Europe
is currently introducing Basel III rules. I have written about this afew weeks ago. In the US, the FED has also published draft
Basel III legislation, available here.
It
seems, though, that we are almost done with transforming the banking
landscape. This is, at least, what I thought and hoped for, until I
came across a new BIS discussion paper entitled “The regulatory
framework: balancing risk sensitivity, simplicity and comparability”.
The paper turns to the complexity of the current regulatory framework
and introduces possible remedies.
My
first reaction was mixed: On the one hand, this exactly mirrors my
critique about the current framework. On the other hand, it’s a bit
surprising to discuss amendments to a framework which is not even in
place today. Anyway, it seems that Basel III discussions will
accompany us in the foreseeable future.
If
a thing can’t be done light and easy, steady and certain, let it
not be done at all. Sounds strange, doesn’t it? But I’ll tell you
a stranger thing. The more effort you make, the less effect you
produce.
(George
Bernard Shaw, Cashel Byron’s Profession)
Concepts
BIS
would like to strike balance between three concepts – simplicity,
comparability, and risk sensitivity.
Simplicity
The
capital standard itself should be expressed in clear and
straightforward language and should use precise and unambiguous
terminology.
As
regards the capital calculation process,
- inputs must be few in number and available through banks’ normal accounting or risk management systems;
- it should not require advanced mathematical and statistical concepts.
The
reasons why simplicity might be compromised are threefold:
- To be risk sensitive, capital requirements must necessarily differ among different scenarios of exposure.
- Bank-internal models evolve continuously.
- Jurisdictions provide for capital adequacy rules under different constraints, namely the stage of development of their financial system.
Comparability
BIS
wants capital standards to be comparable among banks, across
jurisdictions, and over time. It recognizes that complex calculations
and differences of regulation and their interpretation jeopardize
such comparability.
Risk
sensitivity
BIS
looks at risk sensitivity from two perspectives:
- Ex ante: It is necessary for capital standards to use different risk weights, mirroring the characteristics of individual exposures and transactions.
- Ex post: The regulatory framework should be capable to vary as a function of differences in risk profiles.
One
comment here: I had a hard time drafting this and this is precisely
because I don’t understand what BIS is talking about here.
The
institution identifies three impediments to risk sensitivity, each of
them more or less common sense:
- Multiple dimensions of risk. My understanding is that BIS simply wants to say: The more facets of risk there are, the more difficult it will be to model them.
- In times of big data, data collection, storage, and analysis become ever more difficult.
- Because you cannot predict the future with certainty, you cannot construct perfectly risk sensitive models.
History
of BIS risk-based capital adequacy frameworks
The
first Basel framework was set up in 1988. It only considered credit
risk of bank assets, i.e. the risk that the bank’s counterparty
would default.
Due
to increased derivatives and securitization business as well as
securities trading, the framework was amended in 1990: The Basel
committee introduced the notion of market risk and allowed banks to
adopt internal models to calculate capital requirements.
In
2004, the Basel II package established three main new suggestions:
- Banks should take risk-based capital assessments into account for internal risk management purposes.
- The committee improved the measurement of risk-weighted assets, especially regarding credit risk.
- The new rules fixed explicit capital requirements for operational risk.
In
2007/2008, the financial crisis then revealed that the overall
minimum level of capital and the quality of regulatory capital were
deficient. This lead, between 2011 and 2013, to further amendments of
the prudential framework: Basel 2.5 and Basel III subsequently
adopted the following:
- Capital requirements for specific trading and securitization related activities were increased.
- BIS strengthened overall capital requirements by raising the minimum level of capital substantially.
- The Basel committee introduced a (non-risk based) leverage ratio as well as two new liquidity standards (i.e. liquidity coverage ratio (LCR) and net stable funding ratio (NSFR)).
In
summary, the evolution since 1988 moves from simplicity and low risk
sensitivity towards underlying risk to complexity and high risk
sensitivity towards underlying risk. BIS writes:
“The
complexity of the current framework reflects the way banking has
evolved during the past few decades.”
BIS
– July 2013
Factors
that increase complexity of capital adequacy frameworks
In my
view, this part of BIS’ report is a bit repetitive. It recognizes 8
factors:
- Greater risk-sensitivity
- Continuous innovation within financial markets, namely new financial products
- Alignment of regulatory standards over multiple jurisdictions
- Complexity of banks’ business models
- Natural tendency of regulatory regimes to accumulate complexity over time
- Tendency of those who apply regulatory frameworks to seek clarity
- Greater use of advanced mathematics in risk modeling
- Concern to create a level playing field
The
above factors actually increase the complexity of the capital
adequacy’s denominator (i.e. risk-weighted assets). To the
contrary, BIS holds that the numerator (i.e. different definitions of
capital) strikes a good balance between simplicity and
risk-sensitivity.
“The
more complex a bank, the harder it is to resolve when it encounters
financial problems and hence the greater the value of the implicit
subsidy from the perception of systemic importance.”
BIS
– July 2013
Potential
ideas to improve simplicity and comparability
After
recognizing today’s too complex calculation of risk-weighted
assets, BIS conducts a brainstorming of possible remedies:
- Explicitly recognize simplicity as an additional objective. This seems obvious; it is probably a purely political statement.
- Enhance disclosure.
- Apply and disclose results of internal models on standardized hypothetical portfolios, thereby providing insights into different modeling choices of banks.
- Apply a broader set of metrics (risk-based capital ratios, risk-weighted assets calculated under a standardized approach, capital ratios based on market values of equity, leverage ratio, risk measures derived from equity volatility, revenue-based leverage ratios (capital/revenue), historical profit volatility, price-to-book ratios, asset growth, and non-performing assets/total assets). I am wondering here whether 10 simple metrics are really better than one complex metric.
- Adjust the design and calibration of the leverage ratio, especially with regards to global systemically important banks.
- Ensure common conceptual foundations and data sources for internal risk management and regulatory models.
- Limit national discretion to improve comparability of risk-weighted assets across jurisdictions.
- Consolidate applicable Basel III standards in a single, accessible, and structured set of documents.
BIS
concludes its report with three rather radical ideas for capital
adequacy regulation:
- Could we measure capital adequacy using a tangible leverage ratio, i.e. tangible assets / tangible equity?
- Would it be wise to abandon internal-models altogether in favor of a combination of leverage ratio and standardized risk-based approach?
- Could it be reasonable to measure and cap the multiple of capital to income volatility?
As
insinuated in my introduction, I have mitigated feelings after
reading the BIS discussion paper: As a paper battling for simplicity,
it is indeed not as easy to read as it should be. Some ideas are
interesting; others are purely political or common sense.
Let’s
wait and see which results BIS’ simplification initiative will
bring.
Resource: