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Basel III Stress-Testing: One Model to Rule Them All…

Reports suggest that cracks may be beginning to appear over Basel III.  Less than three months after approving the use of internal risk models for the 8 largest banks in the US, concerned that firms will “monkey with their risk models to boost profit”, the Fed is allegedly looking set to perform a volte face and enforce its own stress-testing rules based on its own internal model.

…and in the darkness bind them

Banks complain that the tests are opaque and subject to change every year, making regulatory compliance a moving target which may be impossible to hit.  This they claim will force them to hold excess capital and constrain their ability to lend.  For their part, the Fed seems to have little truck with this argument.  Ignoring the fact that the last round of stress tests revealed flaws in its own model, the Fed appears determined to keep its methodology under wraps, for fear that banks may start to game the system.

This one looks set to have a long way to run.  To some degree, the Fed has a point.  However, any decision to “go it alone” risks destroying the international consensus over Basel II and triggering a race to the bottom between jurisdictions over capital standards.  Moreover, if the suggestions of “regulate but don’t communicate” prove to be accurate this would be a worrying departure from the basic tenet that regulation should be transparent to those to which it applies.

 

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