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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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Banks’ Model Risk Worse than Ever, Thanks to Basel III

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By giving final approval to Basel III capital standards this week, U.S. regulators have inadvertently exposed the financial system to massive model risk.

Implementing robust capital standards that give individual institutions sufficient buffers from extreme events and protect the system at-large has been a major challenge for regulators and the Basel Committee since the inception of risk-based capital charges years ago. However, overreliance on analytic methods that failed miserably during the crisis puts the entire system at risk while creating enormous burdens on institutions and regulators to closely oversee these models.

The Basel capital rules feature essentially two types of requirements: leverage ratios that do not make adjustments for specific risk types; and risk-based standards that do account for such differences. In the past, critics of simple leverage ratios have called out the potential for such measures to be overly simplistic. Without differentiating, risk leverage ratios may artificially lead to market distortions and misallocations of capital across sectors. Eventually, Basel got around to adding risk-based standards for credit risk and then components for market and even operational risk. The concept of imposing a set of risk-based capital standards spanning these major risk types is sensible in theory, but turns out to be extraordinarily cumbersome at best and systemically risky at worst in practice.

Tagging Basel III as overly complex is hardly a revelation. Prominent regulators such as Andrew Haldane of the Bank of England and Thomas Hoenig, a director at the FDIC, have been vocal critics of Basel III's overengineering for some time. Both have been proponents of leaning more on leverage ratios than on the risk-based capital standards driven by complex models that played a role in vastly underestimating the buildup of risks before the crisis and remain prone to a host of governance and technical weaknesses. Three areas that highlight Basel's overreliance on models are treatment of operational risk; the use of value-at-risk models for determining capital requirements; and counterparty valuation adjustment computations for derivatives.

Operational risks stemming from breakdowns attributed to people, process and technology have become increasingly apparent in banking over the years. Measuring a bank's average exposure to such risks does not easily lend itself to strict quantification due to inherent challenges in measuring events that occur very infrequently but generate large losses when they happen. However, statistically-based models are used in estimating Basel operational risk capital under the advanced measurement approach for the largest banks. Generating loss distributions, which describe the range of potential losses that a bank could experience, from inherently stable internal data sources is challenging enough. It becomes almost a form of alchemy when applied against noisy operational risk data sets. Applying the latest statistical techniques to operational risk measurement lulls us into a false sense of analytic security and desensitizes management to the important qualitative aspects of controlling these risks.

Basel also permits the application of VaR models – notorious for vastly underestimating bad scenarios during the mortgage crash – in estimating credit, market and even operational risk. Even today issues with VaR models remain, as evidenced by last year's JPMorgan Chase derivatives trading incident, where changes in VaR models and errors in measurement of trading losses contributed to misidentification of emerging risk. VaR models and extensions of these methods (referred to as stress VaR models) heavily depend on stable data and assumptions about model inputs. Moreover, there is a tendency to become overly enamored with modeled outcomes given their intellectual rigor and empirical basis – but that doesn't make them right.

Another example of misplaced emphasis on models occurs in estimating counterparty risk for derivatives activities, or CVA calculations. The financial crisis underscored the need to strengthen counterparty risk assessment. However, this is an area where models replete with mathematical elegance are notoriously sensitive to a number of critical assumptions and data. And if this weren't enough, VaR for CVA is allowed under advanced measurement methods for Basel – further subjecting the CVA results to inherent flaws in estimating extreme loss events using VaR techniques.

Unfortunately, despite impressive advances in computational and technical risk estimation, our ability to accurately measure complex risks over extreme outcomes remains elusive in many instances. By no means should we cease research and development on risk quantification. However, despite all the advances in modeling, we need to admit that it is simply not practical to cement these technologies in bank capital rules.

Rather, as Hoenig and Haldane suggest, getting back to basics until then with simple leverage ratios, as imperfect as they may be, is the most palatable solution. Standards approved by U.S. regulators and set up in part to mitigate systemic risk may actually wind up increasing it under Basel III.

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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Comments (4)
Banks should do all the risk-modeling they can and, if they do it right, then there is no problem for anyone. And that is why the only role for regulators is to prepare for when bankers' might not get it right.

Also regulators must be very careful of not introducing distortions that might affect the resource allocation in the real economy which, at the end of the day, is in fact even more important than the banks.

All that speaks loudly in favor of the simplicity of the leverage ratio, that is championed by Hoenig and Haldane.

http://subprimeregulations.blogspot.com/2013/07/my-opinion-in-journal-of-regulation-and.html
Posted by Per Kurowski | Friday, July 12 2013 at 9:07AM ET
Mr. Rossi, your article has to be the best one I have ever read on Basel III. It should be required reading by all bank regulators and any member of Congress who has some say on financial regulations. Obviously, your ability to cut through the sales-talk by the consultants and hired quants is not going to win you too many friends in the nation's capital or in Basel, New York, or London.

But you hit the nail on the head. I worked on the Basel capital accords in Basel, Switzerland and have to say that while the VaR and the quantitative methods at the core of the Basel capital standards appear scientific, they are nothing but smoke and mirrors. The accords are a consultant's dream. Let's come up with something that appears rigorous that few understand, and then we can charge big bucks to others.

See http://govwhistleblower.wordpress.com for more.
Posted by Dwihas3 | Saturday, July 13 2013 at 8:49PM ET
As a Banker with over 30 years of experience, I find that we tend to complicate so many of these issues. For example, take the ALLL calculations that have emerged over the last 10 years or so. Impairments, risk factors etc that are applied to come up with an ALLL. 30 years ago - if you had a watch loan - you held 5% in reserve and if it was substandard, you held 15%. Amazing how these numbers still work without going through all the gyrations
Posted by Watchdog1 | Monday, July 15 2013 at 10:22AM ET
Precisely... all the numbers are designed to make someone dizzy

http://subprimeregulations.blogspot.com/2013/07/regulators-turned-our-banks-into-cash.html
Posted by Per Kurowski | Monday, July 15 2013 at 11:01AM ET
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