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Clifford Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.
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Guess What? Basel III Oversimplifies

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Since the announcement of Basel III capital standards in 2010, the Basel Committee has been busy extending and tinkering with a number of its provisions. One of the latest considerations by the Basel Committee is an interest rate risk capital charge for bank assets held in portfolio.

The intent of such a capital charge may be to limit the potential for banks to engage in arbitrage between their held-for-investment portfolios and their trading books. But without giving credit to the fact that bank risks do not exist in isolation from each other, Basel may impose even higher regulatory capital charges than warranted.

Such an approach underscores a major flaw in the Basel capital standards as a whole that applies capital charges in piecemeal fashion and imposes an array of analytical measurements and modeling frameworks that, while elegant in design, remain abstract representations of complex risks and markets. An integrated approach to assessing capital that recognizes some risk diversification effect would represent a major leap forward in the evolution of Basel capital analysis.

So far the Basel capital standards address a myriad of risks including credit, counterparty, market, operational and liquidity. However, the current framework does not adequately represent how these risks relate to one another. Curiously, for all their analytic complexity, the Basel capital standards suffer from the oversimplified view that bank risks are essentially additive. In fact an elevation in one risk type may actually lower another form of risk. In such circumstances simply adding capital for both risks, without taking into account their unique risk diversification qualities, overcharges banks for risk.

Take for example mortgage loans held in significant quantities across the banking industry. An enormous amount of energy has gone into stress testing these assets under various scenarios over the years as part of the Federal Reserve's Comprehensive Capital Analysis and Review. Yet understanding the competing risk nature of these assets is important to fully appreciating the relationship between credit and interest rate risk in mortgage instruments.

Consider a borrower a few years from now with a healthy credit score of 750, who puts 20% down on a new home and starts paying a 5% mortgage. Assuming other risk factors for the borrower, collateral and loan product are also strong, the bank holding this asset probably has a relatively low likelihood of experiencing a default under normal circumstances. If, a few years later, market rates drop, that borrower will likely refinance into a lower-rate loan assuming his or her credit and equity in the property have remained the same or improved since origination. That exercise of a borrower's right to prepay the mortgage reduces the default risk to the bank if another lender does the refinancing. And if the original lender holds the new loan, the credit risk is probably lower because with a lower monthly payment, the debt will be easier for the borrower to service.

However, this refinancing activity of borrowers affects the value of the mortgages held by the lender and hence increases the interest rate risk exposure of the bank.

Conversely, a borrower with a 620 FICO who puts only 5% down on a home poses a much higher credit risk than the borrower in the first example. When faced with the same reduction in market rates, this less-creditworthy borrower is not as likely to prepay the mortgage and hence poses a lower interest rate risk to the bank.

In a similar fashion, one can imagine that the operational risk of a plain-vanilla set of mortgage products is lower than that of a set of products featuring a high degree of risk-layering and process shortcuts such as abbreviated appraisals or reduced documentation. Even with such known tradeoffs in risk exposure among three distinct risk types, Basel's determination of how much capital to hold fails to recognize that the total capital charge for the bank across all three risks should be less than the sum of the individual capital charges for credit, interest rate and operational risk.

The current approach to regulatory capital assignment appears to levy charge upon charge on banks based on risks that clearly contributed to the demise of many institutions after the crisis. Capital conservation buffers, liquidity coverage ratios and the like may well be reasonable concepts for Basel to consider. However, there is great danger over time in deploying analytical metrics that are crude proxies for risk and cannot recognize tradeoffs between risk types. Allowing banks to make such tradeoffs according to their unique comparative advantages as intermediaries supported by a capital framework that recognizes risk diversification benefits would improve market conditions while effectively managing institution-specific and systemic risk.

Clifford Rossi is the Executive-in-Residence and Tyser Teaching Fellow at the Robert H. Smith School of Business at the University of Maryland.

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