Finalisation of Basel III regulation eyed

The Basel Committee on Banking Supervision will publish proposals to constrain internal risk modeling by banks by the end of the year, its chairman Stefan Ingves said on Monday.

The move signals that international regulators remain intent on taking away the leeway that was given to large banks before the financial crisis to assess their own capital buffer needs.

Taking his audience in Madrid back to the turn of the century, Mr Ingves said that the use of internal models for assessing credit risk was a defining feature of the previous regulatory framework, known as Basel II.

“In the Committee’s quest for greater risk sensitivity, it introduced the role of internally modelled approaches for credit risk and operational risk and expanded the role of models for market risk”, he stated.

Credit risk, operational risk and market risk are the three major risk categories in banking regulation, of which credit risk for many banks is by far the most important one.

Since then there has been ample evidence to suggest that internal models do not “strike the right balance between simplicity, comparability and risk sensitivity”, Mr Ingves said.

One piece of such evidence was a 2014 research paper that showed that large banks in Germany had used the newly introduced internal models to increase their profitability, by lowering capital requirements without actually lowering risks. Such counterproductive results, among other evidence, taught the committee that “ever-more precision in measuring risk can be illusory”, Mr Ingves said.

Rather than focusing solely on the risk-weighted capital ratio, that uses the internal models, regulators over the past years have forged the new Basel III framework, with multiple regulatory constraints that complement each other.

“Having in place multiple regulatory constraints provides more safeguards against the risk of a defect in any single element of the framework”, Mr Ingves, who is also governor of Sweden’s central bank, said during the annual convention of the Spanish Asociación de Mercados Financieros. The text of his speech was given to journalists in advance.

In addition to the risk-weighted ratio, banks will have to comply with a leverage ratio, large-exposure limits and minimum metrics for liquidity. As Mr Ingves said a couple of weeks ago in Lima, the system of multiple metrics has made it harder for banks to game capital rules for their own benefit.

In his speech, Mr Ingves said that while many people might have already forgotten the financial crisis, the Committee remained mindful of the lessons of the crisis in creating a stable regulatory framework.”This in turn will provide the foundation for a resilient banking system that supports the real economy”, the Basel committee chairman concluded.

He said many of the post-crisis reforms are now complete, and there is a clear direction on what still needs to be done with its finalisation within reach. “Completing the job will provide much needed clarity to the markets, to banks and to supervisors.”

Around the end of the year, the committee plans to publish the outcome of its strategic review of the capital framework, including plans to overhaul the calculation of the risk-weighted capital ratio through internal models.

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