1 Implementing Basel II: Is the Game Worth the Candle? Richard J. Herring Director of the Lauder Institute Co-Director, The Wharton Financial Institutions.

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Implementing Basel II: Implementing Basel II: Is the Game Worth the Candle?Is the Game Worth the Candle?

Richard J. Herring

Director of the Lauder Institute

Co-Director, The Wharton Financial Institutions Center

The Future of Banking RegulationLondon School of Economics

April 7-8, 2005

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Basel II Attempts to Reconcile a Number Basel II Attempts to Reconcile a Number of Irreconcilable Objectivesof Irreconcilable Objectives

Increasing the safety of the banking system without changing overall level of capital in banking system

Increasing risk-sensitivity of capital requirements without exacerbating pro-cyclicality of lending

Providing incentives for adoption of more sophisticated techniques while maintaining a level playing field

Recognizing responsibilities of host country supervisors without multiplying compliance costs

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Concern that Banks Found Ways Concern that Banks Found Ways to Undermine Basel Ito Undermine Basel I

Increase exposure to risk without increasing risk-adjusted asset denominator– Shifting allocation from AAA to BB– Loan sales– Securitization

Increasing exposures to non-credit risks Increase numerator without increasing economic Increase numerator without increasing economic

capitalcapital– Gains tradingGains trading– EvergreeningEvergreening

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Basel I Lacked Incentives for Banks Basel I Lacked Incentives for Banks to Adopt Advances in Risk to Adopt Advances in Risk

ManagementManagementEconomic capital became industry standard for

measuring and managing risk– Amount of equity capital a bank requires to provide a

given level of protection against default to its creditors against unexpected loss

– Operationally expressed as a target rating for its long term debt

VaR (or RAROC) revolution in trading rooms extended to loan portfolio– Better risk taking decisions– Better distribution of risk

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Despite Lack of Incentives, Basel 1 Saw Despite Lack of Incentives, Basel 1 Saw Tremendous Advances in Risk ManagementTremendous Advances in Risk Management

Why?– Perhaps facilitated by low costs of compliance under

Basel I– Began in North America soon after Prompt-Corrective

Action Least-Cost Resolution reforms increased market discipline

– Banks responded to market demands not regulatory commands

Presumption that banks must be rewarded for improving risk management complicates Basel II

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Internal Models Approach to Market RiskInternal Models Approach to Market Risk

1996 Amendment on Market Risk permitted qualifying banks to rely on supervised use of their own internal models to determine capital charge– Diminished incentives for regulatory capital arbitrage

because capital charge reflect bank’s own estimate of risk

– Accommodated financial innovations readily– Provided an incentive for banks to improve their risk

management processes and procedures to qualify for the internal models approach

– Reduced compliance costs since regulated in the same way managed

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Boundary between Credit Risk and Boundary between Credit Risk and Market Risk Increasingly BlurredMarket Risk Increasingly Blurred

Traders increasingly deal with less liquid, less creditworthy instruments.

The market for bank loans is becoming more liquid.

The market in credit derivatives is booming.

External stakeholders press to consolidate accountability for risk management.

Why not extend the internal models approach to credit risk?

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The holy grail of risk management: The holy grail of risk management: probability density function of lossesprobability density function of losses

Percentage Losses

Pro

ba

bili

ty

Probability Density Function of Losses Expressed as a Percentage of Total Assets

Allocated Economic Capital (BB rated)

Allocated Economic Capital (A rated)

Expected Loss Maximum Sustainable Loss (BB rated)

Maximum Sustainable Loss (A rated)

Target Probability of Insolvency (BB rated)

Target Probability of Insolvency (A rated)

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Problems with full model approachProblems with full model approachConceptual differences in measuring credit lossesData limitations in modeling credit risk

– Estimation problems– Model validation problems

Inability to deal with low frequency, high severity hazards — the main source of systemic risk

And so Basel II developed a very complex internal ratings based approach and a regulatory model

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Basel II Aims to Basel II Aims to

Eliminate incentives for regulatory capital arbitrage by getting risk weights right, even at the cost of enormous complexity

Provide banks with incentives to enhance risk measurement and management capabilities

