An important issue in the next chapter of bank reforms will be the role of bank risk models in setting bank capital requirements. One way or another, models are here to stay. But trust needs to be rebuilt in those models.
It is a pleasure to speak with you again this year. Time flies when you are having fun, and the last 12 months have certainly flown by on the international regulatory front. By my count, the Basel Committee on Banking Supervision (BCBS) issued more than 30 publications in 2013 including various reports, proposals for consultation and final standards. 2014 is also shaping up to be a busy year, as we write some new chapters in the saga of global regulatory reform.
This afternoon, let me discuss three issues that are front and centre on the international regulatory landscape. They include the new Basel III leverage ratio, new Basel liquidity standards, and the continuing debate about the role that bank risk models should play in setting regulatory capital requirements.
Basel III leverage ratio will replace OSFI ACM requirement
OSFI has imposed a leverage requirement on banks -- known as the Asset-Capital Multiple (ACM) requirement -- since the 1980s. It is a rather simple leverage test that constrains the amount of assets banks can carry for a given level of capital. Its simplicity is a virtue. In the years leading up to the global financial crisis, the simple ACM helped prevent banks from shedding too much capital when more sophisticated bank risk models were bewitched by the benign environment and signaling opportunities to reduce capital. Using both approaches in tandem in Canada has served us well.
The benefits of a simple leverage test have been recognized by the international community in the wake of the global financial crisis. Indeed, the Basel III leverage standard has just been approved by the BCBS. It differs from OSFI’s ACM requirement in that it includes more off-balance-sheet exposures on the asset side, and a narrower definition of capital (Tier 1 instead of Total Capital) on the liability side. It is also more complex than the ACM because it has been designed to look through differences in accounting rules across jurisdictions so that bank leverage data can be compared on an “apples to apples” basis across banks. But, at the end of the day, it basically serves the same purpose as the ACM.
Basel III requires banks to begin publicly disclosing their Basel III leverage ratios in early 2015. As a result, OSFI will issue a new leverage guideline later this year that will replace the ACM with the new Basel III leverage test. Federally regulated deposit-taking institutions will be expected to have Basel III leverage ratios that exceed three per cent. As has been the case with the ACM, OSFI will continue to set more stringent requirements on an institution-by-institution basis as circumstances warrant.
Some jurisdictions like the U.S. have signaled they are considering higher leverage ratios for major banks within their jurisdictions. But as with many things in Basel the devil is in the details when one tries to compare prudential requirements across jurisdictions. OSFI is not planning to do so at this time for several reasons:
- First, we believe incentives work best when regulatory capital requirements are driven in the first instance by the risk-based framework, with the leverage requirement serving as a backstop to guard against the model uncertainty inherent in the risk-based framework.
- Second, as I just indicated OSFI wants to be able to continue to retain flexibility from a supervisory perspective to set more stringent leverage requirements on an institution-by-institution basis as we have done with the ACM. This becomes more challenging the higher the industry-wide requirement.
- Third, there are some fundamental differences between Canadian and foreign banking systems, notably in mortgage finance, which argue for lower leverage requirements for Canadian banks.
- And, fourth, as I just mentioned, we need to see how the Basel III leverage requirement is actually implemented in other jurisdictions.
Finally, as you know, there has also been some debate in recent months as to whether securities financing transactions (SFTs) should be handled on a gross or net basis in the leverage test, as well as on how to handle off-balance-sheet exposures in the test. In the end, the Basel Committee agreed to a limited form of netting for SFTs. And, it agreed that notional values of off-balance-sheet exposures will be converted into credit exposure equivalents using Basel-specified credit conversion factors. But, the public disclosure requirements accompanying the leverage ratio will also allow you, the investing public, to apply your own judgment as to how different elements should be handled in the test. For example, you will be able to readily compute what bank leverage ratios would look like if you assumed either no netting for SFTs and/or applied your own credit conversion factors for off-balance-sheet exposures.
Coming soon—a second Basel liquidity standard
As you know, part of the regulatory reform saga has been focused on promoting more prudent liquidity and funding management by banks. So, let me now turn to developments on that front. In late November OSFI released a draft guideline setting out how we propose to monitor and set expectations for the liquidity and funding profile of federally regulated deposit-taking institutions. Among other things, it includes details on how the Basel Committee’s Liquidity Coverage Ratio (LCR) standard will be implemented by OSFI, as well as information on how OSFI’s own Net Cumulative Cash Flow (NCCF) supervisory tool will operate in tandem with the LCR. The comment period for the draft guideline closes on January 24. OSFI will publish the final version of the guideline later this year with effect from the start of 2015. Given the strong financial position of Canadian banks, OSFI expects them to fully adhere to the new LCR requirements from the start. Indeed, banks will begin disclosing their LCR ratios in the first half of 2015.
But that is not all on the liquidity front. In addition to focusing on the ability of banks to weather periods of funding stress, the Basel Committee has also been preoccupied with questions related to appropriate funding structures of banks. As a result, it has just released a revised proposal for its second liquidity standard, the Net Stable Funding Ratio (NSFR). The NSFR complements the Liquidity Coverage Ratio (LCR) by focusing more on the extent to which a bank relies on short-term versus medium- to longer-term sources of funds. After the Basel Committee finalizes the NSFR later this year, we, at OSFI, will begin work to incorporate it into our new Liquidity Guideline. The NSFR standard will take effect in 2018 and like the LCR will also come with some disclosure requirements.
The LCR and the NSFR introduced by the Basel Committee will go a long way towards discouraging risky funding structures and giving you, the investment community and us, as regulators, a better picture of how banks fund themselves and how they manage their pools of liquid assets.
