Consultative Document. Reducing variation in credit risk-weighted assets – constraints on the use of internal model approaches.

Comments for the Basel Committee on Banking Supervision

The Basel consultation proposes to remove risk sensitive models, or put floors to them, for Counterparty Credit Risk capital calculations of OTC derivatives.

I believe that, while the Committee’s objectives are understandable, the changes proposed would have very damaging consequences indeed. For that reason I submitted my view to the committee as an independent expert in the field.

In this paper, I explain that, should the new proposals be implemented,

1. Systemic risk is created, as when simple models fail then they will fail in all banks in the world at the same time. This is precisely one of the key risks the regulatory landscape is mandated to remove from the trading system.

2.Market dislocations are created, because trading activity will be steered to those areas with low capital requirements but high relative risk as this is where return on capital will be maximised.

3.The distribution of risk is inhibited, as a consequence of non-economic-based excessive capital flat rules compared to advanced economic-based modelled capital. This would clearly have an (unnecessary) negative economic impact.

4.Banks are un-incentivised to invest in sound risk management practices, as it sends messages to the industry that a bank does not need to be concerned about adopting its own internal risk controls.

5.Innovation is inhibited. Innovation is at the core of any healthy industry, economy and society. Why would a bank invest in research and development of better risk management processes, methodologies and systems when the potential benefits that might accrue have been removed by regulation?

No doubt there is some benefit in simplifying rules for both regulator and for some players in the industry, but those benefits need to be balanced out with the reduction in the efficacy of those rules. One of the fundamental goals of those rules is to provide a stable financial system on which the real economy can be based and grow. My intention with this document is to bring to the Committee’s attention the fact that the new proposals materially reduce the efficacy of the capital framework; i.e., that they increase the instability of the financial system and constrain real economic growth

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