Friday, September 6, 2013

BoE's Carney calling for clampdown on bank risk model to restore trust

Bloomberg reports that Bank of England Governor Mark Carney is calling for a clampdown on bank risk models to restore trust.

This call highlights the need for banks banks to disclose their current global asset, liability and off-balance sheet exposure details.  Without this disclosure, market participants are never going to trust bank financial statements as they have no idea what the banks, with the permission of their regulators, are hiding on and off their balance sheets.

As for a clampdown on bank risk models, this is a classic case of why complex rules combined with regulatory supervision doesn't provide the same benefit as transparency and market discipline.

In the world envisioned by Mr. Carney, all banks would value securities the same way.

Fortunately, this isn't the way the real world works.  There are legitimate business reasons why different banks would assess the risk of and value the same security differently (hint: this difference of opinion is what makes markets).

To have all banks assess the risk of and value securities in the same way would be to make the financial system more prone to instability.

If the mandated risk assessment and valuation proves faulty, then every bank is has a problem.  This doesn't add to stability, but rather instability.

Regular readers know that trust in the financial markets is a function of transparency.  By making the banks disclose their current exposure details, each market participant can independently assess the risk of and value of each bank's exposures.  Market participants trust their own assessment.

Based on this assessment, market participants can adjust their exposures based on the risk of each bank.  This subjects the banks to market discipline and adds an additional layer of robustness and stability to the financial system.

The additional layer of robustness and stability takes the form of market participants limiting their exposure to each bank to what they can afford to lose and ending the risk of financial contagion.

“The risk models that banks use to calculate their capital needs show worryingly large differences,” Carney, governor of the Bank of England, said in a letter yesterday to leaders from the Group of 20 nations meeting in St. Petersburg, Russia. “This must be addressed for depositors, investors, clients and authorities to have full confidence in the strength of bank balance sheets and their resilience during a downturn.”...

The Basel Committee on Banking Supervision, an international regulators group, said in July that some lenders were backing investments with as much as 20 percent more capital than other banks. European banks generally apply lower risk weights to their holdings of bank-issued debt than lenders based elsewhere, the Basel group said. 
“Given large banks risk-weight based on internal models approved by supervisors and populated with their own historic data, it is not surprising that there is substantial inconsistency,” Bob Penn, financial regulation partner at law firm Allen & Overy LLP in London, said in an e-mail.

“Consistency is arguably a good thing here: but for so long as the Basel rules explicitly embed inconsistency it is hard to see how Mr. Carney’s call will be heard,” he said.

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