Capital Standards: Can 'Strong' Yet 'Simple' Peacefully Coexist?
The capital regulations proposed by the Bank for International Settlement's Basel Committee grow ever more intricate. From the original 1988 Basel I Accords1 to today's Basel III capital standards, complexity has grown to the point where some veteran bankers and their regulators may at times not always fully understand the rules, or the risk parameters and assumptions in a bank's asset portfolio.
In an effort to stem the tide of ever-increasing complexity, on July 8, 2013, the Basel Committee issued a Discussion Paper "The regulatory framework: balancing risk sensitivity, simplicity and comparability" to the public for comment.2 Comments are due Oct. 11, 2013, and internationally active banks should take advantage of the opportunity to advise the committee on the effect such complexity has had on their operations and compliance. This month's column will discuss major points of the discussion paper and the questions the Basel Committee is soliciting from commenters.
The financial crisis that began in 2008 caused the international banking regulators to see the shortcomings in the regulation of banks, and to introduce a range of reforms to strengthen the banks to make them more resilient and to be better able in the future to withstand the shocks to the financial system that hit during the recent financial crisis. In addition to the Basel III capital adequacy proposal,3 there were additional proposals that also were meant to shore up the system, among them, a capital surcharge on systemically significant banks,4 minimum liquidity requirements,5 a leverage ratio (a requirement familiar to U.S. banks but not to many banks headquartered outside the United States),6 and a new framework for measuring and controlling large exposures.7
The Basel Committee now has become concerned that pursuing the objective of strong risk sensitivity has led to another risk—an inability to reach an "appropriate balance between the complementary goals of risk sensitivity, simplicity and comparability."8
The Basel Committee in June 2012 established a task force to review the Basel Capital framework and develop recommendations aimed at achieving the aforementioned "balance." The Task Force on Simplicity and Comparability undertook this formidable task and submitted to the Basel Committee a report that provided a range of recommendations, which are set forth in the discussion paper. At this stage, the committee is not proposing adoption of any of these recommendations, it wants to first receive comments from the public, especially stakeholders such as banks, before deciding whether to proceed with any of the proposals for reform recommended by the task force.
In the Beginning
In order to set the context for the remainder of the discussion paper, the Basel Committee set out its definitions of simplicity, comparability and risk sensitivity.
Simplicity has two components: A capital standard is simple if it is clear, can be understood with reasonable effort by affected persons and is clearly expressed in straightforward language. A capital calculation process is simple if data is retrievable from the bank's current systems; the calculations do not require a large amount of data input; the calculation can be made without a need to use advanced mathematics and statistics; and the calculation can be easily verified by third parties such as regulators or auditors.
Comparability refers to being able to apply the capital standard to banks with identical risk portfolios and achieve the same result, which would change only when the underlying risks change. Conversely, banks with different risk profiles should reach capital calculations that accurately reflect the differences in risk.
Risk sensitivity has two components: a risk-sensitive standard that makes distinctions based on the characteristics of individual exposures or transactions, and a risk-sensitive standard that can differentiate in advance between risk profiles in order to distinguish those bank risk profiles tending to result in a more sound bank and those bank risk profiles tending to lead to failure.
While strengthening the capital requirements for banks, Basel III also added to the overall complexity of those requirements, which has led in part to problems of compliance for banks, and of effective supervision for regulators. Not every banker or regulator is well-versed in the intricacies of the advanced risk management analysis that is needed to understand the internal models of some of the world's largest banks. The Basel Committee has seen the consequences of such complexity and now sees that a "reasonable balance between simplicity and risk sensitivity" is critical to the success of the overall Basel capital framework.
Potential adverse consequences of the current complex Basel III framework raised in the discussion paper included the following.
• It has become more difficult for bank management to fully understand the regulatory regime.
• Banks face increasing challenges in capital planning.