The final approvals for the BASEL III capital standards provided by US regulators. Was going through one of the article published in imagesAmerican Banker written by Clifford Rossi, opens up that implementing robust capital standards that give individual institutions sufficient buffers from extreme events and protect the system at-large has been a major challenge for regulators and the Basel Committee since the inception of risk-based capital charges years ago. However, over reliance on analytic methods that failed miserably during the crisis puts the entire system at risk while creating enormous burdens on institutions and regulators to closely oversee these models.  

As the Basel capital rules feature essentially two types of requirements: leverage ratios that do not make adjustments for specific risk types; and risk-based standards that do account for such differences. In the past, critics of simple leverage ratios have called out the potential for such measures to be overly simplistic. Without differentiating, risk leverage ratios may artificially lead to market distortions and misallocations of capital across sectors. Eventually, Basel got around to adding risk-based standards for credit risk and then components for market and even operational risk. The concept of imposing a set of risk-based capital standards spanning these major risk types is sensible in theory, but turns out to be extraordinarily cumbersome at best and systemically risky at worst in practice.

Three areas that highlight Basel’s overreliance on models are treatment of operational risk; the use of value-at-risk models for determining capital requirements; and counterparty valuation adjustment computations for derivatives.

Operational risks stemming from breakdowns attributed to people, process and technology have become increasingly apparent in banking over the years. Measuring a bank’s average exposure to such risks does not easily lend itself to strict quantification due to inherent challenges in measuring events that occur very infrequently but generate large losses when they happen.

Basel also permits the application of VaR models – notorious for vastly underestimating bad scenarios during the mortgage crash – in estimating credit, market and even operational risk. Even today issues with VaR models remain, as evidenced by last year’s JPMorgan Chase derivatives trading incident, where changes in VaR models and errors in measurement of trading losses contributed to misidentification of emerging risk

Another example of misplaced emphasis on models occurs in estimating counterparty risk for derivatives activities, or CVA calculations. The financial crisis underscored the need to strengthen counterparty risk assessment. However, this is an area where models replete with mathematical elegance are notoriously sensitive to a number of critical assumptions and data. And if this weren’t enough, VaR for CVA is allowed under advanced measurement methods for Basel – further subjecting the CVA results to inherent flaws in estimating extreme loss events using VaR techniques.

The Three areas that highlight Basel’s overreliance may mitigate systemic risk may actually wind up increasing it under Basel III.