Bank capital under the microscope – again

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Ask any big bank just how much time and money was spent on complying with the latest set of capital rules, and they'll tell you it was a Herculean effort.

Yet after instituting strict new rules that force banks to hold 7 per cent of common equity against their risk-weighted assets, the Basel Committee on Banking Supervision is proposing changes to the way the banks calculate their capital ratios.

The pain, it seems, never ends.

To be clear, the Basel Committee, which drafted the Basel III Accord, still thinks a risk-based capital regime is the best way to keep the banks afloat in times of crisis. But it's found a flaw in the current system.

The most pressing concern: each bank seems to calculate their capital levels in different ways, making it almost impossible to compare the safety nets for two different institutions.

The Basel Committee is also worried that their capital rules are too complex and "that the marginal benefits from incremental complexity may be small, or even negative."

That can lead to big problems. "A bank's board and senior management may, at times, find it challenging to fully understand the risk profile of a bank's underlying risk profile and, as a result, the key drivers of the capital framework, even though the public has a legitimate expectation that they have that ability, and they are under a legal obligation to do so," the Committee said in a new paper.

Plus, "the use of highly complex internal models can jeopardize sound internal risk management to the extent that bank management places undue reliance on them."

So what to do? The committee has a few ideas that it's now floating, asking for public comment by October. There are a few options on the table, but the most pressing proposals include:

More disclosure

Banks should be disclose precisely how they're calculating their risk-weighted assets by detailing their formulas for determining credit risk of the borrower, market risk, etc. "Other types of disclosure might also be of assistance: for example, banks could be asked to regularly disclose the results of applying their models to standardized hypothetical portfolios, thereby providing additional insights into the different modelling choices banks have made," the committee said.

Rely on more than capital ratios

Though the committee still strongly supports mandatory capital ratios, it happily acknowledges that other measures "can also be useful and robust predictors of serious distress." Examples include: risk-weighted assets calculated under a standardized approach, capital ratios using market values of equity in the numerator, and risk measures derived from equity volatility.

Beef up leverage ratios

The committee's already forced banks to meet a 3-per-cent leverage ratio in the coming years. (More on that here.) But they also propose forcing the globally systemically important banks to meet an extra leverage requirement, putting their total leverage ratio at 5 per cent.

(Tim Kiladze is a Globe and Mail banking reporter.)

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