Martin Wolf at the Financial Times recently wrote about how financial regulations are procyclical: regulations, or more specifically prudential measures, relax during economic booms and tighten at stressful times. Wolf identified this regulatory procyclicality as a contributing factor to past and potential future crises, attributing it to reasons ranging from economic and political, to ideological and human.
With Brexit looming close, evidence of this procyclicality can be seen in the UK as the Bank of England changed the length of time that some banks must hold easy-to-sell assets, increasing it from one month to three. This tweak to the so-called Liquidity Coverage Ratio will affect banks with larger investment banking and asset management businesses and represents a tightening of prudential thresholds at a point of heightened macro-uncertainty.
The announcement came just months after major UK banks comfortably passed the 2018 Bank of England Stress Test which included a no-deal, no-transition Brexit scenario. While the regulator is rightly cautious as severe uncertainty remains over the Brexit end-game, this does raise the question of just how resilient our financial system is to withstand not just stress tests, but also real-life shocks.
It also adds to a run of recent events placing the spotlight on other parameters central to banks’ financial resilience – notably risk-weighted asset (RWA), a measure the Basel Committee have questioned in the past with regards to its comparability across financial institutions.
Part of the problem of RWA is the inevitable trade-off between consistency and arbitrariness when attempting to risk-weight complex balance sheets.
RWA calculated using the standardised approach is consistent and comparable, but ignores institution-level idiosyncrasies. The contrary is true for banks’ internal rating-based systems (IRB), which scrutinises institution-specific risks but at the cost of cross-institution comparability.
A 2016 study by the Basel Committee uncovered significant divergence in how different banks would risk-weight an equivalent mortgage book using their internal models: in one incidence, a median risk weighting of 16.9% disguised a low of barely 5% and a high of over 80%.
This variation also casts doubt over the improving performance of other risk measures that are based on the RWA, such as the all-important capital ratios, and raises the question of whether our financial system has meaningfully strengthened following the Global Financial Crisis.
Regulators are taking notice. The most recent supervisory statement from the Prudential Regulation Authority (PRA), published March 2019, seeks to move towards a more homogeneous regulatory capital assessment for financial institutions implementing the IRB approach. Most evidently through the definition of default in which the PRA states an expectation of alignment with European Banking Authority (EBA) Guidelines.
Further guidelines from both the PRA and the EBA, including increased clarity and specificity on acceptable methodologies and model calibration processes, are clearly intended for a higher degree of alignment across both jurisdictions and institutions. More recently, the Basel Committee went a step further in giving blessing to the idea of having external auditors checking banks’ RWA calculation.
Whilst the move towards a more congruent capital calculation approach will help to increase comparability between financial institutions, it does add to a growing array of changes in prudential risk and capital management. Alongside the recent transformation in impairment modelling and the increasingly high bar being set for regulatory stress testing, the pace of change within prudential regulation looks set to continue, at least for the foreseeable future.
Given the elevated asset values, high corporate and public debt, plus concerns about slowing growth across major economies it looks likely that the final step in post-crisis prudential reform may be one of the hardest to take. It will test banks’ delivery capabilities across modelling, data infrastructure and internal reporting and controls. It is also likely to be procyclical in nature.
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