BIS Releases Document on Minimum Capital Requirement for Banks

On Christmas eve we published a post with a tongue-in-cheek "legal" version of 'Twas the Night before Christmas'. We compared it to trying to read an IMF or BIS (Bank of International Settlements) work paper. This week the BIS releases a new document that perfectly illustrates this concept. It is called a consultive document and the title is 'Capital Floors: the decision framework based on standardized approaches'. Normally I suggest you read the full linked article, but you can skip this one if you like :) 

I'm sure if you are a banker this document is an easy read. But for the rest of us I will just try to focus on the key point for us to consider from it. The key point is that the BIS is still quite concerned about the risk of another banking system crisis. They have been working for quite some time on new rules for banks that require them to keep enough liquid capital on hand to deal with a situation where the bank sustains large losses (think derivatives here).

Basically, they are trying to come up with a minimum level of capital that banks need to keep on hand and are working through various formulas and ratios they want banks to use. We won't focus on that (your welcome). Instead let's look at why they think all this is needed. This is a direct quote from the new BIS document:

"Capital floors are an integral component of the capital framework. The objectives of capital floors include:

• preventing undue optimism in bank modelling practices, thereby ensuring that modelled capital requirements do not fall below a prudent level;

• mitigating model risk due to such factors as incorrect model specification, measurement error, data limitations and structural changes that may not be captured in historical data;

• addressing incentive-compatibility issues, as banks face incentives to use overly optimistic internal models to reduce risk-weighted assets and thereby maximise return on equity;

• improving comparability by providing a standardised assessment of risk which can be compared against internal model-based outcomes; and

• constraining variation in model-derived risk-weighted assets (RWAs) that arises from differences in bank and supervisory practices, thereby improving the comparability of RWAs across banks and over time."

If you look at the list above of the objectives of the capital floor (minimum capital a bank needs to keep on hand), an obvious concern jumps out. We don't have to be bankers or understand all the jargon to get it. Just look at the phrases "undue optimism in bank modelling practices","incorrect model specification", and "incentives to use overly optimistic internal models" in the objectives.

Translation into english: They are concerned that banks are using forecast models for their investments that may be "overly optimistic". They want some kind of standard that forces all banks to hold enough capital to withstand a situation where their losses exceed their "overly optimistic models" forecasts (hold enough cash to prevent a bank default).

If too big to fail banks holding trillions in derivatives are using "overly optimistic" models, it creates a risk to the entire banking system. That is what this BIS project is all about. 

The question remains: In a world where big banks hold trillions in these derivatives and many are not transparent to the public, how do we know if any minimum level of capital they come up with will be enough?   

Answer:  We don't and they don't. They just know that they don't like the way things are now and some minimum standard (capital floor) is better than none. But this BIS document shows that the concern is there. And it implies they think banks have incentive to use overly optimistic forecasting models to "maximize return on equity".

Added note:

Here is a related story:

A reader at Jim Sinclair's blog site alerts him that the US Office of the Comptroller of the Currency has just issued a new warning about credit risk at US banks. You can access the OCC report directly here. The OCC is part of the US Treasury Department.