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Typical. You wait ages for one examination of the reliability of the IRB approach to own funds requirements to come along and then two appear at the same time.
Just as the Basel Committee on Banking Supervision (BCBS) has become bogged down in the political and market backlash against its Basel IV capital floors proposal, the ECB’s targeted review of internal models (TRIM), which is due to start in April, has hoved into view and stolen the limelight.
Basel IV and TRIM have the same objective: to restore the credibility of internal models used by banks. They go about this in different ways. TRIM targets the models themselves while Basel IV’s capital floors target their outputs.
There are merits to both approaches, but what is clear is that TRIM renders Basel IV redundant. As far as the BCBS is concerned, therefore, TRIM could not have come at a worse time.
What TRIM is not is a surprise – contract bids for consultants to work on the project were first put out in 2015. It has been part of the regulatory debate for almost as long as Basel IV has. It is a huge project that will consume 15% of the Single Supervisory Mechanism (SSM)’s resources.
Danièle Nouy, chair of the ECB’s supervisory board, has described it as one of the bank’s key priorities for 2017, involving as it does 68 banks in 15 different countries. It will look at the treatment of credit, market and counterparty risk in internal models to reduce variability of results and restore credibility and comparability.
Global regulation works as a set of compromises and might be a luxury that, in the current political climate, the industry can’t afford
Typical areas of disparity include the treatment of defaulted assets, permanent partial use and roll out of the standardized approach, the definition of default and default rate, the probability of default calibration, loss-given-default calibration and low default portfolio specifics.
Ninety people are already involved in the project, a figure that will rise to 800 over this year, including national supervisors and consultants. TRIM will also be a huge resource drain on the banks as they are required to provide data and host the examining teams for up to three months at a time.
This has been brewing for a long time. European banks using the IRB approach, particularly those with large derivative and level 3 asset exposures, have long been accused of massaging the numbers by some of their US counterparts.
TRIM reflects part of the transatlantic stand-off around IRB models: the Basel view is that if risk-weighted asset (RWA) models have lost credibility then ignore the models and rely on the leverage ratio to neutralize the impact of their variability. The ECB view is: get better models.
The root of the problem is the fundamental flaw with Basel II: it was meant to be risk sensitive but provided no objective definition of risk. Should banks be trusted to measure risk or is risk unmeasurable? If it is, then what you are measuring is uncertainty.
The SSM is viewed as a strong regulator by the market so TRIM gives the European IRB oversight process greater credibility, but even though it plans more than 100 missions in 2017, it might be wildly optimistic to expect this project to be done and dusted by 2019.
Given the scale of the challenge – large international banks can be operating with more than 50 internal models – it is more likely to turn into a permanent and ongoing model review process. The regulator also launched a new round of stress tests for all 110 banks under its supervision to gauge their sensitivity to interest-rate shocks.
Unwarranted variability
The aim of TRIM is not for all banks to end up with the same models. The industry needs variability. What TRIM is trying to get rid of is unwarranted variability. Banks will have to justify their modelling to the regulators to explain variability that appears unwarranted. It will be up to the SSM to make sure they cannot game the system.
If a strong and professional supervisor now ensures a harmonized approach to IRB in Europe then the need for capital floors under Basel IV disappears. This plays to the deglobalization theme within bank regulation: the idea that in future global banks will all operate as a network of regionally supervised organizations is becoming ever more real.
Global regulation works as a set of compromises and might be a luxury that, in the current political climate, the industry can’t afford.
US congressman Patrick McHenry, vice-chairman of the House Financial Services Committee, has called for the US to halt discussions on Basel IV until the Trump administration finalizes its position. It will be enormously difficult for the BCBS to finalize the Basel rules if that happens.
The market expects some word on Basel IV by June, and it seems more than coincidence that the ECB is throwing enormous resources at TRIM at the same time. The two approaches are in direct conflict: if Basel IV decrees a capital floor of, for example, 60% of the standardized approach for certain RWAs, but TRIM determines a lower level is correct for those same RWAs, what happens then?
The ECB does not like Basel IV, and if it can show more robust oversight of the IRB process then it weakens the Basel Committee’s case for capital floors. However, if the pushback against global rules gathers momentum and the Basel Committee’s relevance starts to be questioned, it is unlikely to go down without a flight.
There could, nevertheless, be a degree of institutional determinism setting in to its deliberations and the sooner they are finished the better it will be for the banks. By setting up a seemingly deliberate timing conflict between the two approaches the ECB has thrown down the gauntlet.
The BCBS could press on regardless, or it could quietly drop the idea of capital floors by devolving the decision on output floors under Basel IV to local regulators.
How this stand-off plays out could be an interesting demonstration of how much impact the verbal pushback against global rules – particularly in the US – is having on the ground.
The aim of a global level playing field in bank capital might now simply be unachievable, but the balkanization being called for on both sides of the Atlantic can only harm global capital flows and make life more expensive for everyone.
