Why talk of bank cap­i­tal ‘floors’ is rais­ing the roof

The floor – though not new – would be­come a more per­ma­nent fea­ture of the en­hanced Basel III cap­i­tal frame­work, based on the re­vised stan­dard­ized ap­proach.

Financial Nigeria Magazine - - Contents - By To­bias Adrian and Aditya Narain

Cal­cu­lat­ing how much cap­i­tal banks should have is of­ten a bone of con­tention be­tween reg­u­la­tors and banks. While there has been con­sid­er­able progress on reach­ing con­sen­sus on an in­ter­na­tional stan­dard, one key is­sue re­mains un­re­solved. This is a pro­posal to estab­lish a “floor,” or min­i­mum, for the level of cap­i­tal the largest banks must main­tain.

Some fi­nan­cial in­sti­tu­tions and na­tional au­thor­i­ties ques­tion the need for a “floor,'' ar­gu­ing ei­ther that dif­fer­ences in busi­ness mod­els or other el­e­ments of the global reg­u­la­tory frame­work – no­tably lim­its on the amount of lever­age banks may take on – make them re­dun­dant. We dis­agree. The floor re­duces the chances that banks can game the sys­tem to re­duce their cap­i­tal buf­fers to lev­els that aren't aligned with their risks. It is an es­sen­tial el­e­ment of global ef­forts to cre­ate a level play­ing field for banks op­er­at­ing across coun­tries by strength­en­ing com­mon stan­dards for reg­u­la­tion, su­per­vi­sion and risk man­age­ment.

Why is the is­sue of cal­cu­lat­ing cap­i­tal lev­els so im­por­tant? Bank cap­i­tal serves as a buf­fer avail­able to ab­sorb losses. When cap­i­tal is de­pleted, de­posits and other bor­rowed funds are put at risk, and this can lead to bank runs, bank fail­ures and wider sys­temic dis­tress. Banks should have cap­i­tal com­men­su­rate with the busi­ness risks they take and the risks they pose to the wider sys­tem.

Well-cap­i­tal­ized banks are more likely to lend to the real econ­omy and less likely to in­dulge in ex­ces­sive risk-tak­ing that could threaten the sta­bil­ity of the fi­nan­cial sys­tem.

Key el­e­ment

The Basel Com­mit­tee on Bank­ing Su­per­vi­sion, which brings to­gether reg­u­la­tors from 28 coun­tries, es­tab­lishes rules govern­ing the ap­pro­pri­ate level of cap­i­tal. The cur­rent ver­sion of these rules, known as Basel III, is a key el­e­ment of the in­ter­na­tional reg­u­la­tory re­form agenda put in mo­tion fol­low­ing the global fi­nan­cial cri­sis of 2008.

Adopted in late 2010 for im­ple­men­ta­tion over a seven-year pe­riod, Basel III has led to a sig­nif­i­cantly safer fi­nan­cial sys­tem. Not only are banks cap­i­tal­ized with more and higher-qual­ity cap­i­tal than be­fore, they also meet new stan­dards for liq­uid­ity risk (en­sur­ing banks hold enough liq­uid as­sets to meet ma­tur­ing li­a­bil­i­ties in times of stress) and lim­its on lever­age (how much banks can bor­row rel­a­tive to their cap­i­tal.)

The largest global banks have been grad­u­ally al­lowed to use their own in­ter­nal mod­els to cal­cu­late cap­i­tal needed for dif­fer­ent types of risk. The Basel Ac­cord of 1988, known as Basel I, used only stan­dard risk weights pro­vided by su­per­vi­sors. In 1996, some banks were al­lowed to de­velop their own, in­ter­nal mod­els for eval­u­at­ing mar­ket risk.

Safety net

Basel II, adopted in 2004, in­tro­duced both a stan­dard­ized ap­proach (sim­i­lar to Basel I but us­ing risk weights based on ex­ter­nal credit rat­ings) and an in­ter­nal rat­ings-based ap­proach (based on banks' own in­ter­nal mod­els). But it added a wrin­kle: banks had to ap­ply both ap­proaches for a pe­riod of two to three years be­fore be­ing fully re­liant on their in­ter­nal mod­els. And, in ad­di­tion, cap­i­tal lev­els had to be at least as con­ser­va­tive as a “floor” equiv­a­lent to 80 per­cent of the level cal­cu­lated from stan­dard risk weights.

The floor serves as a safety net to in­ter­nal risk-based ap­proaches. It gives banks and their su­per­vi­sors time to in­ter­vene should changes be needed be­fore sign­ing off on the use of fullfledged in­ter­nal mod­els. Basel III kept the in­ter­nal mod­els from Basel II, but it did not re­vise the floor. The Basel com­mit­tee now seeks to rein­tro­duce the floor.

