UK: Is Basel Driving Banks Down A One-Way Street?

In recent papers1, the Basel Committee (BCBS) has proposed a number of changes to the scope and use of internal modelled approaches.  Taken together, they represent a tectonic shift in banks' ability to use internal models for regulatory capital purposes:

The good news is that for most retail portfolios – where there is sufficient data to evidence empirically accurate and predictive models – the BCBS has kept open the option to use internal ratings based (IRB) approaches for Pillar 1.  This does potentially enable some banks to use IRB models only for portfolios where there is a regulatory capital benefit, albeit that benefit could be reduced as a result of the floors that the BCBS has said it will unveil later this year.

The BCBS's justification for these changes is that banks have not demonstrated that they are capable of modelling risk in these portfolios in a consistent, statistically robust way.

Some feel that the BCBS has gone too far by proposing such a significant reduction in the use of modelled approaches on such a scale.  At present, there is a regulatory incentive for banks to invest in improved risk models (and thereby, risk management) which arises from the ability to reduce Pillar 1 Risk Weighted Assets (RWAs) by using internal models.  Critics of the proposals argue that removing the ability for banks to recognise models in Pillar 1 may reduce the priority – and therefore investment – banks place on risk modelling, with possible knock-on effects for broader risk management.  Banks will feel justifiably aggrieved if supervisors then compound the injury by imposing higher Pillar 2 charges because they take the view that the overall quality of risk management has declined.  Critics also highlight that a low number of defaults in a portfolio over a long period of time is not necessarily the same as evidence of a lack of ability to model risk in the portfolio (absence of evidence is not evidence of absence).

The countervailing argument is that, in the light of experience since the financial crisis, the onus is on banks to develop models that are predictive of both default and loss characteristics, and the burden of proof is on banks to persuade regulators to allow them to be used for regulatory capital purposes. 

The BCBS has, in many of its recent papers, stated that its aim is not to significantly increase capital requirements as a result of its proposals.  The BCBS does not define what it regards as "significant" – and it is worth noting that the BCBS view on this relates to the overall level of capital in the system, so it is happy to have a mix of some winners and some losers.  Nonetheless, on the face of it there are far fewer changes in recent BCBS proposals that result in lower RWAs than there are changes that lead to higher RWAs. 

This leads to a separate, but related question: how many constraints does the BCBS feel it needs on the use of models?  The leverage ratio is intended as a limit on risk adjustments to capital (particularly at the top of the cycle when models may underestimate risk); the current proposals both reduce the range of portfolios where models can be used and limit the capital benefit that models can achieve. In addition, later this year, the BCBS is expected to issue proposals for an overall floor based on the Standardised approach.  Might this be a case of two's company, three's a crowd?

One key point that the BCBS has not addressed in its recent papers is whether the withdrawal of modelling options for these portfolios is a one way street, or if it might perform a U-turn at a later date and permit these models to be used for regulatory capital again. 

There remain a number of consultations currently open - with more to come – and a major Quantitative Impact Study (QIS) exercise will be undertaken over the summer.  It will be interesting to see the extent to which the QIS assesses the impact of the complex inter-relationships between the BCBS proposals, as opposed to looking at the impact of each of the proposals in isolation. 

The consultations and the QIS represent an opportunity for industry to provide feedback and to try to influence the Committee to allow the option for some of these models to get back on the road again – provided they pass the appropriate safety checks. 

Footnote

1.Standardised Measurement Approach for operational risk: Basel Committee on Banking Supervision, March 2016;
Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches: Basel Committee on Banking Supervision, March 2016

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