Basel’s Internal Ratings Based (IRB) approach, where institutions undertake their own strictly defined risk measurement has supported greater sophistication in risk management and created incentives for a greater emphasis on risk in strategic decision making.
But current proposals stand to reverse this trend, in our view diluting the focus on risk which makes it timely to revisit the lessons of the pre-crisis Basel I era.
As well as providing misincentives, Basel I saw material reductions in banks’ average Risk-Weighted Assets (RWA). Contrary to several claims, average RWA has at least stabilised, and often increased, since banks moved to IRB.
SIMPLE RISK WEIGHTS
Developed in the 1980’s, Basel I provided simple risk weights for each asset on a bank’s balance sheet, based purely on the borrower’s category, namely:
• Sovereigns: 0 per cent
• Banks: 20 per cent
• Mortgages: 50 per cent
• Corporates: 100 per cent
These risk-weights were mandated with no reference to the creditworthiness of the individual borrower. Capital requirements were the same for all mortgages (prime or sub-prime) and for all corporates (low-geared blue-chips or highly leveraged start-ups).
Where market yields might have some sensitivity to risk but be applied over a flat capital requirement, banks could grow their ROE by lending to the riskier borrowers. They were rewarded for being riskier.
This created some obvious arbitrage opportunities: where banks did lend to a strong corporate, they could hedge this with another bank, immediately reducing the risk-weight from 100 per cent to 20 per cent.
Entering a transaction to achieve this 80 per cent reduction made economic sense for high-grade corporates (where the hedging cost was relatively small), though not for weaker credits with expensive spreads (risk premia), meaning banks were being driven toward adverse selection within their corporate portfolios. Similar opportunities existed with securitised mortgages.
There were many contributing causes to the crisis, not least insufficient total levels of bank capital and liquidity. But the misincentives and arbitrages also exacerbated some of the distortions and imbalances allowed to develop in the pre-crisis years.
Significantly, the next iteration of global regulation, Basel II, was not yet implemented during the run up to the crisis. Basel II and internal models commenced only for the first banks in Europe, Japan, Canada and Australia during 2008. Even this was a gradual process: all internal models had to be assessed, validated and approved by national regulators.
In the US, this came much later, with the first approvals in February 2014, and Wells Fargo and Bank of America only approved in 2015.
It is therefore a mistake to blame Basel II models for the crisis. If a bank had managed its capital efficiently to its prevailing constraints, it entered the crisis with a Basel I portfolio, before Basel II's risk-based modelling reversed the misincentives, promoting better credit quality and the exiting of arbitrage positions.
Basel 2.5 and Basel III retained these strengths and built on them further, raising the required capital ratios and improving risk coverage in areas such as counterparty credit and market risk.
The system and industry are better for these changes.
The Bank of England’s Andrew Haldane gave a speech in 2012 about the “Dog and the Frisbee”. He argued risk-based capital was no better at predicting a bank default than a non-risk-based Leverage Ratio, across bank failures up until 2006.
However, the crucial point is Haldane’s data is all prior to the commencement of Basel II and internal risk models.
In contrast to Haldane's Basel I comparisons, Moody's compared the Leverage Ratio against Basel II risk-based metrics in their 2015 updated Bank Rating Methodology, affirming the predictive power of RWA as the best indicator of potential default.
“In our failure study, the TCE/ RWA [Tangible Common Equity divided by RWA] measure was the most predictive indicator of failure amongst a number of other measures, including an un-weighted leverage measure,” Moody’s said.
While some claim banks’ risk-weights have reduced because of internal models (and models are merely a way to reduce capital requirements), post-crisis data reveals a different picture.
Across 30 major international banks (globally systemically important banks (GSIBs) plus Canadian and Australian Domestic SIBs), post-crisis Average RWA has been reasonably stable, before stepping up when US banks first reported Basel II in 2014, as follows.