[MUSIC] Now, that we have seen how we can define the value increase and the expected short fall. A natural question is how did we get there? In fact, we get there because of the initiative of the Basel committee. So, here I will look at two questions in the session. So, what are the main steps leading to the Q-hunt registration on banking? And, the second question that I will address is what is the whole of the Basel committee? So, why do we call the Basel committee the Basel committee? Well, the Basel committee is located in a very nice building in Basel, which is a Swiss city. And, it's located in the building of the Bank of International Settlement. And, here you have a very nice picture, and this is indeed the oval building of the Bank of International Settlement. So, what was the goal of the Basel committee when they started to work is to avoid disaster. And, the disaster is known as the Herstatt bank disaster, which was in fact the default of an Austrian bank. And so, they come up with legislation in order to avoid a second Herstatt bank event. So, the Basel Committee came up with two types of ratio. One, which is an adequacy ratio, and the second one which is a solvency ratio. And, the solvency ratio is very well known, and this is known under the name as, under the name of the Cooke ratio. So, this is in fact the first initiator of the Basel committee. Now, of course, the Basel committee, after the first proposal, continued to work in order to try to improve the regulation of the banking sector. And, what they came up with is BIS98. BIS98, what do the bank had, they had the choice between what is called the internal approach, and the internal approach was indeed based on the Value at Risk. And, this explains why I talked in a previous session about the Value at Risk. And, the second one is called the standardized approach, which is in fact a static approach based on simple weights. Now, the Basel committee initiative, in fact, respond to what I called an external initiative, in the sense that it's coming from external people to the banking sector, which are here the regulators. Now, of course, you have also internal initiative which are coming from the bank themself. And, the most well known one is coming from Dennis Weatherstone, which was the CEO of JP Morgan. And, he came up with a very, very simple question. So, can you give me a very simple fact sheet which will summarize the risk of JP Morgan for the next 24 hours? So, as you can see, this is a very simple question. Bu,t this is very, very difficult to address because, as you know, JP Morgan is a very large bank with a lot of positions. So, what the staff of JP Morgan did is to work on a solution for that question. And, they came up with what is call the RiskMetric methodology which is in fact exactly the approach that I explained in a previous a session. And so, using the the variance covariance approach, they come up with report which is called 4:15 report. Why 4:15? Because it's 4 o'clock 15 minutes, and what Dennis Weatherstone got in this time is a report after the market close at 4 o'clock. And, that report was simply summarizing the risk for JP Morgan over the next 24 hours. So, now that we have seen what was going on in the banking sector, another question is what is going on in the corporate sector? So, were there spreading of the banking regulation toward the corporate regulation. And, the answer is indeed yes, because in the corporate sector, there was what is called the disaster period. So, the disaster period was a period where corporates were playing with off-balance-sheet insurance. For example, particularly options or swaps, etcetera. And, they didn't know really what they were doing. And so, the result was really a lot of losses, and often those losses were of an amount of $1 billion, which is really a significant amount. So, the regulators for the corporate sector wanted, of course, to avoid those types of disaster, and they come up with all sorts of regulation for corporates. So, the main body of regulation for the corporate sector is the SEC. So, the SEC came up with a proposal, and the proposal was that the corporates sector have a choice to these three possibilities. So either the usual value at risk, fair value or a sensitivity measure. And, the goal was here indeed that corporates should reveal the ways that they take on hedge instruments or their options, or their swaps, etcetera. You remember the whole of the Basel committee in terms of banking regulations. So, now with this, and this is what I call back to the future. And, this is one of my favorite movies I would say. So, if you look at the Basel three committee they come up with the new regulation which is currently implemented in Europe. And, the Basel three regulation with respect to Basel one and Basel two tried to focus on two new types of risk coming, of course, from the previous financial crisis. Which is the risk associated to liquidity and the resource associated to leverage. And, the Basel three regulation really tries to focus on those two risks. What you also have in Basel three is introduction of stress tests. So, stress tests will be scenarios, which would naturally complement this measure which are used in standard within banks. So, what you will do is look at stress scenarios corresponding to crashes, for example. The third innovation in Basel three is the use of the expected shortfall instead of the value-at-risk. So, if you remember the advantage of the expected shortfall which is the possibility, and the fact that it gives you an additional information, which is the average losses when my loss is above the value-at-risk. They are finally recognized by the Basel committee, and this is why they have chosen to use the expected shortfall in the new regulation. So, let me summarize the learning outcomes of this historical session. So, first of all, we saw the different main steps. Yielding to the banking regulation, we saw essentially the whole of the Basel Committee. We see as well that the banking regulation is really an ongoing process and we have new proposals coming from the Basel Committee. We saw as well that the regulation, which was initially suggested for the banking sector has now spread to the corporate sector. [MUSIC]