04 March 2014

BCBS/Ingves: Restoring confidence in banks

Ingves outlined why confidence had been lost in the past, then highlighted what the Basel Committee is doing to help restore confidence. Until the question marks on the reliability and comparability of RWA calculations are resolved, confidence in capital ratios cannot be fully restored, he said.

The financial crisis, which began seven years ago, was in essence a collapse in confidence. It stress-tested regulation just as much as it did banks. Both were found wanting. Bank risk managers severely underestimated the risk that such a widespread loss of confidence in the banking system could occur. The regulatory framework was inadequate to protect against such a crisis of confidence when it did. The result was a crisis that continues to impose substantial costs on society.

There's no doubt that Basel III and the other post-crisis reforms will produce a more resilient financial system. BCBS intends that banks should be able to ride out the next set of financial shocks much more capably than before, both for their own sake and for that of the credit they intermediate. Restoring confidence in banks is critical to the end-objective, which is to buffer the real economy against financial stress.

The problem of risk-weighted asset variability

People are asking if we can rely on the risk-weighted asset measurements that stand at the Basel framework's core - or, more precisely, in its denominator. At a stretch, you might compare these measurements with the sensors that set off the airbags in your car. If the sensors don't work as intended, the airbags won't be of much use.

The Basel Committee takes these questions very seriously. As matters stand, we've so far published three studies on risk-weighted asset variability - two for the trading book and another for the banking book. Taken together, these show that actual risks drive the lion's share of differences in risk weights and capital requirements. This, of course, is just as it ought to be. But variations also arise from supervisory and bank practice-based idiosyncrasies, and these can result in material discrepancies. While it is difficult to be precise on how much scatter is "too much", the range of bank practice-based variations is uncomfortably wide.

Let me give you a sense of that scatter. If we just take the banking book results - which only focused on risk-weighted assets for sovereigns, banks and wholesale credit - two banks with exactly the same assets could report capital ratios that differ by 4 percentage points. That is, if the most conservative bank reported a regulatory capital ratio of 8 per cent, the least conservative one would report 12 per cent. Of course, this simply compares the extremes in the sample - most banks were much closer to the average. But the potential for differences this wide, particularly as they are derived from only a part of a bank's business, weakens confidence in the measurement of bank capital.

The first step to solving a problem is acknowledging you have one. From the Committee's perspective, we see there is a key problem that needs to be fixed. To bolster confidence in the reliability of their capital ratios, banks should also have a keen interest in ensuring that their risk measurement methods are viewed as robust and credible. Any doubts in this area also begin to call into question stress-testing results and risk management systems more generally, since these are all built on the same foundations.

Thus far, the response from the banking industry on this issue has been mixed. Some banks - and organisations like our hosts today, GARP, and the IIF - have been keen to engage with the Committee and are endeavouring to offer constructive ideas and suggestions on how to reduce variability. This is very welcome. Some others in the industry have been less keen to acknowledge there is a problem. The message I would like to leave you with today is that there is one, and we plan to do something about it. And, ideally, we would like your help. Success is critical to restoring confidence in bank capital ratios and this is of great importance to both banks and regulators alike.

So what is being done? Clearly, when the causes are multifarious, there can be no single "silver bullet" solution for risk-weighted asset variability. It follows that the regulatory response also has to pursue several different leads. In fact, these efforts can be grouped into three main strands, that of (i) policy, (ii) supervision and implementation, and (iii) disclosure.

(...)

Basel III has materially addressed shortcomings in the numerator of the risk-based capital ratio, and it has added additional safeguards in the form of leverage and liquidity requirements. But, to use another Swedish proverb, don't celebrate until you have crossed the creek. Question marks remain about the reliability and comparability of risk-weighted asset calculations and, until these are resolved, confidence in capital ratios cannot be fully restored.

When deciding what to do about this issue, let me assure you that supervisors are keen to engage the industry in a constructive dialogue on the best way forward. Indeed, I hope my remarks today will be taken as part of that dialogue. My focus today has been on the actions already taken by the Basel Committee, or in its pipeline, that will help restore confidence in banks. But this is just one element in the equation. Banks themselves must take a leading role, as the ultimate restoration of confidence depends on the actions they take. The Committee is eager to hear from banks and other interested parties on their preferred course of action. Industry-led initiatives to foster improved understanding of these issues are therefore more than welcome - they are a vital part of the process.”

Full speech

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