There is growing exasperation in the banking community regarding the Basel Committee on Banking Supervision’s desire to reduce variations in bank risk-weighted assets in the name of simplifying comparisons, writes Justin Pugsley.

What’s happening?

Four industry bodies fired off a letter to the Basel Committee on Banking Supervision (BCBS) on June 21 with a long list of concerns over risk-weighted assets (RWAs) and internal models, warning that current proposals could damage the economy if implemented. 

The four trade associations in question are the Global Financial Markets Association, the International Swaps and Derivatives Association, the International Association of Credit Portfolio Managers and the Japan Financial Markets Council.

The focus of their concerns is a set of proposals the BCBS published in March, intended to make it easier to compare the risk profiles of banks and also to make them safer. The proposals, the industry bodies wrote, threaten to hinder economic growth, make finance and hedging more expensive for ‘real economy’ companies and could negatively skew capital allocations, inadvertently creating more risk.

The most contentious suggestion regards replacing internal models with approved simplified models from the BCBS for a number of exposure types, such as financial institutions and very large corporates. Other proposals include changes to the treatment of credit valuation adjustments, credit counterparty risk and credit risk mitigation.

What is causing so much angst is that despite the best efforts of the industry, these concerns to do not appear to be registering with the BCBS, which seems set on pushing through the bulk of its proposals. 

Why is it happening?

Simply put, the BCBS wants to make it easier for supervisors and investors to understand and compare banks’ risk profiles. It believes there is too much variation in the way risk is measured by individual banks, particularly large European institutions. There is also deep suspicion among committee members that banks use these models to game the rules, effectively boosting their profits by setting aside less capital.

The BCBS is worried that all this variation could conceal lingering risks in the financial system, and its solution is to make banks use its own set of simplified risk models for a whole host of exposures, particularly where there is a shortage of historic data. Project finance and aircraft loans, for example, fall into this category, whereas credit card and mortgage loans do not.    

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What do the banks say?

While supporting the principle of reducing variability, the four industry associations cite the European Banking Authority’s statement that 75% of variance is down to genuine differences in risk. That is, banks are doing their job properly. 

Also, the BCBS’s simplified models are a blunt measuring instrument, able to compute only in the equivalent of centimetres, unlike bank internal models, which can drill down to the millimetre and therefore pick up on the finer nuances of risk. 

Banks argue that a lack of risk sensitivity will lead to capital being misallocated, and when coupled with other proposals, such as those on risk mitigation, could result in some undesirable outcomes. For example, refusing to acknowledge the positive effects of risk mitigation will lead to some unsecured loans receiving a lower risk weighting than those that have been collateralised.

Instead of harmonising risk models, banks believe work should be done on coming up with and applying common definitions covering terms, such as default. They are even willing to pool their data on asset classes, such as project finance, very large companies and financial institutions loans, to create larger datasets.

The banks also argue that they have very specialist knowledge in some of these loan types and can therefore make judgements based on inputs that go beyond data, such as experience and the ability to carry out precise modelling. Furthermore, many of these loans, such as project finance, rarely default anyway.    

Will it provide the right incentives?

If the banks are correct, then the answer is an emphatic no.

Not only will loans and hedging become more expensive for the real economy (which might not be a bad thing if risk was being priced incorrectly), but exposures that do occur will not even be properly measured and risk-weighted (which could be problematic when financial shocks occur).

This matters less to the US, where capital markets play a much bigger role in financing the economy, than in Europe, which is plagued by struggling economies relying on in many cases equally unhealthy banks.

Expect arguments with the BCBS over topics such as models, RWAs, leverage ratios, liquidity requirements and so on to heat up, because European policy-makers are increasingly concerned that these measures might be choking off the supply of credit. Of course, the BCBS will respond that such tough measures are necessary to stave off another financial crisis.

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