It's finally here. The Bank for International Settlements (BIS) officially released its proposals for revised regulation of commercial banks on Tuesday. Early reactions suggest that there are no great surprises in its blueprint for a new Basle Capital Accord, which has already been widely discussed with the banking industry. There are, of course, some technical details that will be pored over by the industry.

But the bigger picture is that the proposals come at a time when some observers have begun to question the wisdom of the Accord’s basic innovation – a market-friendly system in which regulators approve banks’ own reserving systems, rather than stipulating the amount of capital they should hold against bad commercial lending.

The banking industry has been living with the current Accord for the past 12 years – although more sophisticated firms might claim it has been more a case of enduring it. Advances in credit risk measurement over the past decade have resulted in tremendous disparities between the ratio-based regulatory capital that banks are required to keep, and the economic capital that their own calculations indicate is appropriate.

Tools such as credit derivatives and loan securitisation made widespread arbitrage of the regulatory requirements possible; banks were shifting capital-intensive loans off their balance sheets, but not the accompanying credit risk. What's more, some analysts claimed that the crude credit scoring of the old Accord actually encouraged banks with more refined credit scoring techniques to make riskier loans, by lending at the bottom of the regulatory ratings buckets to maximise return on capital.

The new Accord should do a better job. The biggest change it delivers are guidelines that allow banks to choose how they allocate credit risk capital – with the more sophisticated banks likely to set their own capital using an system based on their internal ratings systems (the “IRB system”). Basle Committee chairman William McDonough says: “The new framework is intended to align regulatory capital requirements more closely with underlying risks.”

But it may not prevent banks from trying to circumvent regulatory capital requirements. One notable omission in the revised Accord is that it does not allow banks to capture the risk reduction achieved by diversifying a loan portfolio, one of the advances in credit risk modelling that banks lobbied hard to have included. “IRB still lags best practice by some considerable distance, and there’s still going to be a difference between regulatory capital and economic capital,” says Kuritzkes.

Banks that have worked to diversify their credit risk exposure won’t be rewarded by the new Accord’s IRB guidelines, and it’s conceivable there will be a new wave of attempts to arbitrage the system, particularly given the likely advances in credit risk management before the expected “live date” of 2004. Kuritzkes argues, however, that the discretionary element of regulatory supervision – more explicitly stated in the new Accord than its predecessor – should help to police the remaining arbitrage opportunities.

Whether a new system of regulation will stamp out arbitrage remains to be seen. But it also comes at a time when more and more observers are questioning the wisdom of linking regulatory capital to banks' estimates of economic risk. This approach was first taken in the 1997 Amendment to the Capital Accord for the market risks of trading. It has been suggested – most notably by State Street's Avinash Persaud – that this encourages the use of models in a way that ultimately leads to “herding” and market crises.

While many practitioners disagree strongly with this perspective, others, particularly academics, believe that the regulators should not try to get close to the regulated. “I see weaknesses in the current Accord,” says Hans Geiger, a professor at the Swiss Banking Institute (SBI) in Zurich, “but making capital requirements more precise is not the answer.” Geiger argues that a greater degree of precision simply provides banks with clearer arbitrage opportunities. “It’s impossible to be a smart regulator,” he warns. “I wouldn’t try to fine-tune the Accord.”

Linking capital to risk could also exacerbate a bank’s difficulties in a time of crisis, according to Jon Danielsson, a lecturer in finance at the London School of Economics (LSE). He points out that if capital is a direct function of risk, any sudden increase in the risk level of the bank’s assets – as the result of a major default, for example – would lead to a corresponding, and equally sudden, increase in the regulatory capital requirement. “How can a bank be expected to increase capital during a crisis?” he asks. Selling equity, or disposing of risky positions – two of the options open to a bank in this situation – might answer the short-term demand for capital, but would increase the pressure on an already strained institution.

IRB may not be as far as the Basle Committee’s fine-tuning goes. Paul Kupiec, deputy chief of the banking regulation division with the IMF in Washington, says: “While supervisors feel an urgency to revise the existing Accord, it is, in my view, premature to embrace and codify the credit measurement systems that are used today.”

Kupiec, who has proposed several other approaches to regulatory capital, notes that the proposals could be seen as a clear step towards green-lighting the kind of portfolio models that would allow banks to factor diversification benefits into regulatory capital. “Some bankers and consultants have argued that the IRB approach in the new Accord is a small step away from allowing the use of credit VaR models,” he says, “and many will continue to pressure the regulators to fully recognise these models for regulatory capital.”

Second-tier banks that want to capitalise on the IRB approach face significant costs in raising their capital management process to the levels required by regulators. It remains to be seen if they will consider it worth their while. At the other end of the spectrum, many small banks will have to live with the inefficiencies of the ratio-based approach, unless a third tier of regulation is introduced.

Danielsson and Geiger would prefer to see regulation based on market discipline – effectively allowing banks to reward or penalise themselves based on relative levels of risk – and reinforced by a system of strong penalties. Banks, Geiger says, should be punished if they make mistakes, and bankers themselves should not be able to pass the buck by blaming the ratings system, a model or any other process. “I would like to see regulators forcing bankers to take personal responsibility for their figures. I think regulation should have more in common with social imperatives than analytical instruments,” he says.

It also doesn’t follow, he says, that market discipline would ensure fair competition. It may be difficult to assess the risk profile of a smaller institution, because there is less publicly available information. In these instances, a counterparty would probably err on the side of caution.

Enforced disclosure might help, but wouldn’t address the issue of variations in accounting standards. “I think it would be somewhat reckless for regulators to throw in the towel at this point and say, ‘we’ll let the market do it for us’,” concludes Kuritzkes.

©2010 Sungard. All rights reserved. Legal Information

Home | About Ambit ERisk | Solutions | Collateral | Contact Us | Search
Risk Reports Case Studies RMA Ambit ERisk Whitepaper Economic Capital Training And Workshop Events	About Ambit ERisk Solutions Collateral