Short History of Basel’s Connection With Bank Risk Models

Banks first won permission to use internal models to meet the Basel Committee on Banking Supervision’s capital requirements in 1996, when the regulator expanded its rules to cover losses on assets that lenders intend to trade.

Prior to that the Basel system, which had focused solely on possible losses on assets banks intended to hold to maturity, was based on a set of fixed risk weights applied to different asset classes.

While studies showed that allowing the use of internal models would lead to lower capital charges, the Basel committee accepted this on the grounds that models reflect “the benefits of risk diversification strategies and provides incentives for firms to develop and implement” sound risk measurement.

The so-called market risk amendment of 1996 “marked the point” at which Basel “began to become more influenced by the technical modeling expertise of the large international banks,” Charles Goodhart wrote in his 2011 book “The Basel Committee on Banking Supervision: A History of the Early Years.”

Internal models were further integrated into Basel capital rules in an overhaul of the international standards, known as Basel II, published in 2004.

This step transformed the organization of bank capital requirements and extended the use of models to the banking book -- assets banks intend to hold to maturity.

Standardized Approach

Under the Basel II system, whose structure is maintained in current international standards, banks can use their own models or a “standardized approach,” based around credit ratings, to measure capital levels.

Banks must seek permission from their supervisors before switching over to models. In practice, they are used extensively by large international banks.

The committee announced in 2011 that it would review banks’ use of models as part of its work to police the implementation of the latest round of capital rules, known as Basel III. It has so far published two reports on modeling for trading assets and one concerning assets in the banking book.

Stefan Ingves, chairman of the Basel committee, said earlier this year that the group is weighing a range of options to rein in bank practices when using internal models, including the use of capital floors.

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