The Future of Basel 3 in 3 times 3

The Discussion Paper The Regulatory Framework: Balancing Risk Sensitivity, Simplicity and Comparability (July 2013) provides an interesting glimpse into the direction that the Basel Committee is heading for the future position of Basel III.

Although the paper is what it is, ie a discussion paper meant to evoke a discussion about Basel III, it sheds some light on the future development of the regulatory framework. We can summarize this development in 3 times 3 windows.

The first window: three design principles

In the discussion paper, the Basel Committee mentions three design principles:

  1. Risk sensitivity
  2. Simplicity
  3. Comparability
The Basel framework is risk-sensitive: the capital requirement of an exposure is an increasing function of its risk parameters PD (probability of default) and LGD (loss given default)

The Basel framework is risk-sensitive: the capital requirement of an exposure is an increasing function of its risk parameters PD (probability of default) and LGD (loss given default)

The important innovation is the second one, simplicity. The Committee acknowledges that banks’ models for the quantification of the credit, market and operational risk and buffer requirement may have become too complex, thereby hindering important internal checks-and-balances and external supervision.

The Committee views the simplification of the Basel capital standards, where possible, as well as improvements to the comparability of their outcomes, as an important part of its agenda to reform the regulatory framework and ensure that it remains “fit for purpose”.

The second window: the pillar structure

The three pillar structure will remain intact:

  1. Pillar 1: minimal capital requirements (a.o. the regulatory capital models for credit risk, operational risk and market risk);
  2. Pillar 2: supervisory review process and Economic Capital;
  3. Pillar 3: disclosure.

My interpretation of the document is that pillars 1 and 3 will become more important, and Pillar 2, the internally-based Economic Capital part, less important.

Economic Capital is the capital requirement that is based on bank internal models as opposed to the regulatory capital formulas that are provided in pillar 1. Often banks use in-house developed economic capital engines that apply Monte Carlo routines. The supervision on these models is principle-based.

If the goal of the Basel Committee is to develop a framework that is more comparable across banks and, hence, more prescriptive, we can expect that pillar 1 regulatory capital will become more important and pillar 2 economic capital less important.

The Discussion Paper underscores the importance of pillar 3 disclosure. The Committee states that the capital adequacy of a bank cannot be assessed with the help of a single ratio but it has be seen through several ‘lenses’:

Viewing capital adequacy through multiple lenses is likely to be more informative than relying on any single measure: indeed, different measures could provide an early warning of distress in differing circumstances.

Interestingly, examples of these measures include metrics that use market-based information for own funds such as capital ratios using market values of equity in the numerator and price-to-book ratios. Also, input variables to RWA calculations could be disclosed, such as (average) PD and LGD values for each portfolio.

The third window: risk-weighting is here to stay

The Basel Committee is very clear on risk-weighting:

The Committee believes that a risk-based capital regime should remain at the core of the regulatory framework for banks.

This means that, notwithstanding all criticism that the risk-weighting has attracted, the system of weighting credit exposures according to their credit risk and, subsequently, expressing the capital requirement in the risk-weighted assets will not change. However, we can expect further analysis on the RWA volatility that is encountered across banks. The Basel Committee has embarked already on the bottom up, hypothetical portfolio analysis, to investigate and explain RWA differences among banks for the same exposures.

The focus on risk-weighting means the following for the future development of Basel III:

  1. We can expect more exercises that are conducted by the Basel Committee to investigate and explain RWA differences, especially bottom up studies that use hypothetical portfolio analysis, meaning that the same (hypothetical) portfolio is sent to a panel of banks, asking them to calculate the RWA for it.
  2. The leverage ratio will continue to function as a ‘backstop’, ‘that provides a floor to the outcome of risk-based capital requirements which provides a protection against model risk and the reduction of capital requirements via the optimistic use of models and parameters’.
  3. Further harmonization of the RWA calculation can be expected through a development towards more prescriptive guidance from Basel and less internally-calibrated parameters.

The paradox: Internal bank models will become more standardized

The result will be that the internal ratings based (IRB) approach becomes itself more standardized, using floors for the IRB outcome (it should be above a certain percentage of the standardized approach) and additional floors for the inputs of the RWA calculation, such as minimal PDs and LGDs for specific asset types.

The re-balancing act is a logical step towards modernizing the capital framework. Sometimes, risk models have become too complex. The identification of simplicity as a design principle, next to risk-sensitivity, is a necessary adjustment.

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Over Folpmers
Financial Risk Management consultant, manager van een FRM consulting department, bijzonder hoogleraar FRM

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