Extend risk assessment to operational and interest rate risks

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What won’t changeWhat won’t changeThe definition of Tier 1 and Tier 2

capital– Tier 2 can be no more that 100% of

Tier 1

Minimum ratio of capital to risk-weighted assets remains 8%

Focus on accounting data, not market values

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Lack of Attention to the Numerator Lack of Attention to the Numerator Undermines Logic of the ApproachUndermines Logic of the Approach

Enormous attention to refining risk weights to replicate economic capital as closely as possible– E.g. debate last year over including “expected loss”

Then judge “adequacy” in comparison with numerator that is emphatically not an institution’s capacity to bear unexpected loss– Includes debt, hybrid instruments, some reserves, and a

number of idiosyncratic, country-specific items

– Based on accounting values, not market values

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Pillar 1 is responsible for most of the Pillar 1 is responsible for most of the complexity and compliance costscomplexity and compliance costs

Capital charges for credit risk– Standardized Approach

– Internal Ratings Based Approaches• Foundation IRB

• Advanced IRB

For most banks, capital charges for credit risk are likely to decline

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But what the Basel Committee giveth, But what the Basel Committee giveth, it taketh away (on average)it taketh away (on average)

New capital charge for operational risk calibrated to offset the reduction in the capital charge for credit risk on average

Capital charges for operational risk– Basic Indicator Approach– Standardized Approach– Advanced Measurement Approaches

Overall adjustments through “single scaling factor”

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A New Regulatory Burden for Some A New Regulatory Burden for Some Specialized InstitutionsSpecialized Institutions

A particular burden where specialist banks compete with nonbanks– Only 10 of the top 30 asset managers are banks– 5 of the top 9 transfer agents in the US are

banksMay lead to exits from some lines of

businessMay lead to acquisitions of specialists by

diversified institutions

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Compliance Costs are likely to be Compliance Costs are likely to be Heavier than IntendedHeavier than Intended

1. Costs to banks

2. Costs to supervisors

3. Costs to economic stability

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Costs to banksCosts to banksDeveloping, validating and maintaining regulatory

models as well as internal models– Complex international negotiations will inevitably lag

innovations in risk management– Already lags behind best practice– Leading banks will need to run separate systems for

regulatory capital and economic capital– Inevitably will reduce resources available for modeling

economic capitalCosts of regulatory-induced diversions from

preferred strategy if regulatory capital requirements were consistent with economic capital models– Eg., too much credit for residential mortgages, too little

emphasis on diversification, etc.

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Costs to Banks (cont’d)Costs to Banks (cont’d)For international banks, dealing with multiple

regulators, multiple regulatory models, validation processes, supervisory procedures and disclosure requirements– In principle, both PD and LGD will vary differences in legal

infrastructure across countries– Prospect of different reports to home and host

Incentives create competitive disadvantages for banks who adopt less sophisticated approaches to credit and operational risk– Level playing field objective rests uneasily alongside

incentives for banks to qualify for the most advanced approaches

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Costs to SupervisorsCosts to SupervisorsStaffing to monitor and evaluate models

– Risk that a “black box” model or even a good model fit to bad data (or an insufficient span of data) may lead to disaster

Monitoring compliance with multiple requirements and preventing cherry-picking

Dealing with home/host issues for international banks under all 3 Pillars– If home country, evaluating models used at foreign

branches– If host country, sharing meaningfully in oversight

• Particularly difficult if branch is “systemically important” in host country

• Nightmare case: small in home country, systemically important in host

• Scandinavian “exceptionalism”?

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Costs to Supervisors (cont’d)Costs to Supervisors (cont’d)

Assuming greater responsibility for outcomes, with certification of models– Relaxation of market discipline can increase

burdens on supervisory authorities

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Costs to the economyCosts to the economy Intensification of business cycles with capital

requirements likely to rise precisely as capital resources fall

Misallocation of resources to the extent that binding capital requirements diverge from economic capital

Reliance on officially-sanctioned regulatory models weakens corporate governance and market discipline & increases moral hazard– May increase likelihood of herd behavior

Deadweight costs of compliance that do not produce higher levels of safety

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Are there sufficient, Are there sufficient, offsetting benefits?offsetting benefits?