Banks detect daylight between EC and EBA on op risk capital

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Bank sources are seeing questions from the European Commission about the ‘cliff effects’ of Basel III operational risk capital requirements as a sign that it favours waiving historical loss-based assessments – potentially putting daylight between it and the European Banking Authority on the issue.

Under Basel III, national regulators were given discretion to set the internal loss multiplier (ILM) that determines operational risk capital to 1 – in effect, neutralising historical losses and making Pillar 1 capital solely dependent on bank size. The EC consultation is currently seeking input on “possible cliff effects that might derive from the introduction of an institution-specific ILM”, thereby throwing a spotlight on the potential negatives of loss-based assessments.

Some sources tell that they see this line of questioning as a sign the EC favours discarding such assessments in order to placate large banks. “They highlighted that maybe we just don’t want to have this loss multiplier because we have to deal with the cliff effect,” says an executive at a large US bank. “So why not just set it to 1? They seem to be leaning toward that. If the industry comes out strong that it should be set to 1, maybe they’ll just go with it.”

Under the standardised approach, ILM is the scaling factor that increases or reduces the amount of Pillar 1 capital a bank needs to hold based on the ratio of its losses over the past 10 years to its size. Banks with comparatively benign loss histories would benefit because their ILM would be less than 1, thereby reducing minimum required capital. Banks that have suffered large losses would need to hold greater capital because their ILM would be greater than 1, but would see their capital requirements drop significantly if their ILM was set to 1 by their national regulator – in the case of EU banks, the European Central Bank.

“The measures seem to be about reducing the regulatory burden and limiting the extent firms are penalised for past losses,” says an operational risk executive at a UK bank.

Such an interpretation could certainly be rosy for many large banks – but it would contrast with the EBA’s recommendation to use historical losses in setting a capital rate. The latter approach would cause significant increases in risk-weighted assets (RWAs) for many European banks. The EBA has estimated that operational risk RWAs will increase by more than 50% for the largest banks if the ILM is allowed to fluctuate, versus an increase of less than 20% if national regulators set it to 1.

Banks in Europe are in two camps on whether the ILM should be set to 1, says Evan Sekeris, a partner in the financial services practice at Oliver Wyman. Small to medium-sized institutions favour allowing the ILM to fluctuate, as it would reward their comparatively small operational losses when calculating capital. Larger banks, which have suffered the lion’s share of losses, want to set the ILM to 1 to blunt the impact of crisis-era losses.

This latter view may be short-sighted, however, because it fails to take into account the improvements large banks have made in risk management and consequently the likelihood that the large banks could have ILMs of less than 1 in the future – and see their RWAs go down as a result.

Evan Sekeris
Evan Sekeris, Oliver Wyman

“It’s a knee-jerk reaction,” says Sekeris. “Most of these banks keep saying their recent history points to much lower losses than in the past. If that’s the case, then you would expect that in a few years, when these large losses fall out of the sample, the ILM would start benefiting them.”

In addition to the day-one impact of transitioning to the standardised approach, cliff effects could manifest themselves in the form of higher volatility in RWAs as losses are added or deleted from the moving 10-year window. For UK banks, large operational losses related to the payment protection insurance (PPI) scandal still fall within the 10-year window.

“The event might have occurred in 2006, but I capture each of my impacts on accounting date,” says the UK bank op risk executive. “So PPI for UK firms doesn’t fall out in one day. You will suddenly get huge values falling out of that 10-year window, and will see material movements as a result.”

Discretion or valour

The discretion to set the ILM has already begun to split national regulators, with Canada advocating for including past losses, while Australia wants to exclude them.

The EC consultation is being viewed by some as an attempt to reconcile these opposing views.

It begs the question whether the Basel Committee, in providing such discretion, defeated the objective of a standardised approach, ensuring comparability across the industry while maintaining a level of risk sensitivity – both of which were considered lacking in the advanced measurement approach (AMA). It has led to different approaches being taken around the world.

The EBA has estimated that op risk RWAs will increase by more than 50% for the largest banks if the ILM is allowed to fluctuate, versus an increase of less than 20% if national regulators set it to 1

“They’re taking a view that there’s not a universal position, and they’re trying to understand the positions that different nation-states are taking,” says a second UK bank op risk executive.

Regulators in the UK and the US have yet to give an indication of their positions on the standardised approach. But the UK’s Prudential Regulation Authority is viewed as wanting to retain authority to reward or punish firms for their risk management practices through regulatory capital add-ons, known as Pillar 2A.

“The PRA likes its flexibility. If total capital requirements under the standardised approach are approximately at or close to the Pillar 1 calculation, it loses a useful tool. This implies that the PRA would be accepting of an ILM of 1,” adds the UK op risk executive.

Some industry experts regret the continuing ambiguity over a new op risk framework.

“The whole objective was to remove complexity around the AMA and have a level playing field,” says Lisa Afonso, operational risk modelling lead and chief operating officer of the KPMG Financial Risk Modelling Hub. “By introducing local discretion, it eliminates that level playing field.”


Editing by Louise Marshall

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