Are We on Our Way to Basel IV?

This summer, the Basel Committee unexpectedly admitted that Basel III may have become too complex not only for the banks and most investors, but also even for most bank supervisors.

The Basel Committee may come to regret releasing the discussion paper, entitled "The regulatory framework: balancing risk sensitivity, simplicity and comparability," in which it indicates a willingness to rethink the risk-weighted asset methodology for risk measurement. By the time all comments are handed in on Oct. 11 and vociferously debated, the committee may well be under way to crafting Basel IV.

The committee is asking the banking and regulatory community to consider ways to improve Basel III with the aims of achieving simplicity, risk sensitivity and comparability of Basel III across different global banks. Right now many people struggle to understand the formulas for capital and, especially, what goes into calculating the risk-weighted assets that are part of the formulas. Also difficult is to compare one bank's RWAs to another's and know what it really says about a bank's risk in comparison to another's.

While the Basel Committee's attempt is laudable, democracy can be dangerous. I have no doubt that, since the committee has requested comments, the next version of Basel is likely to be even more complex. This is what happened in transitioning from Basel I to II and then to III. The Basel committee now has 27 members, each of which will be making recommendations based on his or her country's banking system. Inevitably, all the horse trading that goes on to reach a compromise risks making Basel III even more complicated.

Basel's complexity affects not only banks but also bank regulators. It is extremely important to realize that in Basel II and III, capital calculations are challenging and require sophisticated mathematical models. This results in high demands being placed on a relatively small pool of supervisors who have the expertise in advanced modeling. It is even more challenging for bank supervisors who are responsible for examining global systemically important banks since those banks use models extensively. Bank supervisors need to focus on the fact that validating GSIBs' internal models usually consumes a significant amount of valuable resources, undermining the goal of risk based supervision which is to be very time efficient so that resources can be deployed to areas of a bank that potentially need more supervision.

Many pundits and regulators are upset that banks use a Risk Weighted Asset framework, but history and context matter. Under Basel I, there was no risk sensitivity, which led to a perverse incentive for traders to invest in the riskiest assets possible since the capital allocation was the same as for less risky assets. Most U.S. banks were still under Basel I when the crisis hit. In the run-up to Basel II, U.S. lobbyists in particular fought hard not only for RWAs but for all sorts of hybrid instruments to be included as capital. This means that as Americans we were extremely influential in getting a larger numerator with instruments that were not truly loss absorbing (as we found out the hard way in 2008), and a denominator that can be smaller due to banks' flexibility in calculating RWAs.

Using RWAs is not the problem; what is the problem is that banks are not transparent. It is natural to fear the unknown. Most journalists and bank examiners have never read the Basel Accord nor tried to understand the formulas for the different risk categories; even fewer have actually seen the type of market, credit, and operational risk models used by bankers. Hence, it is easier just to say that RWAs can be manipulated and advocate the allegedly simpler leverage ratio. The leverage ratio is also not simple; its usefulness depends entirely on what on- and off-balance-sheet items regulators allow in the denominator.

While I am sure that I will get flak on this point, there are significant advantages to an RWA system for bank management and regulators. RWAs can help bank examiners identify exactly what risk exposures banks have, and they can then spend more time focusing on the riskier areas of a bank. The use of RWAs can also provide a fair basis for a level playing field for banks in different banking structures. The risk-weighted approach is also good for the banks in that it helps them determine what businesses are riskier and not sufficiently rewarded. Banks can use RWAs to help them price loans and derivatives better to reflect the risk.

Despite Basel III's shortcomings, I have yet to hear of a better solution than combining RWAs with a good strong, leverage ratio. Both, however, require good, uniform guidelines for banks to follow and inputs need to be disclosed to the public. Given all the guidelines released by the Basel Committee this summer, it probably will not be long before it releases further guidelines for bank supervisors to aid them in requiring more uniformity in how banks calculate RWAs, the leverage ratio, and how they conduct their stress tests. Importantly, in most guidelines released this summer, the Basel Committee has been reiterating the need for transparency. Unless regulators strengthen Pillar III, the market discipline requirements, and force banks to comply with its disclosure requirements, too much time will continue to be wasted in finding ways to better regulate and supervise banks. We already have the tools to reform banks. We just have to use them.

The Basel Committee had a very busy summer, and now that the autumn is upon us, I expect that the Committee will not get much rest. The comment periods for all those guidelines released in the summer will end in September and October. It will be up to the committee to analyze the comments and finalize the guidelines, with any luck by the end of the year. I expect that the finalized guidelines will place great emphasis on RWA uniformity and transparency, something which I and many in the market would welcome.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at the New York Institute of Finance.