29 January 2018

ECB's Sabine Lautenschläger: Basel III - sense and sensitivity

Basel III marks the end of the post-crisis reforms; regulatory certainty has been restored. The banks know what awaits them; they can be confident about the regulatory framework, and can plan ahead and support the real economy.

But does Basel III deliver what was promised? Does it, on the one hand, create rules which are sufficiently risk-sensitive to set the right incentives for banks? And does it, on the other hand, create rules which are simple enough to decrease model risk?

Banks are not enchanted by Basel III. Many of them claim that it throws risk sensitivity overboard and penalises low risk exposures. Are these claims justified?

Risk sensitivity helps align capital requirements with actual levels of risk and supports an efficient capital allocation. It prevents arbitrage and risk shifting. And risk-sensitive rules promote sound risk management.

Mrs Lautenschläger says: “But we all know how challenging it is to measure and model risks. Much depends on the quality of the models; much depends on the data and the assumptions that feed into those models; and much depends on supervisors’ capacity to act. If there are errors along the way, banks might end up undercapitalised and vulnerable. This, in turn, might lead markets to question the reliability of risk-based capital requirements in general, which would undermine trust in banks more generally.

“Therefore we need to balance risk sensitivity with some safeguards. And this is exactly what we aim to do with Basel III. It preserves risk sensitivity. It retains internal models for most asset classes. And it enhances the risk sensitivity of the standardised approaches. But at the same time, Basel III adds a few safeguards.

“First, I think we can all agree that it makes no sense to allow for more complex risk-sensitive capital requirements if risks cannot be measured and modelled. Basel III therefore aligns the degree of risk sensitivity with the extent to which it is possible to measure and model risks.

“Second, there are some more conservative haircuts on collateral and some input floors. These input floors lie beneath the parameters for “probability of default” and “loss given default”. And there will be floors beneath the “exposure at default” calculation as well. These floors work bottom-up; they will keep banks from feeding their internal models with excessively low inputs. This serves as a safeguard as it prevents capital requirements from being set too low.

“Third, there is the hotly debated output floor. It ensures that risk-weighted assets calculated with internal models do not fall too far below those calculated with standardised approaches. “Too far below” means they must reach at least 72.5%. Does that kill risk sensitivity? No, it does not. Obviously, there is still room for banks to apply individual risk weights and to benefit from lower capital requirements for classic, low-risk banking business.”

What impact will the final Basel III package have on banks – and on their business models and their capital?

The rules are not neutral. The bottom-up safeguards in Basel III, including the input floors, will impact on risk weights in some business areas. Certain retail credit card exposures are one example. The top-down output floor affects overall capital requirements, depending on the overall portfolio composition of a bank.

Overall, it is hard to predict how business models will evolve. This depends not only on regulation, but also on many other factors, including the future path of profitability in different business areas, the pricing power of banks and, eventually, how banks will adapt their business models.

To sum up, Basel III preserves risk sensitivity in a sensible way. At the same time, banks will be able to handle its impact and, in the long run, they too will benefit from a more stable banking system.

Full speech

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