Less latitude in calculating banks’ market risks, and better disclosure, is needed to boost investor confidence, suggests Fitch Ratings in a new report.
Global banking regulators reported recently that they see variations in trading book risk weights due to the discretion exercised by banks and regulators. A study by the Basel Committee on Banking Supervision noted substantial variance in market risk weights for large trading banks. Some of that is due to regulatory discretion, and some of it stems from the modeling choices made by banks themselves.
Fitch notes that some of those differences arose from regulatory decisions, particularly on the use of value-at-risk (VaR) multipliers, which accounted for about one-quarter of the variance in capital requirements. Other sources variances arose from banks’ choice of models and the assumptions allowed by regulators. The length of historical period selected to calibrate VaR models for general risk, and the crisis and duration selected for stress VaR, can lead to significant outcome differences, it notes.
Now, the rating agency says that the differences in calculating market risk capital could be heightened when volatility picks up in a crisis. And, it says that regulatory capital requirements would increase substantially in periods of high market volatility, meaning these additional capital charges could come at a time of stress when the ability of banks to exit positions or to increase equity is likely to be constrained. This could also weaken investor confidence, particularly without consistent disclosure, it adds.
“More consistent risk weights could raise investor trust and confidence for the global trading banks as well as improving the ability to compare reported metrics,” Fitch says.
It suggests that limiting some of the options that banks have for calculating trading book risk-weights would remove some of the variances and could raise market confidence. “But greater consistency would need to be coupled with better disclosure so that the underlying market risks can be more easily compared across large trading banks,” it adds.
The goal should not necessarily be to eliminate variances entirely, it suggests. “The Basel framework recognizes that not all variations should be viewed negatively and aims to reduce rather than eliminate the differences. Flexibility allows risks to be more accurately reflected and can prevent a build-up of systemic risk due to all banks acting in a similar way,” it says. “One of the keys, however, is to improve the quality and consistency of disclosure so that important differences can be better understood and assessed.”