Why is the is­sue con­tentious? In test­ing whether the new method was be­ing ap­plied con­sis­tently across in­sti­tu­tions in dif­fer­ent coun­tries, the Basel Com­mit­tee found that banks with sim­i­lar port­fo­lios came up with very dif­fer­ent cap­i­tal re­quire­ments when they used in­ter­nal mod­els. This raised the pos­si­bil­ity that some banks were un­der­es­ti­mat­ing the risks or gam­ing the mod­els to de­liver out­comes that re­quired less cap­i­tal. Hence ad­dress­ing risk weight vari­abil­ity be­came a top pri­or­ity.

To solve this prob­lem, the Basel Com­mit­tee con­sid­ered sev­eral pro­pos­als: · Re­vis­ing the stan­dard­ized ap­proach to bet­ter cap­ture the risk­i­ness of bank as­sets, mak­ing it a bet­ter com­ple­ment to the in­ter­nal risk-based ap­proach; · lim­it­ing the use of the in­ter­nal riskbased ap­proach; and

· im­ple­ment­ing a floor to mit­i­gate in­ter­nal model risk and to make it eas­ier to com­pare out­comes across banks.

The floor – though not new – would be­come a more per­ma­nent fea­ture of the en­hanced Basel III cap­i­tal frame­work, based on the re­vised stan­dard­ized ap­proach. This ap­proach of­fers the best of both worlds: the flex­i­bil­ity of the in­ter­nal mod­els com­bined with the min­i­mum stan­dard rep­re­sented by the floor.

The dis­cus­sion rag­ing now is whether there is a need for a floor, given that the lever­age ra­tio es­tab­lished un­der Basel III serves al­ready as back­stop. And if there is a floor, should it be set at 80 per­cent, as spec­i­fied in Basel II, or some other level?

Banks' con­cerns

Some banks us­ing in­ter­nal mod­els worry that their cap­i­tal re­quire­ments could go up if these floors were ap­plied, which would re­duce their prof­itabil­ity. The govern­ing body of the Basel Com­mit­tee, how­ever, has em­pha­sized that the en­hance­ments to Basel III should not lead to a sig­nif­i­cant, over­all in­crease in cap­i­tal re­quire­ments across banks.

It is our view that the risk-weighted cap­i­tal ad­e­quacy ra­tio, lever­age ra­tio and out­put floors are all es­sen­tial el­e­ments of a ro­bust cap­i­tal frame­work:

· The cap­i­tal ad­e­quacy ra­tio re­lates risk to cap­i­tal, but it is com­plex and makes it dif­fi­cult to com­pare cap­i­tal out­comes among banks.

· The lever­age ra­tio con­strains the over­all abil­ity of the bank to grow its bal­ance sheet out of pro­por­tion to cap­i­tal. It is not risk sen­si­tive but is sim­ple to cal­cu­late and pro­vides a back­stop to the risk-weighted cap­i­tal ra­tio.

The floor ad­dresses the risk that a model may not per­form as ex­pected when banks use it to cal­cu­late cap­i­tal. It al­lows banks to con­tinue us­ing more risk-sen­si­tive ap­proaches but con­straints any un­war­ranted cap­i­tal re­lief, while also mak­ing it eas­ier to com­pare in­sti­tu­tions through dis­clo­sure of the stan­dard­ized ap­proach out­puts.

While we wel­come the ad­di­tional risk sen­si­tiv­ity that in­ter­nal mod­els bring, we re­main cau­tious about their un­con­strained use. Su­per­vi­sory ca­pac­ity to en­sure ef­fec­tive pru­den­tial over­sight of in­ter­nal mod­els re­mains a work in progress. At the same time, banks will al­ways have in­cen­tives to game the mod­els and re­duce the amount of cap­i­tal they hold. In­deed, a re­cent study by Fed­eral Re­serve econ­o­mists finds ma­nip­u­la­tion of risk weights to be wide­spread.

Well-cap­i­tal­ized banks are more likely to lend to the real econ­omy and less likely to in­dulge in ex­ces­sive risk-tak­ing that could threaten the sta­bil­ity of the fi­nan­cial sys­tem. This only strength­ens the case for a ro­bust cap­i­tal frame­work.

Prop­erly cal­i­brated and care­fully phased, the Basel III en­hance­ments of a floor on risk mod­els can help pre­vent ex­ces­sive vari­abil­ity in cap­i­tal out­comes and al­low for mean­ing­ful com­par­i­son across in­sti­tu­tions and coun­tries, while still per­mit­ting for risk sen­si­tive ap­proaches to take hold. The cap­i­tal floor is a linch­pin of this sys­tem.

To­bias Adrian is the Fi­nan­cial Coun­sel­lor and Di­rec­tor of the IMF's Mon­e­tary and Cap­i­tal Mar­kets De­part­ment.

Aditya Narain is Deputy Di­rec­tor in the IMF's Mon­e­tary and Cap­i­tal Mar­kets De­part­ment. Source: IMFDirect – the blog of the In­ter­na­tional Mon­e­tary Fund

Bank for In­ter­na­tional Set­tle­ment, Basel, Switzer­land

Newspapers in English

Newspapers from Nigeria

© PressReader. All rights reserved.