Op risk capital fight a limp political thriller

Like a late-term politician, the revised standardised measurement approach (SMA) for op risk capital could find itself in office, but not in power, once it is finally implemented.

The debate on how to set Pillar I capital requirements began in late 2015, when the Basel Committee said the advanced measurement approach (AMA) – intended to be the industry’s gold standard when it was introduced under Basel II – had not met its expectations.

With the committee’s member states split roughly evenly between proponents and detractors of the AMA, the search for a suitable replacement was never going to be easy.

It is understood the French regulator, for instance, was a strong proponent of the AMA, and the Germans were also keen on the approach, as evidenced by their efforts to push their bigger banks onto the methodology. Experts at the Australian Prudential Regulation Authority, meanwhile, have already said they want to keep the “good parts” of the AMA, and will not change their expectations for banks’ op risk capital levels.

“We were not against AMA. We did think the best way to capture risk, which is so difficult to get consensus on, was to allow for modelling. We were consistent in not favouring a standardised method,” grouses a source at one regulator. 

Yet despite widespread opposition, the SMA was unveiled in March 2016, with the promise that it would provide a stable, comparable, and risk-sensitive capital measure.

Others perceived different motives behind the committee’s advocacy of a new standardised approach. US banks openly criticised the AMA, which they say afforded too much flexibility to national regulators, and left many with far higher capital requirements than their European peers. 

The Americans were very keen on removing AMA – they were for removing models

A source at one regulator

“The way the AMA guidelines have [been implemented in the US]… produces a number that is much more of a tax than a true measure of risk,” says one US bank’s head of op risk measurement.

It’s unsurprising, therefore, that some see a US influence behind the SMA’s ascendancy. A team of Federal Reserve economists were behind the SMA’s initial calibration. When an industry study found the capital increase implied by the new measurement would be many times larger for European than US banks, mutterings about a US-led fait accompli grew louder. 

“The Americans were very keen on removing AMA – they were for removing models,” says the regulatory source.

Mindful that European objections to the SMA could yet jeopardise the so-called Basel IV package of reforms, stakeholders negotiated a series of fixes – some of which were detailed in a leaked briefing paper from Basel chair Stefan Ingves dated May 19 – to dial down the implied capital increase.

Some commentators see political expediency behind the revised quantitative parameters, however: “All the recent SMA calibrations since the start of the year have been political negotiations. They started recalibrating over the past few months by negotiating coefficients that will reverse-engineer the numbers they already have,” says Evan Sekeris, a partner at Oliver Wyman. 

How the final SMA calibration will shake out is anybody’s guess; a number of insiders relate that further changes are on the way. In an interesting twist, one of the architects of the original SMA, Marco Migueis, a senior Fed economist, has issued a proposal for an alternative forward-looking and incentive-compatible approach, which proponents suggest could form the basis of a US-specific Pillar II capital overlay to the op risk capital framework.

It has yet to win many fans, however – particularly among Europeans. “Frankly, Mr Migueis and his Fed colleagues did not inspire confidence in their initial attempt to ‘improve’ op risk via the SMA, which seemed like a crude and poorly thought-out way to measure capital requirement,” says the head of op risk controls at a European bank.

Even now, there are growing expectations that national regulators will be given the flexibility to ignore or amend parts of the framework. After 18 months of politicking, the industry could now be left with a lame-duck capital methodology.

The Basel Committee declined to comment.