This article is the second in a two-part series.
Now that Basel III rules are largely in place, the Basel Committee has entered the important phase of analyzing their effects. Based on my conversations with the committees secretary general William Coen, I believe the industry can expect the Basel Committee to engage with three crucial issues: performing quantitative impact studies, standardizing banks' risk models and strengthening banks' operational risk requirements.
Quantitative impact studies are a very important way to analyze periodically how committee members are implementing different bank regulations and how effective the rules are. Some of the questions that quantitative studies can answer, for example, are if recent requirements are effective in reducing banks' leverage and making them more liquid with high-quality assets, and if banks are better capitalized than before the crisis.
All the work related to these studies is undertaken at the Bank for International Settlements. "It is a massive job. Supervisors from different jurisdiction cleanse data and then send it to Basel. The information is anonymous," says Coen.
Coen works with a modest staff of twenty-four people.Yet when I am at consulting or training assignments, I often hear bankers describe the Basel Committee as "a gargantuan bureaucracy with hundreds of economists and regulators."
In fact, nothing could be further from the truth. "We draw heavily on the member countries and representatives of central banks," Coen explained to me. "We have more than 40 working groups which are chaired by representatives from our members, which include the Bank of England, the European Central Bank and the Federal Reserve Board. The professionals at the Basel Committee focus a lot on ensuring strong coordination of all the tremendous amount of activity that takes place in these committees."
Another very important theme for Coen and one near and dear to my heart is the variability in the models that large banks use to set regulatory capital. As I have argued in previous columns, reducing banks' flexibility in their risk models and making their risk inputs more transparent is of paramount importance in ensuring the market's ability to discipline banks.
"This is a regular topic at our meetings," Coen assured me. "It is troubling to see such wide variances in banks' risk-weighted assets."
Fortunately, the Basel Committee seems to be moving toward a solution. In December, it released a proposal I have long awaited, "Capital Floors: The Design of a Framework Based on Standardized Approaches." Since the comment period closed at the end of March, I would anticipate that the proposal should be finalized before the end of this year. Implementing capital floors will lessen the flexibility that large, internationally interconnected banks have in determining the level of regulatory capital necessary to sustain unexpected losses.
One way that the Basel Committee can address concerns from risk-weighted asset critics is by updating an important discussion paper, "The regulatory framework: balancing risk sensitivity, simplicity and comparability." This paper gives good insight into the Basel Committee's current views balancing banks' desire to use models to be risk-sensitive with the desire of the committee to keep the framework simple and comparable.
I also look forward to the Basel Committee strengthening its operational risk requirements in Basel III's Pillar I.It was the one part of Basel II that until recently was left untouched in Basel III.Further updates are crucial to the stability of the financial system. For the past two decades, I have observed that the vast majority of banks' problems lie in operational risk: a breach in the day-to-day running of a business due to people, processes, systems and external events.
Coen has assured me that "operational risk is also a focus of the Basel Committee." He pointed to a proposed guideline that the committee released in October last year.
The Basel Committee is lucky to have a leader who is not only familiar with the nuts and bolts of banking, but also knows the intricacies of being a bank examiner and is experienced in crafting policies. In over two decades of working both with bankers and regulators, I know that it is extremely rare to find a professional who has been in all these different roles.