Finance Watch believes, however, that such incremental improvements will not remedy the fundamental shortcomings of the risk based capital adequacy framework. The shortcomings of internal risk models have been documented extensively and we believe that the marginal benefit of relying on these models for the purposes of risk management declines even more rapidly with size and complexity. Moreover, the parallelism of standardised and internal ratings-based approaches provides banks with ample opportunities for regulatory arbitrage.
Finance Watch maintains that the regulatory framework should not be reliant on RWA as the principal Pillar 1 indicator of capital. To achieve a robust and balanced capital adequacy regime the Leverage Ratio should be adopted as a primary benchmark, not as a ‘backstop’ or ‘supplementary measure’.
- The Basel III framework still provides for three different approaches to measuring and reporting risk: the Standardised Approach and two versions of the Internal Ratings Based (IRB) Approach, Foundation and Advanced. Finance Watch proposes a cost-benefit assessment of the need for this proliferation of standards and, in particular, for a dual-track IRB framework. In the interest of removing excessive complexity and restoring a level playing field, Foundation and Advanced IRB could be merged into a single IRB standard.
- Banks should not be allowed to apply different approaches (Standardised, Foundation or Advanced IRB) for different asset classes over extended periods of time, one of the more egregious examples of regulatory arbitrage. The length of IRB roll-out periods should be subject to a regulatory maximum and banks opting for the IRB approach should be obliged to apply this method for all asset classes where it is available. The provisions of the Basel framework governing the ‘permanent partial use’ of the Standardised Approach for certain asset classes should be reviewed accordingly.
- The proposed simplifications of the treatment of credit risk on low-default exposures are constructive but appear to stop short of the target. The classification of ‘large corporates’ for the purposes of credit risk assessment should be aligned with the definitions of other exposure classes, notably SMEs and Retail. The treatment of sovereign exposures, which continue to represent a major item on many banks’ balance sheets, should also be reviewed accordingly.
- The use of VaR modelling for regulatory risk assessment purposes should be re-evaluated in view of its inherent flaws, which have been exposed in the course of the financial crisis, most notably its failure to account for low probability / high-impact risks. Moreover VaR modelling is known for distorting incentives for market participants and encouraging excessive leverage.
For further questions, please contact Christian M. Stiefmueller, senior policy analyst at Finance Watch.