Reining in capital models is bad for risk management

There were few winners from the global financial crisis, but the practice of modelling is surely one of its greatest losers.

From value-at-risk to the Gaussian copula, a variety of models failed to anticipate the scale and severity of the crash that began in 2008. Some might add that those using the models also failed to properly understand and compensate for their limitations.

Across the industry, the response has been to place less emphasis on modelling; and nowhere is this truer than in the arena of regulatory capital. In Europe, banks using their own models to calculate regulatory capital under Basel III cannot hold less than 80% of the capital they would have faced under the original Basel I rules. In the US, the Dodd-Frank Act floors regulatory capital for the most sophisticated banks at the levels set for smaller firms, and prevents capital from falling beneath where it would have been in July 2010, when the law was passed.

In December last year, the Basel Committee on Banking Supervision unveiled new trading book capital rules that would force all banks to model their market risk capital using the standardised approach. The approach would provide "a fallback in the event that a bank's internal model is deemed inadequate", the committee said, and could be used "as an add-on or floor to an internal models-based charge".

That same month, the committee published proposals for floors on modelled risk-weighted assets that would limit the level of variation between banks. More recently, in July, a review of Basel's credit valuation adjustment (CVA) framework raised the possibility that banks might no longer be allowed to use their own models when calculating CVA.

The advanced measurement approach (AMA) to operational risk capital is seemingly next in line for this kind of treatment. Under Basel, the AMA is one of three possible approaches banks can take to calculating their op risk capital, along with the standardised and basic indicator approach. In place of these approaches, a consultation due in December is set to include a new "standardised measurement approach" that is fairly simple but includes some degree of risk sensitivity, the Basel Committee says.

There are differing views among global regulators on whether the AMA should be scrapped entirely. To some extent, this reflects a broader conversation about the benefits of banks using their own models for regulatory capital. On one hand, banks' use of their own models allows them to develop a deeper understanding of the risks they bear, advocates say. Firms that develop a greater mastery of their risks can hold more or less capital depending on the outcome of those models, which are tested by regulators. On the other hand, regulators are now very keenly aware of the need to ensure firms are sufficiently capitalised at all times. Some are also understandably cautious about banks' tendency towards hubris.

On paper, these differences are translating themselves into a delicious fudge. Regulators' prescription is: ‘Please continue to do your own modelling to enhance your understanding of the risks, but don't use it for capital purposes'. Banks' subsequent retort is: ‘Why bother?'

If banks stop modelling their own risks and start being blindly led by regulatory minimums, the world may certainly look safer in theory. But in practice, we are likely to be in a much more dangerous place: one in which regulators will be all the more culpable if things go wrong.