Wednesday, November 4, 2015

Basel Tightens the Reins on Internal Risk Modeling by Banks

Author: David Schwartz J.D. CPA

In a November 2, 2015 speech in Madrid,  Stefan Ingves, Chairman of the Basel Committee and Governor of Sveriges Riksbank,  announced that the Basel Committee on Banking Supervision will revisit internal risk modeling by banks. According to Mr. Ingves, "ample evidence has accumulated to suggest that the current role of internal models in the regulatory framework does not strike the right balance between simplicity, comparability and risk sensitivity."  While "the use of internally modelled approaches was a defining feature of Basel II," the Basel Committee expects to revisit this reliance on internal modeling and, perhaps, broadly eliminate it for some risk categories.

Because of the Committee's concerns about the reliability and robustness of internal bank models, the Committee plans to publish new proposals "around the end of the year."  In some cases, the proposals will remove internally modelled approaches for some risk assessments. 

The Basel III framework imposes multiple regulatory constraints that  compliment one another, rather than relying solely on the risk-weighted capital ratio. Under current rules, in addition to calculating risk-weighted ratios, banks must also  comply with a leverage ratio, limits to large exposures, and metrics for minimum levels of liquidity.  According to  Mr. Ingves, "Having in place multiple regulatory constraints provides more safeguards against the risk of a defect in any single element of the framework." This system of multiple metrics has also made it harder for banks to game capital rules for their own benefit.  Limiting the extent to which banks may use internal risk modeling will further prevent banks from tipping the scales in their favor.  

Mr. Ivges promised that details of new proposals in these areas "will come in due course."