How Regulators Can Truly Simplify Basel Capital Regime

The formation and continual evolution of global capital rules by the Basel Committee are often driven by a battle between dueling regulatory desires: simplicity versus risk sensitivity.

In the Basel II accords reached well before the crisis, risk sensitivity seemed to hold the upper hand. In developing the so-called Advanced Approaches — a component of Basel II allowing large banks to align their capital levels with their specific level of risk — regulators believed that the key to safe and sound banking was risk management, putting the onus on banks to measure their risk exposure and corresponding capital reserves.

But a more recent series of papers and proposals from the Basel Committee, not to mention statements by key regulators, have put more emphasis on simpler capital standards, including heightened across-the-board capital standards no matter the risk of an asset. Yet policymakers are emphasizing simplicity without clarifying for banks the extent to which their risk-sensitive models — which they have spent tremendous resources to construct — still matter. This regulatory ambiguity does not aid banks or regulators in managing risk.

As part of the Basel II effort, then-Federal Reserve Board Chairman Ben Bernanke said in 2007 that the Advanced Approaches were "designed to foster good risk measurement and management practices." It took another six years, and hundreds of millions of dollars spent by banks to build their Basel II risk models, until eight institutions were actually permitted to use the Advanced Approaches to calculate regulatory capital — a regulatory milestone.

Unfortunately, for proponents of the Advanced Approaches, this was an empty victory.

Since the financial crisis, there have been a growing number of voices arguing against risk-based approaches to capital and the Advanced Approaches. Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig, long a critic of the Advanced Approaches, cited them as a "contribution to the crisis." It is worth noting that the comment was anachronistic since no U.S. bank operated under the Advanced Approaches before, during or immediately after the recent financial turmoil. Until recently, none of the banks was given permission to use the models for capital purposes. In the run-up to and aftermath of the crisis, no U.S. bank reduced its capital as a result of the Advanced Approaches.

The attacks on the risk-sensitive approaches to capital have succeeded with policies placing greater emphasis on risk-blind leverage ratios. Even within the risk-based framework, models are "floored" by simpler approaches. Federal Reserve Gov. Daniel Tarullo has even signaled in a 2014 speech that core components of the Advanced Approaches should be removed in light of simple risk-based capital floors, heightened leverage standards and stress testing.

Not only is the shift in emphasis jarring for banks, but it is confusing for institutions attempting to satisfy the regulators' mandates when officials also praise the risk models applied to large banks in the Advanced Approaches. Here, banks would agree that many of these models are extremely useful in terms of risk management. In the same speech, Tarullo, while encouraging a reevaluation of models in the capital framework, stated that the Fed "would continue to expect that firms practice sound quantitative risk management using internal models and other techniques."

A clearer understanding of risk management expectations is vitally important if regulators shift away from a risk-sensitive capital framework. There is a significant danger that resources and key personnel could be repurposed as the capital standards shift to less risk-sensitive approaches. Models and programs that cost millions of dollars to develop could be left to atrophy. In fact, banks are already discussing reallocating staff and resources away from operational risk modeling based on a speech from the chairman of the Basel Committee, where he indicated the removal of operational risk modeling was imminent.

If the regulators are intent on establishing non-risk-sensitive approaches to regulatory capital, they must clarify the expected role of risk-sensitive models. Should they be abandoned or repurposed solely for risk management purposes unrelated to capital? Regardless of the final approach, regulators need to set clear expectations for risk management to strengthen bank safety and soundness going forward.

Hugh Carney is vice president of capital policy for the American Bankers Association.