Can Basel 4 work? What can go wrong? An examination of the new Basel proposals
Abstract
Regulators are sceptical of the internal models developed under the A-IRB approach, largely due to the variability of capital calculated by different banks for seemingly similar risk. A number of measures are being taken to reduce what the Basel Committee calls the ‘excessive variability’ in banks’ regulatory capital ratios. Among these measures is a new proposed standardised approach and its use as capital floors for A-IRB banks. Although not explicitly stated, the intention appears to rely on simpler and standardised approaches, rather than banks’ internal models, for the purposes of calculating capital requirements; the impacts are so significant that the proposals are already being referred to as ‘Basel IV’. The stated intent of the new standardised approach is to make risk weighed assets (RWA) more risk sensitive and to close the gap between the standardised approach and the A-IRB approach. In this paper, we examine if this is achievable. Based on both a theoretical and empirical analysis, we found that the standardised approach, no matter how well it is calibrated, cannot be an adequate alternative to A-IRB. Imposing these simplified approaches can have wide-ranging implications, including increasing the gap between economic risk and capital, providing perverse incentives, marginalising good management practices, and ultimately increasing systemic risk. Instead of ‘throwing the baby out with the bathwater’, the focus should be to fix the parts of A-IRB that are not robust.
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Author's Biography
Bogie Ozdemir is a Vice President in Sun Life Financial Group. He is responsible for economic capital and is building out its capabilities for Solvency II/Own Risk and Solvency Assessment (ORSA) and model validation. Bogie was a Vice President in the BMO Financial Group responsible for economic capital, stress testing and Basel analytics, and jointly responsible for the Internal Capital Adequacy Assessment Process (ICAAP). Previously he was a Vice President in S&P’s Risk Solutions, globally responsible for engineering and implementing new solutions and business development. He has co-authored various papers and a book on Basel II implementation.
Gokul Sudarsana is currently Director, ORSA and Internal Models at Sun Life Financial. He is responsible for economic capital modeling and producing the Own Risk & Solvency Assessment (ORSA), an annual, Board-approved process that integrates risk management with capital and strategic planning. Additionally, Gokul leads the research and development of advanced capital modeling techniques, as well as the identification and advocacy of Global Risk Strategies identified through ORSA. Gokul graduated from the University of Waterloo with a Bachelor of Mathematics in Actuarial Science. He is a Fellow of the Society of Actuaries and Canadian Institute of Actuaries, as well as Chartered Enterprise Risk Analyst.
Michael Giesinger is an Associate Director in the Wholesale Credit Risk group with Barclays plc. He supports the setting of the bank’s risk appetite through the monitoring of exposure and capital limits. In particular, he has oversight over the stress testing process. Michael was a Manager in the BMO Financial Group with responsibility for economic capital methodology development and stress testing. He has also previously worked in insurance and pension consulting.
Citation
Ozdemir, Bogie, Sudarsana, Gokul and Giesinger, Michael (2015, July 1). Can Basel 4 work? What can go wrong? An examination of the new Basel proposals. In the Journal of Risk Management in Financial Institutions, Volume 8, Issue 3. https://doi.org/10.69554/QULM4669.
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