Where banks operate internal models, there are variances generated between each bank’s models, and it is accepted that some of these variances are too large.
It also causes some consternation that two banks can calculate different RWA values, even when lending to the same borrower.
The sources of such variance between banks’ internal models come under three broad categories:
- Legitimate differences between banks, reflecting their distinct risk practices and policies; banks have different approaches (and therefore different historical data) in how they manage deteriorations in their borrowers’ creditworthiness, and in how they collect on bad debts.
- In their modelling approaches, banks have made varying assumptions, and used different parameters and inputs.
- National factors, including regulators’ requirements, consumer protection laws, and accounting treatments.
Some degree of variance between banks is therefore expected and is actually desirable; the objective should not be to eradicate all variance. If all banks were straitjacketed to a single uniform model, model risk can become a new source of systemic risk, and promote ‘herd behaviour’.
Canada’s OSFI Senior Director Richard Gresser noted recently:
“We don’t want banks to all have identical views of risk but we don’t want them to have radically different views either. We have got to recognise that there is no perfect knowledge, no single perfect view of what’s the right risk measure.”
The IIF RWA Task Force (comprising 43 banks, including 3 of the Australian majors) has made a series of proposals to harmonise modelling assumptions and parameters, so as to narrow the scope of RWA variance to just those legitimate differences.
Some critical views
There have been some well-founded criticisms of internal models, which banks need to take on board. Unfortunately, there have also been some erroneous claims – some have even sought to blame internal models for the financial crisis, notwithstanding the timeline described above.
Among these criticisms is a misconception that banks can somehow set their own capital requirements. Models are subject to robust internal and external governance and control, including strict protocols for approval by regulators.
Banks need to invest in not only developing and validating models (and proving them to their regulator’s satisfaction) but also maintaining, updating and back-testing models and driving continuous improvement.
Some contend internal models are merely an excuse for banks to be able to reduce their capital requirements, citing a 20 per cent reduction in the ratio of banks’ RWA to Total Assets from 2007 to 2013.
However, this statistic reflects banks’ selective deleveraging since the crisis, demonstrated growth in secured financing, and the accumulation of highly-rated liquid assets. As banks moved to the Basel II advanced regime, this has helped them to become more judicious in their provision of credit. They have effectively shifted their portfolios towards lower risk-rated assets and indeed, particularly in Europe, shrunk their traditional lending.
Simultaneously, banks have been actively accumulating stocks of highly-rated securities, ahead of new liquidity requirements commencing in January 2015. Over that same 2007-13 period:
This dramatic growth of highly-rated assets has materially reduced the overall average risk-weightings across the industry.