Wednesday, July 24, 2013

Is banking too complicated? – BIS discusses simplification of Basel III regulation


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.


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