BOE Signals Skepticism Over U.K. Lenders’ Risk Modeling

Banks may be banned from using their own risk models to calculate capital requirements if regulators consider them too optimistic, the Bank of England said.

The supervisor needs to have a “credible capacity” to withdraw a risk model if it’s seen as “inadequate” or the bank “has not demonstrated the capacity to use it safely,” Andrew Bailey, chief executive officer of the central bank’s Prudential Regulation Authority unit, told bank executives in a speech at Bloomberg L.P.’s London headquarters today. The regulator already used its power to pull “permission for whole types of models,” focusing on commercial property assets, he said.

The central bank, led by Mark Carney, has shown a tough stance on bank capital since taking over from the now defunct Financial Services Authority last year. Its first move was to order the five largest U.K. lenders, including Barclays Plc, Lloyds Banking Group Plc and Royal Bank of Scotland Group Plc, to plug a 13.4 billion-pound ($23 billion) capital shortfall to withstand possible losses on loans, fines and other risks.

“The debate becomes more around whether the relevant risks can be modeled, how easy it is for supervisors and firms to observe the performance of models, and the ability of supervisors to police the performance of models,” said Bailey. “None of this is easy.”

Capital Buffers

Global accords put in place since the 2008 financial crisis, known as Basel III, have raised minimum capital levels from 38 billion pounds to 271 billion pounds worldwide, according to Bailey. Lenders will become even safer when so-called IFRS 9 global accounting rules, which push banks to value assets based on expected losses, come into force next year, he said.

The standards will mean banks have more capital to mop up an “unexpected loss,” said Bailey, who is also a deputy governor of the Bank of England.

In the U.K., lenders have made “significant progress” in rebuilding their capital, according to Bailey. There are “few, if any, banks” that have been weakened as a result, he said.

“Our own analysis indicates that banks with larger capital buffers tend to reduce lending less when faced with an increase in capital requirements,” he said. “These banks are less likely to cut lending aggressively in response to a shock.”

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