduce through-the-cycle measures for managing funding liquidity risk. "Leverage coming from maturity mismatches contributed to a huge funding liquidity requirement," said a spokesman for the group. "Banks traditionally took funding liquidity for granted, so efforts to measure funding liquidity risk at a system-wide level are likely to get more attention."

See also: IMF: leverage best for determining bank bailouts
A vicious circle