Technocrats vs Politicians Round 1...

The world of bank regulation is being torn between two very different agendas. First, the technocrats of Basel, as they struggle to put in place amendments to the comprehensive version (June 2006) that has formed the bedrock of much market and credit risk management thinking for the past few years. BIS has introduced a host of new consultative documents, subject to ratification, that promise significant increases in the levels of regulatory capital and liquidity particularly for the trading book. Initiatives like the stress var calculation, the calculation of an incremental risk capital charge for users of internal models for specific risk, counterparty credit risk capital increases, the Liquidity Coverage Ratio, the Net Stable Funding Ratio and the Leverage Ratio, all proffer band aids to weaknesses in the original accord. The danger is that the technocrats responding to real issues in the original accord lose the "high ground" and surrender the two principles that made Basel II such an innovation - capital is alligned with risk, and the better the job we do of measuring risk the lower the capital charge. Unfortunately the "band aid" approach understandable as it is, risks making an already highly complex set of regulations, conflicting, opaque and even more open to the regulatory arbitrage that brought down its predecessor - Basel I.

So not surprising therefore is the new found emphasis on the agenda of the second group of actors in this drama - the politicians. They are reacting to market and economic crisis, and selling their approaches to an angry and impatient tax paying public. Here initiatives are basically four fold. In the US, a raft of initiatives have been proposed by the Obama government, in general limiting the scope and the size of federally insured bank activities. The real challenge of all these initiatives is of course congress, where well funded lobbyists may easily derail the worst vicissitude of the proposals. The UK has taken a different approach, experimenting with macro prudential regulation an structural regulatory change, but they face two different challenges - increasing regulation yet not killing the Golden Goose of the City that sustains a sizable chunk of the UK economy. Added to which is the upcoming election which may endanger any initiative. The EU has been hamstrung by government deficits in certain member countries and has revealed just how hard it is get cross the board agreement in such national sensitive economic issues. Finally enter the G20 and the IMF, frustrated at the lack of regulatory changes a full year after the crisis, has argued for the simplest, but possibly most destructive approach of all, bank taxes based on the size of liabilities.

So whose constraints will determine the future of banking for the next ten years? I vote for the politicians - but it will further push financial innovation to the east and away from established financial centers.

Basel 3 = Basel 1.8? And is this a bad thing?

The proposed and partly ratified changes imposed on the Basel II accord have certainly exercised the minds of bankers (and a surprising number of others) over the last year. But are they really a major change? Do they reflect any change of philosophy? Or are they actually a step backwards away from some of the basic assumptions of Basel II. I believe that these widely touted Basel 3 requirements are better understood as a partial rollback of the original accord.

The basic concept of the Basel accord is the better alignment of capital with institutional risk as measured by extreme percentiles of the distribution of portfolio value. A couple of points come out of this:

• Banks should operate on a consistent global playing field.

• Market values are good measures of asset values

• More sophisticated approaches to risk measurement should be rewarded with lower capital

• Avoid double counting of Risk and incorporate where robust correlation effects

• Limit the extent of ad hoc regulatory supervision.

• Quantitative measures are better than qualitative ones


In some ways the new adjustments are consistent with that philosophy. For example, the introduction of an Incremental risk capital calculation to capture credit risk in the trading book. This is very much in line with the concepts of IRB and IMM, indeed is almost an integration of them both – which incidentally is why it will be difficult to implement. Similarly, macroprudential risk is an extension of scope of the Basel II accord to consider the entire system rather than one element within the system. So too the changes to the definitions of capital – the removal of T3 capital, the more precise use of equity in T1.



But I believe the bulk of the modifications run counter to the underlying philosophy of Basel. For example, the double counting of risk under Stress VaR and the general VaR calculations, the double counting of IRC and the specific market risk capital models. The use of simple Leverage and liquidity ratios as an additional constraint on banks to reign in lending may be more binding on many banks than the capital requirement. The use of liquidity adjustments to valuation clearly notes the limitations of market prices as measures of asset value. The introduction of a range of additional liquidity metrics that will be incorporated into regulatory judgments on appropriate bank liquidity levels.



