Banks Face Basel Clampdown on Risk-Model Variation

Global regulators are preparing to narrow banks’ options for assessing credit risk in a bid to prevent the understatement of possible losses.

The Basel Committee on Banking Supervision will publish a report by early November on “excessive” variability in the models banks use to assign risk and measure capital needs, Secretary General Bill Coen said in an interview at the regulator’s headquarters in Basel, Switzerland. The document has been prepared for the Group of 20 nations.

The report “will include things like a non-risk-based leverage ratio and the introduction of floors or benchmarks, which is requiring banks to publish what its capital requirement would be if they used the simpler standardized, non-model based approaches,” Coen said.

Some global banks have improved their capital ratios since the financial crisis in part by understating the riskiness of their assets, a practice the Bank for International Settlements, which contains the Basel committee, has compared to “window dressing.”

Studies by the BIS and the Bank of England have found unexplained differences in risk weightings for identical assets. At the same time, the euro-area debt crisis put into doubt rules allowing sovereign debt to be generally treated as risk-free.

As a result, regulators are looking at leverage, a measure of a company’s reliance on debt to finance its activities, to gauge banks’ financial strength. Their focus intensified as some banks improved capital ratios by altering internal models or cutting risk-weighted assets without also shrinking their balance sheets.

‘Variety of Drivers’

“A lot of our analytical work shows that there isn’t a single factor that leads to variability of risk weightings from bank to bank,” Coen said. “It’s a variety of drivers.”

Given this variety, there isn’t a single silver bullet for fixing the problem, Coen said. The committee’s proposal will in part aim to improve transparency, for example by forcing banks to publish capital ratios based on different models.

“There are a number of technical fixes we are considering that would constrict the degrees of freedom banks have when they use their models,” he said.

Bankers including Jamie Dimon, chief executive officer of JPMorgan Chase & Co., have said that flexible implementation of previous rounds of Basel rules in the European Union has allowed the region’s lenders to hold less capital against some assets than their U.S. counterparts.

The Basel committee has consistently said that relying only on the leverage ratio may create additional risks because it gives banks no incentive to make a judgment of an asset’s propensity to create losses, and therefore isn’t advisable.

‘Active Debate’

“There is an active debate around the extent to which banks should use internal models for regulatory purposes but the committee’s position is that there must be both a leverage ratio along with a risk-weighted approach -– the belt-and-braces approach,” Coen said. “Banks can arbitrage one, but you can’t game both.”

The Basel committee, a group of regulators from nations including the U.S., France, the U.K. and China, is in the process of reviewing the implementation of global rules known as Basel III. It plans to publish its review of EU and U.S. legislation this year.

“This way in which we do our business has been one of the more dramatic changes for the Basel committee,” Coen said. “After finalizing a global standard, we never systematically evaluated compliance and adherence to those rules. This is now a significant component of our work. We examine very closely how the national adaptation of the Basel standard compares to the global rule and the materiality of any departures.”

In a preliminary scorecard, published two years ago, the committee concluded that the EU’s proposals were not specific enough in limiting the range of instruments banks may count as core capital and also said lenders were given too much scope to label government debt as risk-free.

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