Beware regulators bearing gifts

Basel IV is supposed to level the playing field on risk modelling, but many fear it will prove extremely costly and restrict lending.

The indication by the Basel Committee on Banking Supervision (BCBS) that it will deliver its proposed regulatory reforms regarding capital reserves by the end of 2016 must be near the top of the list of unwanted Christmas gifts for many banks.

Dubbed “Basel IV”, the reforms would aim to simplify the regulation around capital reserves, improve comparability and address variability in the capital requirements for credit risk.

This “variability” has come about because, under Basel II guidelines, some banks were allowed to use their own risk parameters – known as internal ratings-based approaches – to calculate regulatory capital. These banks were effectively the chosen ones, deemed to have met certain minimum conditions, including disclosure requirements, by national supervisors. All other banks were subjected to so-called ‘standardised’ approaches.

Perhaps unsurprisingly, this appears not to have resulted in a level playing field. Banks following the standard approach have long argued that the so-called “advanced” banks have been using their IRB models to price debt aggressively and give them a competitive advantage.

The BCBS appears receptive to this claim – proposing to remove the use of IRB approaches for certain exposures. The committee has speculated that there may be cases where the IRB models are simply not reliable enough. Furthermore, even where IRB modelling is still allowed, it would be made subject to a “floor” to try to ensure a minimum level of conservatism.

However, this planned toughening of global rules has led to a backlash. On 31 August, the European Banking Federation, Japanese Bankers Association and Canadian Bankers Association signed a letter to the BCBS saying the proposals would “significantly increase capital requirements” and further limit banks’ ability to lend. The EBF has claimed the changes could result in European banks needing to raise an additional €850 billion in capital.

There are also concerns that the proposals may lead to unintended consequences. In an article on Deutsche Bank’s website, the bank’s chief regulatory officer, Sylvie Matherat, argues that exposures with the same name – “mortgage” or “trade finance facility”, for example – may obscure very different levels of risk; but such distinctions are not made by standardised modelling. She goes on to contend that the proposals mean banks will not have to possess more capital for high-risk businesses than low-risk ones – making riskier business more attractive.

This is a view backed by a report out this week from Standard & Poor’s, which predicts that full Basel IV implementation would likely result in an “increase in the amount of capital allocated to lower risk-weight portfolios … in turn, this could cause a migration in banks’ risk appetites to higher-risk assets”.

The season of goodwill may be upon us, but members of the Basel Committee may find themselves being struck off some Christmas card lists as the banks ponder a potentially expensive and uncertain new year.

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