No escaping bank risk models in bank capital requirements
No saga would be complete without a few twists and turns in the plot. Basel III is no exception. Just as it is getting underway, questions are surfacing about the reliability of models used by banks to calculate the risk weights in their regulatory capital ratios. Further ammunition for the critics has been provided by three studies published by the Basel Committee that suggest that model-based risk weights vary widely across banks.
Why is that? Well, the Basel studies argue that a large portion of the variation can be explained by differences in portfolio composition. This is understandable and reflects differences in bank risk preferences as intended under the risk-based capital framework. But material variation remains. Partly this reflects supervisory constraints on bank modeling practices that often serve to raise portfolio risk-weights (and thus increase the diversity in risk weights across banks, especially across jurisdictions), but frankly a large portion reflects modeling choices made by banks.
In October 2013, in a speech to a Risk USA conference in New York City, I discussed how bank risk models should be supervised drawing on OSFI’s practices in this regard. But, better supervision is not enough. More needs to be done if we are to re-establish investor confidence in model-driven risk weights. A good place to start is to consider what steps can be taken to provide investors and other stakeholders with the information they need to hold banks accountable for the adequacy of their risk management practices so that comparisons can be made across institutions.
This is where the recommendations of the Enhanced Disclosure Task Force (EDTF) come in handy. In 2012, the Task Force provided 32 recommendations on how banks can shed more light on their risk exposures and risk management practices, including their modeling practices. In the case of risk-weighted assets, the six major Canadian banks are working hard to adopt the EDTF recommendations over the course of 2014 and enhance their disclosures to provide more consistent information. This should help you, the users of this information, understand how bank risk models are influenced by data inputs, modeling assumptions, mathematical formulations, manual overrides and point-in-time versus through-the-cycle assumptions. You should also expect to see more explanations as to how banks assess their model performance, including how credit risk models perform relative to actual default and loss experience.
Another way of restoring confidence in the model-based capital framework is by showing more restraint around what models can accomplish and applying some safeguards, including tighter calibration standards. By construction, models are crude simplifications of reality. Some risk exposures are bound to be more challenging to model than others, and some data used as inputs in models are bound to be more fragile than others. This is where greater use of floors on calculations of specific elements of capital may be a helpful antidote against acute model uncertainty or intentional and unintentional gaming.
Similarly, it is worth considering tying some model-based capital calculations more tightly to those arising from the standardized capital framework -- especially for those exposures that appear to carry very low risk due to a paucity of risk events. It is difficult to judge whether such exposures are truly low risk, or if there were few adverse events in the data sample used to run the model. This is particularly relevant for low frequency events that come with severe consequences when they materialize. These types of risks are not well served by the typical models-based expected loss approach. The latter tend to suffer from narcolepsy in that they have a habit of becoming sleepy when confronted by an extended period of benign conditions, only to snap awake too late after the risk has crystalized.
You can see where this story is going in the Basel Committee’s recent proposal for reforming market risk capital requirements. First, it proposed establishing a closer link between capital charges resulting from the models-based and standardized approaches. Next, it suggested requiring a mandatory calculation of the standardized approach by all banks. Third, it signaled that it would require mandatory public disclosure of standardized capital charges by all banks on a desk-by-desk basis. Finally, the Committee is also considering the merits of introducing the standardized approach as a floor or surcharge to the models-based approach.
Some observers, including some Committee members, would like to go further and apply these approaches throughout the capital framework as a whole. If they succeed model-based capital requirements will clearly be on a much shorter leash in the future. However, it would be a shame if this led investors to simply focus on the standardized capital charge calculations and ignore the internal model-based ones. After all, at its heart the standardized approach is itself just one arbitrary model. While it may result in capital ratios that are computed on the basis of the same formulae across banks, the resulting ratios would likely be less informative about the risks actually being carried by individual banks.
Moreover, as we rein in the model leash for the Basel rule book, it is also important to bear in mind that when it comes to models, you can run but you cannot hide. There is no getting around the fact that discussions of bank capital requirements need to be grounded in the information provided by well-designed and properly used risk models. Simplifying the rule book will not change the game. It simply moves more of the conversation into the realm of private discussions between individual banks and their supervisors. As a result, more demands would be placed on front-line bank supervisors to ensure that each bank carries enough capital to absorb any losses it might incur.
At the end of the day, we cannot escape the need to make sure that models are well designed, with appropriate use of floors and other safeguards. We also need to ensure that they are used in a more transparent fashion, if investors and other stakeholders are to understand why banks are carrying capital at certain levels. I have outlined some steps that we, in the public sector, are taking to try and rebuild investor confidence in bank risk models. But, frankly, more needs to be done, and it is time for banks themselves to step up to the plate and take charge of this issue. They are, after all, the owners of the models and could do more to be the masters of their fate.
Let me end by reiterating my main points:
- OSFI will replace the Asset-Capital Multiple test with the new Basel III leverage ratio in January 2015. This will be reflected in a new leverage guideline that will be issued later this year.
- The Basel Committee has proposed a second liquidity standard called the Net Stable Funding Ratio. After it is finalized, OSFI will include it in our new Liquidity Adequacy Guideline. The NSFR will take effect in 2018.
- An important issue in the next chapter of bank reforms will be the role of bank risk models in setting bank capital requirements. One way or another, models are here to stay. But trust needs to be rebuilt in those models.
Thank you again for the opportunity to speak with you today. As you can see, together we are continuing to write new chapters in the saga of global regulatory reform. The benefit of this work will be a safer, more resilient financial system that will continue to earn the well-deserved confidence and trust of depositors, creditors and investors.
I wish you all the best in 2014 and would be pleased to respond to your questions.