Basel's 2014 Agenda: Promising, But Incomplete

Chairman Stefan Ingves used an excellent metaphor when describing the plight of the Basel Committee on Banking Supervision on Friday: "If you bring the devil aboard the boat, you have to row him ashore."

There is certainly much more rowing to be done as the committee executes its 2014 agenda, since the majority of countries will in one way or another implement its recommendations. The committee certainly deserves much credit for the very challenging task that its 27 members have in trying to establish uniform regulatory capital standards for internationally active banks. Three main points are particularly noteworthy in its ambitious agenda.

First, by stating that there is more work to done on the leverage ratio, banks should be aware that the watered down leverage ratio released a few weeks ago, is not really final. However, if the committee strengthens the ratio, it probably will not be until 2017 since other agenda items are likely to take priority and studies needed to be conducted on the ratio's impact. Until strengthened, the leverage ratio will not serve as an important backstop to risk-weighted assets, which has long been a committee goal.

Second, I am very pleased to see that the Basel Committee continues to emphasize its awareness of the pronounced disparity in how banks calculate RWAs. Unfortunately, the committee is not likely to propose uniform standards to calculate RWAs or to come up with some other viable alternative until 2015. It is enormously challenging to come up with a framework that will not be too simplistic (as was Basel I or Basel II's Standardized Approach) or too complex and opaque (as is the Advanced Internal Ratings Based Approach now used by global systemically important banks).

Until a more uniform and transparent risk-weighted asset framework is crafted, banks will always be suspected of manipulating data. The Basel Committee has found much of the difference in RWAs amongst similar banks is actually due to their different type of portfolios. Importantly, Ingves pointed out that the subjectivity of supervisors also plays an important role in how RWAs can differ. Given all the bank guidelines that were issued last year, I believe that this year, guidelines for supervisors and examiners should also be released in order to help them more uniformly supervise banks using AIRB.

Thirdly, the most important part of the agenda is that a more robust Pillar III (market discipline) will be proposed during the first half of this year. This pillar, the most neglected of the three, could go a long way to reduce bank opacity globally. This potential bank disclosure far outweighs any other current committee goal. Until banks disclose what types and quality of inputs they use to calculate credit, market and operational risk, the results will always be suspect and not useful in comparing one bank to another.

Additionally, for countries, like the U.S., where accounting rules have derivatives off balance sheet, Pillar III needs to require banks to disclose a lot more about what side of a trade they are on; where they book derivatives' trades in terms of banking versus trading book; and in what legal subsidiary, if any, derivatives and collateral are booked. Part of the disclosures should also include the extent to which a bank is involved in a securitization, either as a sponsor, servicer, liquidity provider or, of course, investor. Quality bank disclosures would be very useful not only to investors and the media, but to the regulators themselves in the event of a bank resolution.

Unfortunately, two important items were missing from the Basel agenda. Bank regulators need to compel banks to focus much more on data collection, aggregation, validation, calculation and reporting. Lack of quality data poses a significant challenge to even the large banks. In practical terms, it means that banks cannot properly monitor their counterparties' credit quality or whether their capital markets' portfolios are liquid. Lacking good data also means that we cannot trust their stress test results or their capital ratios. The Basel Committee is aware of the issues surrounding data as evidenced in its most recent December report. Yet until there are uniform guidelines insuring banks will have consistently reliable and transparent data, we will have no idea about banks' actual financial health.

Also missing from the agenda is a major upgrade of Pillar I's operational risk measurement. Operational risk remains one of the least understood and most ignored risk by risk managers. If one looks at the long list of recent banking scandals, they are almost all about operational risk, a breach in the day-to-day running of a business due to people, processes, technology and external threats.

The major areas that have been upgraded in the transition from Basel II to III are in the area of quantity and quality of capital, credit risk and market risk, in that order of emphasis. Operational risk measurement, however, remains untouched. Because of the Basel Committee's long and challenging agenda for this year, improvements to operational risk measurement are a long way off. I just hope that while the Basel Committee continues to row, we do not have a bank that drowns due to the weakness in how it identifies, measures, controls and monitors its operational risk exposure.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World