Karen Shaw Petrou’s memorandum to Federal Financial Analytics clients on how Basel blessed Russia and thus damned its capital framework.

TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: March 18, 2016

How Basel Blessed Russia And Thus Damned Its Capital Framework

Over the past year or so, the Basel Committee addressed the growing cacophony of the global rulebook not by simplifying standards or – God forbid – considering their cumulative impact, but rather by trying to standardize the capital rules so that bank models and national discretion make nary a dent. We have analyzed Basel’s various standardization initiatives, providing clients this week with one on the revised operational-risk rules that, to sum it up, makes a mighty hash of them. However, take it as a given – if you can for just a minute – that standardization makes sense. How then to do anything other than laugh when reading, as we did earlier this week, that Basel says Russia is A-OK on the capital-compliance front? Next to get Basel’s blessing – North Korea? The more Basel papers over national differences, the greater the risk that the standardized rules intended to counteract them will do nothing but more deeply mask real risks better captured with disciplined, well-governed – and, yes, complex – models.

Russian banks are no more compliant with Basel’s actual risk-based capital rules than Russian oligarchs pay all their taxes right on time and in full. That Russian authorities have put another chapter in their vaunted rulebook laying out Basel’s standards is sweet. That Russian banks in fact adhere to them and are thus well capitalized is quite another thing. Basel’s blessing of Russian adherence to its rulebook is more than humorous. It’s yet more evidence that Basel cannot eliminate national differences in its capital standards – or, for that matter, any of its other edicts – if national regulators like things their way.

Recognizing this, the head of the FSB, Mark Carney, tried in 2014 to institute what he called a “name-and-shame” regime in which global regulators would call out national laggards. So far, though, the FSB, like Basel, is pretty much a “name-and-try-to-make-nice” regime – global regulators have no power to force national-level change and clearly they know that trying to shame countries into
compliance will only lead some overtly to bolt the global fold, dooming whatever credibility it has left.

Plowing on, earlier this week Basel hopefully sent out a set of questionnaires in which it queries national regulators about how well they comply with some of the new standards. This reminds me a lot of school exams – had I been allowed to grade my own, I surely would have done a bit better and then some. One has to suppose that all the regulators that grade themselves for Basel will report considerable progress and appropriate deference. Basel can then admire itself and its adherents, but the global rules will be no more consistent than if Basel had saved itself the standardizing trouble and allowed continued use of internal models. Models permit arbitrage, but – as Russia’s grade-A report bears witness – so do standardized requirements judged with a forgiving hand.

In the new operational-risk based capital (ORBC) proposal, Basel may be trying to correct not only for model variability, but also national pliability. The ORBC consultation is perhaps the simplest yet, using a single criterion – the “business indicator” – sometimes adjusted by another – the “loss indicator” – to come up with requisite ORBC.

The only problem is that neither indicator has diddly to do with actual operational risk. The business indicator is adjusted gross income – that is, the more money a bank makes, the riskier it is presumed to be. Operational-risk mitigation – e.g., insurance, the costly back-ups that keep the lights on – count for naught in the business indicator, creating a perverse incentive to skip on risk mitigation to minimize “risk”-based capital. Fiddles with the indicator adjust for some of the tricky bits – for example, some losses are turned into income by Basel alchemy – but Basel never makes clear just why being good at what you do – at least as measured by your ability to make money at it – is necessarily correlated with risk.

In essence, the business indicator attempts to approximate just how much money is good for a bank and then set capital accordingly. The loss indicator is supposed to make the business one more risk sensitive; since it’s purely retrospective, it clearly doesn’t.

What’s good about this ORBC requirement? Well, it’s for sure standardized. Most of both the business and loss indicators are easily derived from publicly-available data. Basel thus could tell not only how banks are doing according to its criteria, but also whether national regulators are matching capital to global edict. All of that may make Basel feel good about itself, but I’m not at all sure the rest of us should be confident in the operational resilience of the resulting global financial system.

It may well be harder to game this standardized ORBC system – the goal Basel constantly cites – but its incentives are so perverse and its costs so high as to make banks riskier and shadow firms still more potent competitors. Way to go.

Basel Russia