Don't kill off banks' internal risk models

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The big three credit rating agencies (CRA), regulators hope, are dying a slow death.

In recent years, policymakers in Europe have promoted alternative rating agencies, investigated the culture and practices of the big three, and, in the US, removed references to CRAs outright in the Dodd-Frank Act.

What’s more, the Basel committee is reviewing the role of sovereign credit ratings in shaping banks’ risk-exposures. For banks using the standardized framework to calculate capital requirements, CRAs are also diminishing in importance thanks to new stress tests, Pillar 2 add-ons, which refer to the supervisory approach of the Basel accord, and the introduction of the non-risk-adjusted leverage ratio as a potential back-stop measure.

However, perhaps the most damaging attack to the credit-rating business came in December with the publication of a Basel consultative document aimed at limiting lenders’ freedom to measure risk by reference to credit ratings.

In a bid to further micro-manage asset-liability mismatches, the Basel paper advocated risk-weighting exposures for corporates by a given borrower’s revenue and leverage, rather than by ratings. For banks, it suggested risk-weighting on the basis of common tangible equity ratios and the non-performing assets ratio.

These proposals are political dynamite since such measurements fail to discriminate between supervisory, covenant, insurance and accounting standards. Bankers have contacted Euromoney to lambast the Basel push, citing the efficacy of credit ratings and internal models in assessing the nature and volatility of credit risk.

Basel proposals to replace rating-sensitive risk measures with blunt financial metrics fail to provide granular and qualitative assessments of the credit risks of corporate entities, from country, industry to competitive risk and from management to governance, critics say.

According to an albeit self-interested Fitch report, Basel’s new proposed metrics could ironically punish low-risk corporates and reward high-risk sectors, such as real-estate. Fitch calculates the proposals lead to an aggregate decline in average risk weights to 84% from 102% as compared with ratings-based risk weights.

But if new risk metrics are introduced in the standardized framework and the internal models many banks now use fall from grace, that raises the prospect of European, and non-diversified, lenders facing a capital shortfall.

Banks in the Netherlands, Denmark and Sweden use average-risk weights for mortgage exposures that are in the low-teens in internal models, compared with the proposed Basel risk weights in the 25% to 100% range.

US lenders, by contrast, are less likely to be affected by the capital floor, given that the Collins Amendment to the Dodd-Frank Act which sets regulatory capital requirements for the large banks by whatever is higher: the standardized approach or internal models.

It’s unclear to what extent banks can continually invest in the IRB approach, given the costs involved and the lack of clarity of the capital relief it provides until the floor, influenced by the revised standardized approach, is calculated.

But if a more standardized approach creates perverse incentives or is less risk-sensitive than internal models, trouble is brewing.

Post-crisis, liquidity reforms mandate that banks hold a large quantum of low-risk, low-yielding instruments. This burden, when combined with the prospect of a less risk-sensitive standardized framework as the backstop for banks’ capitalization over internal models, could trigger unintended consequences. For example, banks, theoretically, would need to hold a large quantum of high yield credits to offset low returns from liquid assets.

In addition, risk managers say if senior bankers are prevented from using internal models as a basis for regulatory capital, they would be less personally accountable for the earnings of particular transaction, relative to a given firm’s invested capital. What’s more, they would have less incentive to take ownership of risk-mitigants involved in a given deal.

This argument only works if internal models are more granular, risk-based, and appropriately calibrated across diverse market scenarios than the more-blunt standardized approach.

Perhaps a grand bargain could be reached. Banks could pre-empt the regulatory push by explaining the variance between model-driven and standardized risk-weights, by risk category and exposure type, to boost market confidence in internal models, and to preserve the current risk-sensitive regulatory metrics.

But regulators need to make their case if the standardized approach is to reign supreme.

If internal models fall from grace, Basel would be blamed for intensifying systemic risks if the standardized approach performs badly during the next crisis.