In the past the size of an institution’s balance sheet was a good indication of the risks it was taking; it made sense, therefore, to link regulatory capital requirements to assets.
Today, however, that’s not so true — and as time passes, an institution’s assets bear less and less direct relationship to the residual risks it faces.
This single and indisputable fact is what propelled the Basel Committee to embark on the development of Basel II in 1999. As a risk-based capital standard, Basel II is the right way to go.
My organization, the Risk Management Association, is on record as having pointed out the many problems with Basel II along the way.
One of the most serious was that by itself it could have tipped the competitive playing field, creating an advantage for the large banks to which it applies over the small banks to which it does not.
The development of Basel IA for non-Basel II banks is aimed at increasing risk sensitivity without making standards unduly complex. The federal regulators have decided to implement the two regimes in parallel.
Coordinating improvements in the risk sensitivity of capital standards across banks of all sizes makes a great deal of sense.
I would concede to the critics of Basel II that even today it is far from perfect. It’s too prescriptive and complex. It is long on rules and short on principles. It is going to be difficult to implement.
That is why Basel II’s implementation will be done in phases under the new time line announced a week ago, starting with a parallel-run period for one year followed by three full years of additional monitoring and transition.
New policy never achieves the Goldilocks ideal of being “just right.”
The remarkable thing about the Basel reform is how close it is likely to get.
Why is that? The process has been an unusually open one in which successive industry and policymaker exchanges have been punctuated by rounds of careful, objective, quantitative analysis. No fewer than four rounds of quantitative-impact studies have been conducted during the development of Basel II.
Each has dredged up issues that have been subsequently addressed by refining the policy. The banking regulators who have adopted such an open policymaking approach are to be commended for accepting so much public criticism as a prerequisite for achieving policy excellence.
Basel II will not be the last word. It will undoubtedly evolve further. Indeed, we view Basel II as it is today as a step toward something more rigorous and refined — an “evergreen” evolving version of Basel II or even a Basel III.
In Basel III, regulators would set capital requirements with best-practice internal models in mind — properly validated models, of course, using properly validated data. It would shift from prescribing capital-estimation methodologies to setting standards in relation to performance volatility.
Such an approach would do more to encourage diversity and innovation in the financial system. In that way, a single regime could apply to institutions of all sizes.
In the near term, the combination of Basel II and Basel IA has a good chance of significantly strengthening the financial system — by distributing capital among institutions in a way that more fairly reflects the risks each takes, and by encouraging improvements in risk management in all of them.
That would be real progress. Standing still is not an option.
