BIS paper on regulatory simplicity is well worth the read; hopefully this is a shape of things to come

The BIS has just released a very interesting discussion paper, “The regulatory framework: balancing risk sensitivity, simplicity and comparability”. It is a well-written piece that, while structured as a request for comments, it really feels like advocacy in favor of simplification of the Basel rules. We have some highlights and interpretation, but it is worth a detailed read.

The Basel system has evolved into a quagmire. For example, RWA calculations are not consistent across institutions, so it is impossible to make comparisons. Even looking at one bank over time is hard to do, as the RWA methodology one year won’t necessarily match the next. From the report,

“…permitting banks to estimate their own inputs into risk-weighted asset calculations provides an incentive to game the system – i.e. by underestimating risk with the aim of reducing risk-weighted assets…

Internal models are unique to an institution, creating a barrier to transparency.

“…Complexity associated with the use of internal models, significant choice in the modeling of risk parameters and national discretions have contributed to material variations in risk weighted assets across banks…”

Comparisons to other banks, much less those using a standardized approach, are next to impossible. So the BIS will give simplicity a try.

“…While the Committee has always regarded comparability as important (indeed, the rationale for regulatory disclosure requirements is to allow investors and other interested parties to compare banks), simplicity has, to date, not been recognised as an explicit objective…

According to the paper, simplicity “…has two dimensions: the simplicity of the capital standard itself, and the simplicity of the capital calculation process…”

“A capital standard is simple if it is clear and can be understood with reasonable effort. This requires:

  • Simple exposition: a simple standard is clearly expressed in straightforward language. It is easily explained to banks to which it is meant to apply, as well as to other groups with a legitimate interest, such as market analysts.
  • Simple interpretation: a simple standard is precise and unambiguous: it avoids imprecise terms that are capable of widely divergent interpretations.

A capital calculation process is simple if it requires:

  • Simple inputs: a simple standard does not require a large number of inputs and avoids reliance on inputs not captured within the normal accounting or risk management systems of banks (i.e., the inputs are subject to internal or external validation so the data called for is more readily accessible, better understood, and more reliable).
  • Simple calculations: a simple standard can be calculated without the need for the use of highly advanced mathematical and statistical concepts, avoids iterative calculations, and can be easily verified by external parties such as supervisors or auditors.”

The impact of “…undue complexity and reduced comparability in the capital framework could potentially include:

  • making it more difficult for bank management to understand the regulatory regime;
  • raising challenges in capital planning;
  • leading to less (or spuriously) accurate risk assessments;
  • creating regulatory gaps and opportunities for arbitrage;
  • undermine the ability of supervisors to effectively assess the capital adequacy of banks;
  • hindering effective review of the capital management process by supervisors;
  • making consistent, comparable implementation of standards more difficult to achieve; and
  • hampering stakeholders in their efforts to understand the risk profile of banks, thereby undermining market discipline

So what direction does the BIS want to go?

“…Possible examples of the suite of metrics that could be used to assess bank solvency include risk-based capital ratios, risk-weighted assets calculated under the standardised approach, capital ratios using market values of equity in the numerator, leverage ratios, risk measures derived from equity volatility, revenue-based leverage ratios (capital/revenue), historical profit volatility, price-to-book ratios, asset growth and the ratio of non-performing assets to total assets…”

The BIS looks at the leverage ratio as a simple, clean metric that does the trick.

“…The leverage ratio affords three important benefits within the capital adequacy regime: (i) it constrains the build-up of leverage in the banking sector, which the risk-based regime is not designed to supply, (ii) it reinforces the risk-based requirements with a simple non-risk based “backstop” that provides a floor to the outcome of risk-based capital requirements which provides a protection against model risk and the reduction of capital requirements via the optimistic use of models and parameters, and (iii) it represents a standardised measure that investors and counterparties can use to make comparisons between banks and over time. In addition, many academic studies have established that the leverage ratio is a statistically significant predictor of potential bank failure…”

The irony is, of course, that you can’t tell if a system isn’t going to work until it is too late. From the report, “…Risk is, of course, unobservable; hence, this type of risk sensitivity can only be accurately assessed ex post…”

A link to the paper is here.

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