Basel Committee capital proposals may not adequately reflect risk, banks warn

Writing to the Basel Committee as part of a consultation exercise by the rule-making body, the Institute of International Finance (IIF) and the Global Financial Markets Association (GFMA) set out alternative proposals which they said would more effectively improve the capital treatment of banks' operational risk. The Basel Committee is currently consulting on the standardised measurement approach (SMA) which would replace use by banks’ of internal modelling practices for operational risk that “exacerbated variability in risk-weighted asset calculations” and reduced confidence in risk-weighted capital ratios.  A SMA should make the process more consistent. Writing to the Basel Committee in response to a consultation exercise by the standard-setting body, the Institute of International Finance (IIF) and the Global Financial Markets Association (GFMA) set out alternatives which they said would improve the SMA.

In the letter, the industry bodies said that they were supportive of the Basel Committee's overall goal of improving the capital treatment of operational risk. However, the current proposals would "have a very significant effect on the system-wide quantity of operational risk capital", they said.

"Since the introduction of Basel II [the Basel Committee’s revised capital standards framework], many banks made tremendous efforts and investments to develop their systems and risk management practices for operational risk," they said. "This has been done in order to create sound internal models that reflect historical losses, changes into bank specific business models as well as future expectations; such features, in the banks' view, should also play a role for regulatory capital purposes."

"Banks understand that operational risk is an integral part of their risk management frameworks, and its alignment with the regulatory capital planning is key to achieving consistency between internal cost and economic capital allocation in support of the business decision making process. However, capital requirements under SMA that lack risk sensitivity would in many cases be well above the economic capital banks have allocated to operational risk. This misalignment could open up undesirable room for arbitrage," they said.

In March, the Basel Committee proposed restricting the ability of banks to use their own models when calculating regulatory capital requirements in relation to certain types of liabilities, including loans to financial institutions and those to the largest companies. It did so in order to simplify the framework, improve comparability and reduce what it saw as "excessive variability" in the capital requirements for these types of credit risk.

In its response to this Basel Committee's consultative document, the IIF said that the standardised approach proposed by the committee would increase the cost to banks of lending to these types of institution, creating the risk that they would "progressively shift their portfolios towards the higher-risk, high-yield segments". Rather than adopt a “blunt measure of capital across the credit spectrum”, the IIF proposed alternative solutions including more data sharing and “more stringent standards for modelling Corporate exposures” aimed at reducing the discrepancies the Basel Committee was concerned about.

A task force set up by the IIF has developed 78 “recommendations of practices and assumptions that could be harmonised within banks’ models in order to reduce variance” and the industry body also refers to these in its response.