Lionel tells us about BASEL III

July 8th, 2016

What changes did BASEL III bring? What are its limits?

Basel III is an answer (with main focus a significant increase in equity capital) to the various issues observed during the subprime crisis: liquidity and solvency crisis and the lack of equity capital.

Several assessments have been made since 2008:

  • The size of the Banks’ Trading Book has increased significantly, there are so far no sufficiently precise rules to indicate whether an instrument should be allocated to the Banking Book or the Trading Book. Banks take advantage of this situation to make arbitration and thus reduce artificially the costs of their risks..
  • The quantification of risk in banks is very heterogeneous and often minimizes the risks caused by extreme market shocks. Moreover, if internal models enable banks to optimize their resources in equity capital, their diversity makes it difficult to compare banks with each other.
  • The data quality currently used in banks to enable good risk estimations is called into question.
  • The quantification and risk management on credit derivatives should be reconsidered even if there have been improvements since Basel 2.5.
  • Interest rate risk was not taken into account in the risk management measures in the Banking Book.
Lionel Kaman Interview Quanteam

The new Basel publications try to provide answers to each of the point mentioned above.
Nowadays, many critics are emerging from financial institutions with regard to the proposed reforms: they denounce in particular the excessive and inappropriate requirements that will weigh on the core business of banks and thus on the credit cost. The leverage ratio is also reconsidered because it is considered as unsuitable and useless since it is not linked to risk.

 

How do you see the evolution?

In the following years, the use of internal models will be more restrictive; from now on, standard bank models will be more sophisticated and more risk-sensitive.
If a bank uses an internal model, it will still have to estimate its risk as a standard model in order to be more easily comparable to the other banks.
Standard and/or internal models of market risk calculations (which are covered by the most successful works, are known mainly as FRTB), counterpart risks, credit risk and operational risks will be improved, which will have huge impact on risks models. Theses texts will provoke important changes in the business model of banks and in the organization of their teams. It will be therefore necessary to anticipate harsh impacts in terms of IT infrastructure and data management.

 

What will change FRTB?

FRTB imposes a new definition of the steering of market activities that makes a break with the current practices. This can be seen by: 

  • An increase in the capital charge;
  • A standard model in control of the internal model;
  • An important effort to produce and validate indicators;
  • A Result/Risk alignment;
  • An improved and supervised data quality;
  • The inflation of the computing load and an increased need for storage


In the medium terms, what will be the future challenges for banks, in terms of equity capital requirement?

Since the subprime crisis, the financial system suffers from regulatory inflation both in the context of the Banking Union at the European level and in the Basel III international banking framework.
In this depressed economic context, financial institutions have reacted in strengthening their financial base in terms of risk-weighted capital and solvency rates to the detriment of their core businesses.

Regulatory inflation usually hinders medium and long-term financing of the economy. The respect of liquidity ratios (LCR and NSFR) implies to shorten the maturity of the financial assets or to increase their cost for customers. As for the solvency ratio, it is extremely expensive, especially for SIFIs (Systemical Important Financial Institutions). All of these regulatory changes will have a negative impact on customers, who, for some types of transaction, exclusively rely on bank financing. If each regulatory measure, considered individually, often provides an appropriate response with regards to financial stability, the various constraints imposed by the regulator and the states interfere with each other. Their accumulation without a global vision is not without risk for t the financing of the economic activity.

Given the slow recovery of the economic activity at a global level, we will witness in the following years a stability of the rules (“regulatory break”). This stabilization would mean that there will be no significant increase in the overall equity capital requirement applied to banks.

 


Therefore, is it too early to talk about a potential BASEL IV?

From the important changes to come: the review of standard methods, those of internal models and the classification of the whole.  No new concept is introduced. It is therefore logical to believe that all projects undertaken aim to ensure a better comparability of internal models, and thus, their best credibility and not to substantially increase the overall capital requirements. So, it is too early to talk about an upcoming BASEL IV agreement.

 

Lionel KAMAN – Expert Consultant in Credit Risk.