12 years after Basel II, ECB sees faults in risk weighted capital requirements for banks, but still doesn’t get it

ECB has published a document titled “The limits of model-based regulation” ECB Working Paper 1928, July 2016. In it the authors find that risk-weighted capital requirements based on sophisticated models applied by big banks, are basically dangerous and worthless.

Of course that regulation is worthless, it does not serve any useful purpose, and only increases the probabilities of financial instability.

But from its “Non-technical summary” it is harrowing to see that they still do not fully understand why these risk weighted capital requirements are dangerous; not only for the big banks with their models, but also for the smaller that apply the standard approach risk weights declared by the Basel Committee; and also, primarily, for the real economy.

For a starter it declares: “In recent decades, policy makers around the world have concentrated their efforts on designing a regulatory framework that increases the safety of individual institutions as well as the stability of the financial system as a whole.”

And so the first observation is: Who gave policy makers the right to concentrate on designing a regulatory framework that completely ignores whether the allocation of bank credit to the real economy is efficient or not? Is the real economy to serve banks or are the banks to serve the real economy? “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926 

Then it states: “an important innovation has been the introduction of complex, model-based capital regulation that was meant to promote the adoption of stronger risk management practices by financial intermediaries, and ultimately to increase the stability of the banking system”... “banks that opted for the introduction of the model-based approach experienced a reduction in capital charges and consequently increased their lending by about 9 percent relative to banks that remained under the traditional [standard risk weights] approach”... “Back-of-the-envelope calculations (abstracting from risk-based pricing of the cost of capital) suggest that underreporting of PDs allowed banks to increase their return on equity by up to 16.7 percent”

How come regulators believed the adoption of “stronger risk management practices by financial intermediaries” would trump the maximization by banks of their risk-adjusted returns on equity? This is like given children a book with indication of calories and expecting them to stay away from the chocolate cake. Worse, in the case of the big banks applying their internal models, it was like allowing the children to calculate on their own the calories of the chocolate cake they desire. How mind-boggling naive are regulators allowed to be?

From the conclusion “Certainly, one would expect less of a downward bias in risk estimates if model outputs were generated by the regulator and not the banks themselves” one could believe the authors favor the standard approach risk weighting. 

Of course that is better than the sophisticated modelling by the big banks, which only guarantees Too Big To Fail Banks. But the all the principal faulty characteristics of the whole risk weighting process remain intact even then... and are still ignored:

Like why basing capital on ex ante perceived credit risks, when all major bank crises have resulted either from unexpected events or excessive exposures to what was ex ante perceived as safe?

Like why if banks by the size of the exposures and interest rates already clear for perceived risk, should they also be cleared for in the capital? Do not regulators understand that any risk, even if perfectly perceived, leads to the wrong actions if excessively considered?

Earlier, on the same issue

And like so many other whys?

The Basel Committee incorrectly assumes “The Risky” will cause more “unexpected losses” than “The Infallible”

A discussion on a blog with someone who insisted that it is ok for the current capital requirements for banks to be higher for those perceived as risky that for those perceived as absolutely safe “because of the volatility”; and called me stupid because I “appear not to understand the whole concept of expected and unexpected losses” made me realize that I had to clarify again The Great Basel Committee Mistake… namely that Basel II (and III) base the capital requirements for banks, those which are to cover for the “unexpected losses”, on the “expected losses” derived from perceived credit risks.

“An Explanatory Note on the Basel II IRB (internal ratings-based) Risk Weight Functions” expresses: 

“The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason for that mindboggling simplification was because it was: 

“This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

And which then leads to:

“In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And to justify their approach they write:

In the specification process of the Basel II model, it turned out that portfolio invariance of the capital requirements is a property with a strong influence on the structure of the portfolio model. It can be shown that essentially only so-called Asymptotic Single Risk Factor (ASRF) models are portfolio invariant (Gordy, 2003). ASRF models are derived from “ordinary” credit portfolio models by the law of large numbers. When a portfolio consists of a large number of relatively small exposures, idiosyncratic risks associated with individual exposures tend to cancel out one-another and only systematic risks that affect many exposures have a material effect on portfolio losses. In the ASRF model, all systematic (or system-wide) risks, that affect all borrowers to a certain degree, like industry or regional risks, are modeled with only one (the “single”) systematic risk factor

But suspecting they might be simplifying beyond reason, just in case, the Basel Committee added:

“It should be noted that the choice of the ASRF for use in the Basel risk weight functions does by no means express any preference of the Basel Committee towards one model over others. Rather, the choice was entirely driven by above considerations. Banks are encouraged to use whatever credit risk models fit best for their internal risk measurement and risk management needs.”

And this very flimsy approach, which ignores any correlation between unexpected losses, and shows very little concern with the problems of rapidly changing volatility, caused the Great Basel Committee Mistake of setting the capital requirements for banks, based on exactly the same perceived risks already cleared for.

In essence the regulators determined that a “risky” creditor, by the single fact of presenting more “expected losses”, also had to provide for more capital to cover for more “unexpected losses”. They never understood the hard truth that the safer something is perceived the greater its potential to deliver awful unexpected negative consequences.

And this the regulator did without absolutely any concern for how that could affect the efficiency of bank credit allocation in the real economy… something that can also be derived from the tragic fact that nowhere in the Basel Committee literature is there a word about the purpose of our banks.

And so they introduced an odious regulatory discrimination against those perceived as “risky”, something which introduces a dangerous risk-aversion, and, consequentially, introduces a favoring of what is perceived as “absolutely safe” that can only guarantee the dangerous overcrowding of safe-havens.

As perhaps the best example of what I am arguing is the absurdity of having what can really grow into dangerous excessive bank exposures, like the AAA to AA rated, being risk-weighted at 20%, while the totally innocuous below BB-rated, get a 150% risk weight.

    

In essence bank regulators have now ended up being the greatest systemic risk producers to the banking system. 

In short we do not need bank regulators, what we need are regulators who understand the banking system. 

In short we need regulators who understand that more important than looking at the portfolio of individual banks, is to look at the portfolio of banks in the whole banking system... and how it relates to the needs of the real economy.

Perhaps our bank regulators do not understand the possibility of a  "regression to the mean"

Did the "A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules" paper of 2002, by Michael B. Gordy, cause the downfall of our bank systems? Yes! It was an essential factor, but Gordy is not solely responsible for it... all those who sat there and did not understand one iota, and therefore never dared to question, are even more to blame.