Internal Models of Banks – Making them more ‘Comparable and Credible’

It can be said with reasonable authority about the contemporary global banking system that investors in bank securities and counterparties to banks’ derivatives conduct their transactions on TRUST and not on trustworthy ratios that can help them assess banks’ true credit quality.

As we draw parlance to Greece , since the Global Financial Crisis of 2007-09, increasing evidence came out that Greece “cooked their books” – essentially lying about the country’s financial health in order to comply with the European Union’s prerequisites to joining the common currency. Some say it still went on up to 2012.Hence as a take away from Greece crisis we can transpose the same modus operandi among banks when it comes to their internal models.

The Basel committee’s goal continues to be to curtail bank regulatory arbitrage, that is, banks moving their activities to countries with weaker capital rules. Internal Models of Banks – Making them more ‘Comparable and credible’ is in lines with this goal

So why counterparties & investors rely on trust?

Those internal models to determine credit, market and operational risks so as to measure their assets’ risks. This determines the amount of capital the banks need to sustain unexpected losses. The banks are not required to disclose the details of how they calculate risk-weighted asset ratios. Hence there is no way for investors, bank analysts or the media to accurately compare banks’ risks.

Banks’ also adopt politically influenced practice of determining the ‘probability of default’(PD) of their home country’s sovereign bonds at zero, no matter what the rating agencies or market signals like credit spreads say. That would have a negative impact on banks in Russia and some European countries, including Greece, where the credit quality of sovereign bonds has been deteriorating. However Banks in the United States that invested in United States Treasuries would not be hurt, though, because yields and ratings imply practically a zero chance of default for United States debt.

How does the Basel committee see the way forward?

a.      The Basel committee is seeking to make the risk-weighted asset ratios comparable. That would help the market to discipline banks by selling bank bonds or shares if it does not like the level of risk the banks are taking.

That may not be altogether possible as it is impossible to perfect uniform standardization of how banks calculate their risk-weighted assets given the fact that banks business models and risks are different. However the critics of such standardization should never forget that   standards as to how the banks calculate their inputs be made stricter and certainly more transparent. This will make banks' risk ratios more meaningful to market participants, investors or the media.

b.      If the Basel committee recommends changing that practice, banks investing in home sovereign bonds that are not investment grade will have to raise equity, increase their retained earnings or jettison risky assets to comply with Basel’s minimum capital requirements. There cannot be a stretched criticism to this action given that we all have seen Greece, Ireland and Iceland among many.

c.       The Basel committee envisages more responsibility to technology employees, compliance officers and auditors. These classes of employees are all too often derided with the shortsighted moniker of “cost center” and not given the necessary resources as they are not generating revenues like traders or lending officers. Most they pay such professionals receive don’t incentives them to better perform their essential functions.

Probably this is the  point where you hit the ground is your internal environment where you ask yourself the question- Am I lying to myself? .It’s the ‘single point of truth’. As Indian IT czar Narayana Murthy says ‘In God we trust others bring facts’.

Many large banks continue to struggle with collecting high-quality data, pulling together risk exposures and identifying counter party concentrations accurately and rapidly. Banks’ technology systems, data and reporting processes require significant investment both financially and in personnel.

The infrastructure has to be built for the future superstructure to thrive for every time we need not wait for Herstatt to remind us that the ‘horses have run away from the stable’. The alternative to data is trust which apart from deceit on boarded Greece into the Euro Zone.

It’s an easy choice between data and it related infrastructure and governance inclusive of personel versus TRUST which relied on Greece historical significance and contributions to Europe in terms of developments in civilization, mathematics, philosophy and literature to bring it to the fold of euro zone.