The BCBS, performing its role as the supranational regulatory authority, typically employs the financial crises as a real time test to assess the adequacy of the Capital Accords, and, after proper consultation periods, and QIS, enacts partial or radical modifications to the existing order.
However, it seems that it usually overlooks many important implications; Demirguc-Kunt, Detragiache and Merrouche study a multicountry panel of banks before and after the subprime crisis of and argue that different forms of capital exert different effects on the performance of the banks. After the crisis and the consequent Basel 2.
Perhaps not surprisingly, the most stinging criticisms are referred to VaR, which application asa risk measure was bolstered in Basel III. From the seminal paper of Artzner et. Furthermore, Artzner et. ES has been extensively studied Artzner et. This last property reveals especially important for regulatory bodies, which are undoubtedly concerned with shortfalls greater than VaR, i.
However, instead of celebrating those amendments, the literature demanded the end of VaR-based models in the capital framework: Danielsson, Shin and Zigrand and Adrian and Shin opine that VaR accelerates the crises instead of halting their progress.
Basel IV effectively replaces VaR for ES BCBS , in what constitutes a significant departure from the previous regulatory approaches to determine bank capital -both conceptually and procedurally-, a move partially suggested by Hellwig and Danielsson, Shin and Zigrand The BCBS took special care in strengthening the process of evaluating the capital estimation; in addition to the qualitative considerations, Backtesting and Stress tests contained on Basel III, a new battery of tests is proposed.
The BCBS maintains its stance at the time of dealing with the schemes within the IMA as there are no specific indications on that respect. The SA has also been subject to a major revamp under Basel IV proposed reform in order to achieve the major objectives outlined by the BCBS materialised in: providing an alternative methodology for banks not qualifying for the IMA, finding a credible fallback for models and, finally, facilitating the comparison of capital levels across borders.
In this sense, the BCBS put forward a sensitivity-based approach that resembles the Markowitz framework , although the market correlations are prescribed by the BCBS. The issue of capital sufficiency, finally, has always been subject to heated controversy, particularly because of its close connection with the regulatory requirements, given that banks usually tend to adjust their capital buffers in such a manner that they only exceed the minimum levels by a small margin Berger et.
Consequently, the adequacy of the capital framework acquires utmost relevance and, consequently, it is not surprising to find opposing views: from Haldane who underlines the complexity and lack of robustness of the regulatory structure which augments the model error in the IMA and the ensuing inappropriateness of the capital ratios, to the staunch support of the countercyclical capital buffers in Shim and the criticism launched by Rossignolo, Fethi and Shaban who question the application of Basel III and propose the utilisation of Basel II with highly leptokurtic models, as well as a complete revision of the SA.
The current article contributes to the literature from different angles, with reference to the new proposals susceptible of being labelled Basel IV: in the first place, it targets the quantification of the introduction of ES in the respective settings forthe estimation of MCR using a variety of models IMA in comparison with the analogous requirements in Basel II and Basel III; in the second place, it critically evaluates the numerical relationship between the ES-based IMA and the market sensitive SA assessing the incentives to develop accurate internal models and, in the third place, it fosters the suitable and easily applicable calibration remedies in order to align incentives, specifications and capital buffers between IMA and SA.
Table 5 Panel A - Portfolios and risk buckets - Mexico. IMA and SA allow the determination of capital levels. The paper proceeds comparing the ERC arising from every validated IMA with that surging from the SA for both portfolios in a bid to gauge the pertinence of the corresponding levels. Finally, the article proposes some straightforward routes to solve the likely problems that may arise because of the disparity in the capital levels derived from IMA and SA, furthermore contributing to deal with the incentives problem that -again- appears in Basel IV.
The paper bolsters the use of a series of calibration parameters that contribute to level the Loss Coverage Ratio LCR across the approaches. In this sense, it is not surprising the failure of HS and the Linear Normal and Student-t specifications to pass Backtesting.
Given that the rest of the schemes pertain to the Yellow Zone i. Finally, EVT manages to deliver outstanding results with no exceptions and, therefore, does not require additions to the capital base due to higher VaRs Table 6. Tables 7 and 8 -Panels A and B- inform the outcome of the first part of the second stage of the evaluation process contained in Basel IV. The comparison of Panels A and B of Table 8 shows that the BCBS achieves coherency at the time of establishing the boundaries for each confidence level as the absence of discrepancies reinforces the outcomes obtained Table 9.
Tables 10 and 11 -Panels A and B- exhibit the quantity of breaches recorded in the Backtesting period and the specification that would be used to capitalise the trading desk for each test respectively. Table 7. Table 8. Table However, the associated analysis of Table 6 and Table 13 crowns EVT as the most reliable model as it does not take any penalty under Stage I former Basel Backtesting and, additionally, weathers Step 2 without any exclusion. This result should not be labelled as surprising, although the novelty in this occasion resides in the fact that the methodology circumvents the prospective Basel IV more stringent criteria.
