Big banks could be underplaying their risks

William Coen, secretary general of the Basel Committee on Banking Supervision, said lenders had made “very good progress” in building up capital buffers since the financial crash, but warned that big banks could be underplaying their risks to reduce the amount of capital they hold, thereby boosting profits, reports The Telegraph.

The Basel Committee is an international group that sets rules on the capital buffers banks must hold to protect themselves in the event of an economic downturn.

The system makes banks hold more capital against risky loans in a bid to make the financial system both fair and safe.

A key clause in the system allows the biggest banks to use their own internal models to calculate risk, resulting in different banks holding wildly different amounts of capital against exactly the same loans.

“In principle, internal models permit more accurate risk measurement,” said Mr Coen in a speech in Sydney. “But, if they are used to setting minimum requirements, banks have incentives to underestimate risk.”

The rules are also highly complex, making it difficult to work out what the “right” amount of capital may be.

“Complexity in internal models, banks’ choices in modelling risk parameters, and national discretions in the framework, have all contributed to this variation,” he said.

“However, I think it’s fair to say that the wide discretion provided to banks in the current framework is likely a major driver of this high degree of variability.”

Small banks have complained bitterly that they face tougher capital rules than their larger rivals, making it hard for the minnows to compete, as they face higher regulatory costs.

Paul Lynam, the chief executive of Secure Trust Bank and head of the challenger bank panel at the British Bankers’ Association, has long argued that the rules should be changed, as a small bank can be forced to hold as much as seven times more capital than a big bank when offering an identical prime mortgage loan.

The Bank of England has already pushed to have this discrepancy addressed, and the Basel Committee appears to be paying attention.

Changing the rules is also important to investors, who want to be able to compare different banks’ capital buffers so they can work out which lenders are the safest.

Mr Coen warned that capital buffers make banks safer but they cannot make lenders bullet-proof.

“These buffers can only be as reliable as the underlying risk measurement and management,” he said.

“No matter what standards the Basel Committee and national supervisors set to safeguard the system, it is banks themselves that determine their risk taking, risk controls, business incentives and, ultimately, success or failure. These factors determine the way people ultimately behave.”