Get ready for Basel 3.5.
Now that regulators have finished fixing Basel III's numerator, they are turning their attention to the denominator.
The rules the U.S. adopted last month make major changes purifying what counts as capital, hiking the total amount required, slapping on a series of buffers to further insulate the largest banks and creating a global leverage ratio as a floor.
But one big problem remains RWA, or risk-weighted assets.
"Basel III fixes a lot, but it really does not fix the shenanigans on the denominator of the ratio," says one senior U.S. regulator. "Basel III will leave the denominator, for the most part, totally at the mercy of internal models."
Our largest banks use internal models to determine how risky an asset is and then assign it a capital charge. No bank does it the same way and no regulator uses the same approach to approving the models. So it's not much of an exaggeration to say Basel III's denominator is calculated in as many ways as there are banks.
As a result, outsiders don't understand, much less trust, the results.
That's why regulators are now turning their attention to RWA.
How do I know? Current and former regulators called to ask why I didn't write about a report the Basel Committee on Banking Supervision issued in July. It was titled "The Regulatory Framework: balancing risk sensitivity, simplicity and comparability." With a title like that, it's easy to see how I missed it.
The only attention this report got was a good ribbing from Karen Shaw Petrou, who noted that what "seems like an incontrovertible policy objective apparently requires a 24-page consultation that parses the pros and cons of simplicity and comparability with such exactitude (not to mention in so much ill-translated prose) as to make even these worthy ideals seem strangely troubling." And the Federal Financial Analytics managing partner isn't wrong. The paper is anything but simple.
Still, it's important because it represents a fundamental rethinking of risk-based capital.
If you read between the lines and you talk with regulators who wrote it it's pretty clear where capital rules are headed. This report's references to "simplicity" and "comparability" are all about frustration over RWA. The Basel Committee has finally concluded that undue complexity is making its capital rules less effective.
Where regulators seem to be headed toward is a more standardized approach to assessing asset risk so that investors and creditors can get a grip on how much risk a bank is taking and how much capital it holds.
The regulators want to be able to compare banks over time and against each other. They want market participants to be able to do the same so that they can help the government police risk-taking at banks.
To do that, regulators may augment a standardized approach with new disclosures. It's unclear yet what these will look like but the goal is clear.
Regulators envision the day when a bank publishes its capital ratios under both a standardized regulatory formula and its own internal models and then explains to the public how and why they differ.
"Disclosure may be the third dimension here that could help break the rocks a bit," says Stefan Walter, the former secretary general of the Basel Committee who is now a global bank supervisory and regulatory policy leader at Ernst & Young.
"I think with those steps you would have a credible RWA framework. There would be the transparency that the market could also impose discipline and it wouldn't just be relying on the banks' internal approaches and the regulators to validate it in a nontransparent way to the public."
The Basel Committee is taking comments on its simplicity paper through Oct. 11, and a proposal affecting the RWA process is likely to follow.
But expect this paper to also have more immediate impact as technicians look to it as they make incremental decisions on the fundamental review of the trading book and reform of the securitization framework.
Why? Because this report is an attempt by Basel leaders to redirect the rule writers toward simpler, more straightforward answers. And that's good news.
Of course the paper also raises the specter of strengthening the leverage ratio for the largest banks. Basel III already has a series of added charges for the giants on its risk-based ratios, but this paper suggests either adding a buffer to the leverage ratio or simply making it higher for the largest banks.
So if you thought the finalization of Basel III meant you could stop thinking about capital rules, think again. More change is coming.