In view of the aforementioned reasons, and considering its untainted performance, the rest of the article employs the EVT-based model in the issues connected with capital levels and its interaction with the SA and further relationships. As expressed in 2. Table 14 Step 3 - Risk Factor Analysis. Table 15 depicts the MCR arising from all the models, calculated for both portfolios.
Unfortunately, the question of the adverse incentives to employ the most accurate techniques underlined by Rossignolo, Fethi and Shaban in Basel III hovers aroundin Basel IV too, given the fact that models with unblemished reputation can still deliver MCR higher than penalised ones. Much in the same fashion as in Basel III, Table 15 Column [11] beckons the somewhat excessive amount of capital buffers that an institution resorting to EVT may be compelled to constitute.
Even though that situation is consistent with the main characteristics of the theory, the values reported seem nevertheless relatively high for the purposes intended, which might result dampened following the procedures suggested in the ensuing paragraphs.
It may be appreciated that the influence of the addition of the stressed VaR in Basel III as opposed to the ratio scheme courtesy of Basel IV plays a role not to be neglected and may potentially help to explain the reasons behind a VaR-based formula exceeding an ES one Table 16 Columns [].
Notably, the establishment of fixed risk weights and correlation parameters produces very stable and uniform ERC Table 16 Panel A, Column [6] with a stunningly low standard deviation of 0. The relationship between the revised IMA and SA undoubtedly comprises one of the aspects of the utmost relevance to evaluate the extent of the revamp.
It clearly reflects the intentions of the BCBS, i. Therefore, given the characterisation of the SA as a fallback, those precise techniques overcoming the strict validation process appear to have little chance of being applied.
However, the current paper puts forward a straightforward alternative to employ the specifications under the IMA in order to align the incentives to utilise either avenue 26 -within the boundaries enacted by the BCBS- based on the introduction of multiplicative calibration parameters in 2. Given the pressing concern embodied in the ostensible differences in the level of the MCR, finding a common threshold where the two approaches approximately coincide could in principle dampen the abysmal motivations to apply one or the other.
In this vein, the article proposes the calibration of the three parameters across portfolios to minimise the RMSE and MSE 27 varying one factor at a time, thus trying to keep the original BCBS structure as unchanged as feasible. The outcome displayed in Table 19 Panels A, B and C hints at the fact that equilibrium could be attained by calibrating the aforementioned factors, without compromising the overall coverage. Table 19 , consequently, gives an inkling of the several possibilities that the national supervisors might introduce making use of the flexibility of the parameters guided by the particular considerations verified in their respective countries.
Furthermore, it highlights the problems that the proposals could pose to the regulated institutions, both in terms of the excess of the capital buffers and the moral hazard that surges as a consequence of the imbalances between the IMA and SA configurations.
As part of the extensive review of the failures of the regulatory framework in the context of the major crisis of , the BCBS introduced a package of reforms collectively named Basel 2. However, despite containing stark differences with their predecessor Basel II, they came under scrutiny and are currently subject to ongoing analysis.
One of the stated aims of the proposed reform is to design a new overall approach to risk measurement for the determination of MCR, characterised by the complete overhaul of the SA and the IMA. However, as it seems customary for all regulations, it leaves many points to improve, many of which appear underpinned by the results of the study. In the SA department, the BCBS correctly detected and modified the setting to enact a more risk sensitive appraisal capable of producing higher capital buffers than its predecessor Basel III.
That homogeneity, arguably achieved through the fixation of the risk weights and correlation parameters across the assets, nevertheless raises lack of efficiency connotations as shown by the substantially high LCR, given the fact that it gives the impression to snub the changing pattern of the correlations among securities.
Regarding the IMA, the article points out that the procedure for the validation of the models is excessively restrictive, thus stifling the development of techniques and limiting the scope for innovation. Furthermore, the study also detects the presence of inconsistencies, as the most precise techniques may be obliged to constitute higher capital levels than lessaccurate ones.
Undoubtedly the BCBS attained its goals of bolstering the capital base by radically revamping both SA and IMA, notwithstanding which the study finds the methodology rather debatable. Although the transformation of the SA into a more risk-sensitive appraisal is healthy, its efficiency remains questionable given that the fixed correlation and risk weights parameters may play to its detriment by neglecting the changing nature of thecorrelations among assets and, consequently, raising the cost of capital.
In order to bridge that arguably unintended consequence, the paper puts forward the introduction of calibrating parameters operating as multiplicative factors in the SA and IMA formulas within the structure of Basel IV.
This modification would entail greater powers and responsibility to national regulators, who must decide on the appropriate values according to the respective environments. These parameters are developed to align the incentives between the SA and the IMA and, consequently, to restore confidence in market risk models. The major contributions of the paper root in the ensuing distinct points. DOWD, K. Select personalised content. Create a personalised content profile. Measure ad performance.
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Bank Capital Bank capital is a financial cushion an institution keeps so as to protect its creditors in case of unexpected losses.
It represents the bank's net worth. Learn about Basel III Basel III is a comprehensive set of reform measures designed to improve the regulation, supervision and risk management within the banking sector. Partner Links. Related Articles. Banking How Basel 1 Affected Banks. Investopedia is part of the Dotdash publishing family.
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