The complexity of Basel III and other regulatory responses to the global financial crisis may be misplaced, Andy Haldane, director of financial stability at the Bank of England, argued in a paper
delivered at the US Federal Reserve's annual economic symposium at the end of last week.
Haldane presented analysis drawn from a sample of 100 of the world's most active banks at the end of 2006. Thirty-seven of these needed aid from the public sector as the crisis progressed.
Drawing on the (so far unpublished) work of BoE colleagues, Haldane argued that:
-- Simple weighted measures have greater predictive power than the risk-weighted measures that are the cornerstone of banking supervision at present.
-- Simpler measures of accounting capital, based on equity capital, outperform broader, more complex measures.
-- Simple market-based measures of banks’ equity dominate accounting measures in their ability to predict the performance of a bank in a crisis.
"The regulatory response to the crisis has largely been based on the level of thinking that created it," Haldane said.
"The Tower of Basel, like its near-namesake the Tower of Babel, continues to rise.
"An alternative point of reference when regulating a complex system would be to simplify and streamline the control framework. Based on the evidence here, this might be achieved through a combination of… policy measures."
Haldane spelled out five of these, including "de-layering the Basel structure", "strengthening supervisory discretion" and "structurally re-configuring the financial system".
By the latter Haldane appears to mean carving retail and commercial banking away from investment banking (and possibly asset management), a theme he has pushed in the past.
Of the complicated rules that permeate the present approach to bank regulation, Haldane said: "The quest for risk-sensitivity in the Basel framework, while sensible in principle, has generated problems in practice."
"It has spawned startling degrees of complexity and an over-reliance on probably unreliable models.
"The Tower of Basel is at risk of over-fitting – and over-balancing. It may be time to rethink its architecture."
Haldane pushed for reliance on a straightforward leverage ratio – common equity divided by assets – of the kind the Australian Prudential Regulation Authority has resolved to push into the background in Australia.
The BoE executive pointed out that banks must now produce tens of thousands of items of data in regular reports to regulators, the utility of which he doubted.
Haldane also questioned the use of internal risk models that rely on data-sets that are simply not available.
"With thousands of parameters calibrated from short samples, these models are unlikely to be robust for many decades, perhaps centuries, to come.
"It is close to impossible to tell whether results from them are prudent.
"One simple response to that concern may be to impose strict limits, or floors, on model outputs," he said.