The Institute of International Finance has recently spoken out against the the Basel Committee on Banking Supervision's regulatory proposals aimed at curbing banks' use of internal models to assess risks. While regulators have sought a simpler and more consistently applied approach to risk treatments, the IIF claims that this proposal swings too far in the direction of simplicity and could potentially slow the global economy.
"The IFF warned that the proposals in their current form could severely 'understate risk.'"
'A material impact'
In a June 6 letter sent to the Basel Committee and posted publicly on their website, the IIF asserted that, while they were "fully supportive" of efforts to reduce risk-weighted asset variance, they stressed the importance of banks being able to make a risk calculation based on proprietary data and internal models.
"Our primary concern with the committee's proposals is less about models, and more about the bluntness of the approach that the committee proposes to replace these with," wrote the IIF's regulatory affairs chief Andres Portilla. The IIF cautioned that the regulation could have a "material impact" on the backs affected and made proposed modifications to the Basel's regulations, including:
- A more granular and risk-sensitive version of the BCBS's bucketed proposals for the banks, financial institutions and specialized lending asset classes.
- Greater use of pooled data across institutions, in the sectors where this can help to overcome the low data challenge, backed by specific guidelines.
- More stringent standards for modeling corporate exposures, with some important amendments to the Committee's proposals that would help to mitigate the negative downstream impacts.
- Some targeted adjustments to the Committee's proposed parameter floors.
- An additional series of specific and more technical enhancements to models that would help to reduce RWA variance, building on the previous work of the IIF RWA Task Force.
The IIF warned that the proposals in their current form could "understate risk on the best credits but overstate it on the weakest." This, according to Brad Carr, Deputy Director in Regulatory Affairs at the IIF, underscores the role RWA plays in the daily operational calculations of many banks.
"Credit risk is probably 80 percent of risk weighted assets for most banks," Carr told Financial Times. "This will have a very significant impact on credit risk."
"The new Basel approach rewards higher-risk, high-yield segments."
While supporters of the Basel Committees' proposal cite examples of lenders at the height of the global financial crisis using internal models to justify carrying insufficient capital to mitigate against proper risk, experts like Anat Admati, a professor of finance and economics at the Stanford Graduate School of Business, say that Basel is taking the wrong lesson from the crisis.
"The lesson from the financial crisis was not that we need more risk sensitivity of capital requirements, but rather that the Basel approach had failed by allowing banks to operate at dangerously low equity levels through both inadequate requirements and through the complex risk-weighting approach that encouraged 'innovations,' created more distortions and increased systemic risk," Admati told Bloomberg. This cuts to the core of much of the criticism of Basel as attacking RWA variance but not being willing to mandate increased capital requirements.
"They continue to tolerate dangerous indebtedness and maintain the flawed approach to risk calibration," added Admati. This seems to support the IIF's assertion that the new Basel standardized approach rewards higher-risk, high-yield segments, incentivizing the type of risky lending that caused the crisis in the first place.
The Basel Committee said it would accept comments on the credit-risk proposal until June 24 and the IIF's letter was published in advance of a two-day Basel Committee meeting. It remains to be seen whether or not Basel will heel the IFF's advice.