Can Basel 4 work? What can go wrong? An examination of the new Basel proposals

Regulators are sceptical of the internal models developed under the A-IRB approach, largely due to the variability of capital calculated by different banks for seemingly similar risk. A number of measures are being taken to reduce what the Basel Committee calls the ‘excessive variability’ in banks’ regulatory capital ratios. Among these measures is a new proposed standardised approach and its use as capital floors for A-IRB banks. Although not explicitly stated, the intention appears to rely on simpler and standardised approaches, rather than banks’ internal models, for the purposes of calculating capital requirements; the impacts are so significant that the proposals are already being referred to as ‘Basel IV’. The stated intent of the new standardised approach is to make risk weighed assets (RWA) more risk sensitive and to close the gap between the standardised approach and the A-IRB approach. In this paper, we examine if this is achievable. Based on both a theoretical and empirical analysis, we found that the standardised approach, no matter how well it is calibrated, cannot be an adequate alternative to A-IRB. Imposing these simplified approaches can have wide-ranging implications, including increasing the gap between economic risk and capital, providing perverse incentives, marginalising good management practices, and ultimately increasing systemic risk. Instead of ‘throwing the baby out with the bathwater’, the focus should be to fix the parts of A-IRB that are not robust.