Is this a bad thing? Should we be concerned that Basel III is moving away from the original philosophy of Basel. Yes and No.

Yes, in so far as the original philosophy was valid, no in so far as it was not. It seems to me that we definitely should be concerned about double counting and the introduction of ad hoc rules that leave much to the judgment of individual regulators – this definitely casts doubt on the Basel project – the imposition of a consistent playing field.

No – we should not be concerned about these amendments in that they reflect true weaknesses of the original accord – the lack of attention they gave to liquidity risk, downplaying of counterparty credit risk in the trading book (which to be fair was less of a concern when the accord was drafted), the inevitable procyclicality of any risk based capital measure. It is indeed the last of these that is probably the most important. Regulators like the rest of us, live in a real world, with banks that affect the real economy. Reality has a bad habit of forcing us to compromise theoretical ideals with the practical effects of those ideals. A major overhaul of Basel that dramatically increased capital requirements (as for example the imposition of countercyclical capital buffers) could jeopardize the very recovery it was design to forestall. And that would be far too big a price to pay for Basel III.

So after all is said and done, perhaps the new amendments do look less like Basel 3 and more like Basel 1.8?

What is Basel III?

The raft of documents produced by the regulators across the world has certainly added to the noise and confusion that the credit crisis has left in its wake. The Basel Committee on Banking Supervision (BCBS) has developed its recommendations to G20 institutions, realizing that radical changes in the regulatory regime could endanger the still fragile recovery after the crisis. So torn between a radical overhaul, and a fear of rocking the already rocky boat, they have produced three major documents:

BCBS 159: The first (BCBS 159) has been ratified by the G20 countries and will be implemented by the end of 2010 in most countries. BCBS 159 focuses on amending the internal models methods (IMM) associated with market risk in the trading book. It requires the introduction of Stress VaR capital calculations in addition to the existing general market var capital calculation. It also requires for international banks implementing internal models for specific risk the additional assignment of Incremental Risk Capital (IRC) – capturing default risk, credit migration risk, credit spread risk in the trading book using similar techniques to those found in the banking book (IRB) – for example, it uses a more conservative confidence interval (99.9%) and a longer time horizon (1 year)

BCBS 164: This has been proposed but not yet ratified. It imposes changes on capital (more focus on Tier 1 capital in general and equity in particular), yet more changes to counterparty credit risk capital in the trading book (above those required in BCBS 159), the imposition of countercyclical buffers and a general leverage ratio constraint. More interestingly it requires the development of macroprudential risk management that go beyond micro prudential risk management (focusing on the risks of particular institutions) and instead looks at the systemic risks of the entire network of institutions as part of a global economy.

BCBS 165: Like BCBS 164, this has yet to be ratified but focuses on the need to implement specific metrics for liquidity risk, a short term 30 day minimum liquidity coverage ratio to handle a major stress scenario, a long term 1 year net stable funding ratio to define a minimum stable funding requirement and finally a set of standard liquidity metrics that all regulators will take into account when evaluating the health of a banking institution.

On Basel III and the difficulty of self regulation

With the so-called Basel III regulations, the G20 central banks are looking to upgrade the Basel II accord in the light of the crisis of the last two years. One of the biggest outstanding issues, is the risk weights assigned to sovereign debt, which remains more or less as before. The risk weights for sovereign debt denominated in foreign currency is based on the sovereign credit rating: AAA to AA (0 per cent risk weight), A+ to A- (20 per cent risk weight), BBB+ to BBB- (50 per cent risk weight); and BB+ to B- (100 per cent risk weight).


Now given that

1) credit ratings are no longer the touchstone of fiscal probity they once were and

2) the central banks are themselves looking to raise capital in the global markets, so lower risk weights make that debt more attractive, and

3) it looks like the world will soon be faced with an impending sovereign debt crisis as government deficits become less and less sustainable.

Does this really make sense that Basel III facilitates the governments funding quite so (L)iberally?