Challenger banks: Moving in opposite directions

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Regulators are attempting to restrict the use of the IRB approach to capital adequacy at large banks just as smaller players are lobbying to be allowed to adopt it.


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If you are a challenger bank, it must be tempting to think that the big firms have it all their own way. They get to use mysterious internal models to calculate their regulatory capital requirements. With large data sets, highly diversified balance sheets, big legacy deposit-gathering networks and savvy model-designers, it seems like the cards are stacked in their favour.

The challengers, meanwhile, lacking the data, the models and the track records that would allow them to use the internal ratings-based (IRB) approach, have to make do with Basel’s standardized risk weights for their own capital requirements. The result, say the challengers, is that they may have to set aside as much as 10 times the capital that the big boys do for an identical risk.

That assessment ignores a lot of complexity, of course. It’s true that IRB models generally produce lower risk weights – sometimes dramatically so, in the case of low-risk mortgages, for instance. However, the absolute difference between the risk-weight outputs of the two approaches is frequently not as great as it is made out to be – it is much less striking at a big monoline lender, for instance. The biggest discrepancies are typically seen at the small number of huge diversified groups.

There’s still a difference though, and it’s increasingly enough to push small banks to pursue IRB, with all the work and cost that this involves. The UK’s Prudential Regulatory Authority (PRA) is trying to help firms make the leap. Later this year it will be publishing a roadmap for the process.

The fact that the Basel Committee has proposed to bolster still further the standardized risk-weight regime as part of its final amendments to Basel III – dubbed Basel IV – adds another impetus. National regulators will likely retain the option to waive the most punitive risk-weights for those areas of the market where they can show sufficient reason for a tweaked national approach, like buy-to-let in the UK. Get onto IRB, challengers say, and a bright future opens up of lower risk-weights and the ability to increase returns on capital.

Wading into IRB

That’s the theory. The problem is that Basel IV is not just taking aim at the standardized approach. It’s also wading into IRB, with simultaneous proposals to impose capital floors for different types of lending, floors that will be based on the standardized approach and are aimed at eliminating the very lowest weights that IRB can produce.

The result could be to make certain activities uneconomical for the big banks, which are lobbying furiously for the proposals to be watered down. They argue that the provision of credit will suffer, either because of pricing hikes or outright withdrawal.

Models that are badly built, inappropriately used or poorly supervised have the potential to cause real harm. Banks must be able to support their assessments; their models should be interrogated regularly; senior management individuals ought to be able to satisfy regulators of their personal understanding of them. And there will doubtless be specific areas where data may be insufficient to support an IRB approach.

But to tilt the regulatory playing field decisively away from risk-sensitivity looks like a retrograde step. Banks are already grappling with preparations for IFRS 9, an accounting standard that will compel them to make provision for expected losses at the time when they assume exposure. The fact that this involves complex modelling of the sort that is frequently used in IRB is one reason why more of the smaller banks have been looking to move to IRB. For Basel to move in precisely the opposite direction looks misguided.

The banking industry needs some consistency of regulatory approach, not a haphazard attempt to unwind the risk-based approach instilled by Basels II and III, under the guise of building on those regimes – as if what is being proposed is some sort of logical development of them. 

A blinkered focus on standardization will not make banking any safer.