I recommend reading the discussion paper issued by the Basel Committee in July 2013: The regulatory framework: balancing risk sensitivity, simplicity and comparability. You can download the document at http://www.bis.org/publ/bcbs258.htm
The paper confirms recommendations I have been giving banks for some time, that they should be separating Economic Equity, used as a management metric, and Regulatory Equity, used as a supervisory imposed constraint. The two are different, their use is different and the models to calculate the equity should or be different. The difference is like management accounting and financial accounting.
For the first time I read that the Basel Committee has accepted the idea that these two are indeed specific and should not necessarily converge. Admitting this changes considerably how banks can respond to supervisory constraints and how the Committee may change its Capital Adequacy recommendations. Actually the Committee has discreetly unveiled some fundamental potential changes that could be excellent news for the vast majority of banks, the banks supervisors and in general all bank stakeholders. Good news for all except for some solution vendors and consulting firms!
But before we discuss these potential changes, there are a few other comments made by the Committee in this paper which need to be underlined.
I will pass on the very good job done by the Committee in justifying their work in Basel I, Basel II, Basel 2.5 and Basel III. Indeed the work done is impressive and the paper is worth reading if only to remember some of the fundamental goals that lead to the development and evolution of the capital adequacy principles and rules. I also appreciated the frank discussion on the key requirements of defining risk based equity requirements based risk sensitivity, simplicity and comparability. We all agree that there are some good risk sensitivity models, but also that they contain certain weaknesses, that they are not simple and that they don’t always allow for ease of comparison. What is not explicitly mentioned but is implicit in the paper, is that the rules and all the comments are written for large internationally active banks (IAB) and the focus of the discussions are around the Global Systemically Important banks (G-SIB). These of course are a minority in the total number of banks and although they deserve the full attention of the regulators and of the Committee, it would be a mistake to disregard the other second tier and smaller banks for which internal models are probably not the appropriate approach at least for compliance. How often have I met bank senior managers and board members that stated they wanted to go advanced IRB as a principle, not for any rational reason?
The resources (financial and human) required to implement internal models is out of the reach of most banks and in many cases would lead to wrong estimations of risks and hence faulty strategies. The reasons for this are many and the controls by the regulators often lacking. The ultimate bad choice is for banks in emerging financial markets to opt for internal models. The tail risks will be huge in these markets, riddled by black swans and lack of market depth and efficiency.
In very diplomatic terms the Committee is not far from admitting this and even suggest that a radical revision of the rules is possible (in the long term) which could include the definition of compliance on the basis of a “Leverage and a Standardised approach” (point 75 bullet 2 of the discussion paper).
“Under such an approach, the regulatory framework would use a leverage ratio and a standardised risk-based approach together, but abandon the use of the internal models approach. This would preserve the “belt and suspenders” approach introduced by Basel III thus limiting regulatory arbitrage and over-reliance on any single model. It would also substantially simplify the regulatory framework, and make the derivation of bank capital ratios more transparent and understandable for all, although ex ante risk sensitivity would again be reduced.”
Personally I see many advantages in such an approach for the whole financial market as the rules could be applied to all banks, on all continents, in all markets. The use of internal models could still be allowed but for limited number of banks such as the G-SIB and a selection of large IAB, but these banks would also disclose under the standard “one size fits all” rule, allowing stakeholders to compare the banks between them and for the small group going internal models to compare that with the standard rules. It should also be made clear through segregation of the disclosed regulatory risk capital the cost (in capital) of being a systemically important bank. Shareholders must know the cost of being TBTF.
Basel IV is around the corner, but how far is the Committee ready to change? Going to the kind of simplification suggested above would probably kill its credibility!
But a major simplification of that nature would meet the constraints of simplicity, comparability and still be risk based.
The responses to the discussion paper are to be sent to the Committee by October 11th 2013. I would suggest that responses not be shy and go the whole way towards simplification. Remember simplification towards standardised rules does not mean “stupid rules” but transparent, understandable and effective risk based rules.
The separation of capital adequacy constraints from management constraints, through independent (but reconcilable) equity models, is an important change in the Committee’s view. It allows for a refined analysis of risk on the basis of the objective of each measure, compliance and management. Management can use simple or more complex internal models if they actually believe that improves their capacity to optimise risk adjusted value and profitability management.
I’m interested in your comments, please tell me what your position is.