JPMorgan, BNP step up calls to re-open Basel III framework

Upcoming implementation of output floor and trading book review will hinder economic rationale of internal models, investment banks warn

by | November 26, 2021 | bobsguide

JPMorgan’s and BNP Paribas’ heads of EMEA regulation urged standard-setters at the Basel Committee on Banking Supervision to re-open discussions on the final Basel III framework, after the risk of global divergence in applying capital rules surged at the end of October.

After the European Commission laid out some key deviations and delays in its implementation of Basel III capital requirements last month, some global investment banks are stepping up warnings other jurisdictions could follow suit and introduce further divergence and time lags, in turn heightening implementation risks and hurdles.

“If different jurisdictions are taking different approaches, in part based on the perception that the final Basel standards were over-calibrated, what we are seeing is potential fragmentation,” Dale Butler, executive director for JPMorgan’s EMEA regulatory affairs, said at an ISDA event on trading book capital last week.

“From that perspective it is slightly discouraging that we’re not actually encouraging some level of convergence around these global markets and the capital requirements associated with it at Basel,” Butler said, “and the reluctance to re-open some of these issues to this day is quite concerning.”

Veronique Ormezzano, head of BNP’s prudential affairs, voiced similar concerns that the Basel Committee was failing its global remit by not taking stock of increased fragmentation.

“Frankly if the US, the EU and possibly at some point the UK too deviate from Basel [standards], I have to wonder whether Basel remains an international standard. 

“We need to make sure that [the Basel Committee] accepts the idea that some targeted amendments will have to be implemented, rather than being in denial and try, by principle, to not re-open anything, which seems to be the stance […] recently.”

Doubling down on calls to run a reality check, Butler urged: “Ultimately it is unfortunate that we have this misalignment in approaches – But we do have an obvious forum for that, and that is Basel, and Basel should re-open this issue.” 

“And we encourage policymakers across the world to do so,” he added. “As the perspective of a global institution, we like global rules.”

Reliance on internal models beleaguered by output floor, FRTB?

One of Basel III’s most notable changes is the introduction of an ‘output floor’ that limits the benefits to banks using internal models (IMA) of potentially lower risk-weighted assets – to maximum 27.5 less than what would be required using a standardised model approach (SA).

Another key novelty of the framework  – the Fundamental Review of the Trading Book (FRTB) – replaces previous capital requirements for market risk and raises the bar for compliance, whether through internal models or standardised ones.

The FRTB will strengthen the approval process for internal models, increase the risk-sensitivity of standardised models mandate a clearer separation between trading and banking books – all measures that, from a regulatory perspective, aim at curbing the economic advantage of banks using IMA and at making SA a credible fallback for internal models, which in turn should lead to a more streamlined and strengthened prudential backdrop globally.

However, combined, these two crucial Basel III changes hold the potential to significantly move the needle between IMA vs SA reliance – with some warning the rationale for using more sophisticated internal models may be quashed by the changes.

“Senior management in particular are really asking – is it worth it? Is the cost of changing the bank, is the cost of implementation going to give me returns when it comes to risk-sensitivity and capital efficiency?” said Katherine Wolicki, global head of regulatory policy at HSBC.

“For many it is not so obvious […] The jury is definitely still out on whether it’s gonna be worthy to do IMA.”

Wolicki admitted the new framework’s SA modelling will allow for much greater risk sensitivity, although it will do so at the expense of simplicity.

“I guess policymakers have succeeded in creating a credible fallback,”  she said. “The standardised approach is much more complex than […] any other standardised approach before.

“We have had an external assurance review [firm]come in and look at our SA reporting capability so much so was the desire to get this right. We also had our second line of defence for the internal model validation function look at the [SA] framework.”

“[But] if the barriers for SA have gone up, the barriers for IMA have gone up that much more,” she said. 

Despite the fact that bolstered IMA approval processes introduced by Basel III will mean that, “basically, using the IMA forces you to stay in a situation of high regulatory uncertainty over time,” BNP’s Ormezzano remained convinced of the persisting benefit of IMAs – with the liquidity glitches experienced during the pandemic having strengthened the case for resorting to highly risk-sensitive models. 

“Risk sensitivity is absolutely essential, and in particular the capacity of managing risk in an extreme situation is what really matters in terms of performance of a trading desk or capital market business.

“At some point during the worst days of the [pandemic-led] market turmoil, our management had the impression that people were managing the regulatory risk of reaching a threshold more than managing the full risk of losses in the real market – and that’s why risk sensitivity in the regulatory framework matters,” she said.

“So is it worth the effort? I guess the answer has to be yes.”

Robert Smith, partner at KPMG’s UK risk management division, said regulatory capital changes associated with FRDB were “by far and away the most complex and hardest to implement and to explain to senior management” and would “impact pretty much every business division and function within a firm.”

“It also makes it really tough to manage a global business if you’ve got different rules in different jurisdictions being implemented in different timeframes,” he said echoing Butler’s worries about global fragmentation.

“How do you look at that across your global businesses? How do you look at an aggregate risk measure [and] at an aggregate capital measure?

“This is a very complex beast […] that is going to have a very big bearing,” also in terms of “the impact on the attractiveness of internal models,” he said.

Companies should decide which entities should adopt IMA and which ones should use a standardised model “early on, because it impacts a lot of what you do – the projects, the infrastructure [and] the data” Smith said.

“But you can’t do that until you have clarity on the timeframe and on the consistency of the rulebook.”

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