Monday, December 5, 2016

Basel Chair Calls for More Research into Bank Risk Models

Author: David Schwartz J.D. CPA

In his December 2, 2016 keynote speech at the second Conference on Banking Development, Stability and Sustainability, Basel Committee Chairman Stefan Ingves invited the financial industry and academics to help better calibrate capital and liquidity standards. As the Committee finalizes Basel III, Ingves said that he welcomes research and rigorous analysis of how the Committee should think about the capital benefits of allowing banks to use internally modeled approaches to calibrate appropriate capital floors. While standardized modeling approaches have the benefit of being uniform and simple, they lack precision and may ignore real differences in risk among banks better addressed by internal models. Recognizing that “academic challenge…is an essential ingredient of a healthy financial and regulatory system,” Chairman Ingves says that the Basel Committee is eager to see research that answers questions like:


  • What are the pre-conditions for such models to produce better outcomes than, say, simpler standardized approaches? 
  • To whom do the benefits of improved modeling accrue?  For example, if a bank using a model can lower its capital requirements by, say, 30%, what are the financial stability and real economy benefits of such an approach? 
  • To what extent do the benefits of modeling accrue to lower-risk borrowers as opposed to the parties being compensated for developing and using the models?  

Ingves also wants academics and industry experts to look more closely at the potential costs versus benefits of using internal models in regulation to enhance banks’ risk management. In his speech, he pointed to a recent study that found that banks using internally modeled approaches for regulation were charging higher interest rates for loans relative to other banks while simultaneously applying lower risk weights for them. Ingves said that "this striking disconnect between banks’ internal risk management and their approach to prudential regulation merits further research."


Ingves also took some time to discuss the complexity associated with bank risk modeling. This complexity arises from banks’ and regulators' desire to measure risk with appropriate sensitivity. According to Ingves, the use of internal modeling pits the goal of risk sensitivity against simplicity and comparability.  


"The issue of complexity in the capital adequacy framework arises mainly from banks’ use of internal models, which itself stems from a desire for risk sensitivity. However, risk is multifaceted and far from straightforward to measure. While a risk-sensitive regulatory framework offers a number of benefits, the resulting complexity also has potentially adverse consequences. In addition, the framework has to produce outcomes that are comparable over time and across banks. The Committee is well aware of the need to strike this careful balance between risk sensitivity, simplicity and comparability.” 


Research demonstrates that complex rules often generate unintended consequences and are more difficult to enforce. On the other hand, simpler rules can be shown to produce more prudent and robust outcomes, and are more resilient in a changing market.  


"What does research tell us about this issue? Complex rules can result in a number of undesirable outcomes. First, they could undermine the ability of supervisors and banks’ own management in overseeing risks. Second, they restrict the ability of a wider set of stakeholders to contribute effectively to the policy development process. And they undermine banks’ own ability to effectively implement the rules– witness the number of reports and studies on the challenges for banks to develop the necessary systems and controls to implement the range of post-crisis reforms. It is perhaps not surprising that the Committee’s Principles for effective risk data aggregation and risk reporting is one of the most downloaded Basel Committee publications. Research has shown that simple rules can often produce more prudent and robust outcomes. For example, several studies have shown that the complexity of rules impact[s] the ability and effectiveness of overseeing them."


So, even as they finalize Basel III capital and liquidity standards over the next few months, Ingves and the Basel committee will continue to look to researchers and academics to provide their ongoing perspectives on the calibration of these standards. Ingves' openness to new work in this area is a positive sign that banking standards are not doomed to ossify, and that the Committee is ready and even eager to consider changes when properly supported by solid research.


The text of Mr. Ingves’ December 2, 2016 address is available via: