Basel floors must be below 75% to preserve models, banks say

Risk managers warn that planned system of capital floors could prompt banks to ditch models – a 25% saving is cited by four as the smallest effective incentive

BIS headquarters, home of the Basel Committee

Banks will stop modelling their regulatory capital requirements if they generate less than a one-quarter saving on the standardised alternatives, risk managers predict – a response to the Basel Committee on Banking Supervision's plans to floor modelled capital at some percentage of the standardised formulas for credit, market and operational risk.

Four bank risk managers shared estimates with Risk on where they believe the floor will be set. Although suggestions began as low as 10%, they all agreed a 75% floor would be too high and could prompt banks to abandon their capital models. The Basel Committee last month launched a consultation on the use of standardised floors, intended to prevent a bank's capital falling below a certain level and to enhance comparability within the industry. The document discusses the design of the framework, but does not address the issue of calibration.

"A meaningful floor would be 50% of the standardised rule's capital. What I would call a tight and very expensive floor would be in the region of 70% or 75%. Above that, I think internal models will die," says one risk manager at a European bank.

The London-based global head of risk at an international bank says he is hoping for a far lower 10% baseline. The one existing example of a modelled floor expressed as a percentage of its standardised alternative is the comprehensive risk measure (CRM), which covers correlation trading exposures and is set at 8%.

"My gut feeling is that around 75% is too high. I would be happy with 10%, which is not too far above the CRM model in Basel 2.5. Banks need something that provides sufficient incentive. If it's 75% you may find that in practice it's easy to have the floor become binding and all of a sudden you have a problem," he says.

A tight and very expensive floor would be in the region of 70% or 75%. Above that, I think internal models will die

Banks have been allowed to use internal models for the calculation of trading book capital since 1996, subject to approval from supervisors, and since the mid-2000s for credit and operational risk. After unprecedented trading losses during the first phase of the financial crisis – and enormous settlements and fines in more recent years – regulators have been trying to boost both the amount and quality of the capital banks have to hold. In addition, analysts have revealed wide disparities in capital between banks that have apparently similar exposures. Floors are seen as part of the solution to both problems.

Risk managers welcome the move in principle, but fear the practical implications if businesses are often caught by the standardised approaches, which generally use a handful of simple inputs and apply a regulator-set multiplier or simple formula, making them less granular and less sensitive to risk.

"If I take a conservative view, this could overrule our internal models in some cases," says Louise Lindgren, chief risk officer at Länsförsäkringar Bank in Stockholm. "Today, we have scoring systems that look into every customer's ability to repay, dependent on many different factors. With a standardised approach, it's no longer of interest how my customers are scored – the only things that matter are loan-to-value and debt-service coverage ratios. A standardised method can never be as granular." Lindgren agreed that a threshold above 70% would hurt the modelled approach.

The past two years have seen the Basel Committee run comparative studies of bank risk-weighted assets (RWAs) – the number against which capital is charged. They asked a sample group of banks to calculate RWAs for an identical portfolio, revealing huge gaps between the participants.

Last year, Daniel Tarrullo, a member of the Board of Governors of the Federal Reserve System, called for the removal of the internal ratings-based (IRB) approach – the modelling framework for credit risk – arguing it was too complex and opaque. He argued the combination of a leverage ratio and supervisory stress tests would be better. Among regulators, that remains a fairly extreme view – at least, publicly – but there is broad consensus that modelling freedom has to be reined in.

"It's pretty clear there is way too much variation with risk-weights and the whole system has lost a lot of credibility. We need to work on ways to restore credibility. That's why we are considering a capital floors system. Those floors are part of a range of measures the committee is developing to enhance the reliability and comparability of risk-weighted capital ratios," Stefan Ingves, chairman of the Basel Committee, tells Risk in an interview to be published later this week.

Although dealers accept change is needed, they reject it in the form of a floor that will limit the power of their internal model calculations.

"The key question as to how important this becomes is the calibration. If a floor for the model is 60% of the standardised approach, maybe it's not such an issue. If it's more like 100%, then from a capital-efficiency perspective, I don't see much benefit in having the model," says a London-based investment banking treasury source at a US bank.

The Basel Committee's consultation runs until March 27. Calibration of the floors will be decided on completion of a quantitative impact study, which will be carried out during 2015.