The weaknesses of Basel I were two-fold, said Andrew Bailey, chief executive of the Prudential Regulation Authority.
In a speech at Bloomberg in London today (10 July), Mr Bailey said Basel I’s capital requirements provided little insight into how firms measured and managed risk.
As a supervisor in the late 1980s and early 1990s, he said he “remember[ed] well meetings with firms which would start by the firm reminding that while they had filled in the risk weighted assets form faithfully, it bore no resemblance to how they assessed and managed risk in the business – what is often called economic as opposed to regulatory capital.”
In one sense, Mr Bailey said this should not matter if the regulatory capital calculation provides a robust floor below which the “economic” capital should not fall.
But he said it was unclear how we could know this was so, and the lack of line of sight into how the firm managed risk was disturbing.
The second weakness, Mr Bailey said was generic to simple systems which conflate different levels of inherent risk, namely that they tend to create incentives for banks to increase the average level of riskiness of their assets.
Mr Bailey said: “One thing we now know, incentives are hugely important in the capital regime.
“Basel III requires more and better quality capital in banks. The good news is that since the crisis broke, banks in the UK and elsewhere have made significant progress in rebuilding capital.
“Evidence to support this is that at its last meeting in June, the Bank’s Financial Policy Committee decided to close its recommendation of March last year that the largest UK banks and building societies should meet a minimum 7 per cent common equity tier one ratio on the so-called end-point (ie full implementation) basis set out in the EU rules to implement Basel III, after taking into account adjustments for expected loss on more vulnerable loan portfolios, the impact of future conduct of business costs, and prudent use of risk weights.
“Since then the actions taken by a number of major UK banks and building societies have put them on course or ahead of the planned actions to meet the FPC’s test.”
