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Home Advanced Approaches Federal Reserve Governor Tarullo Discusses Removal of Internal Ratings-Based (IRB) Approach to Regulatory Capital

Federal Reserve Governor Tarullo Discusses Removal of Internal Ratings-Based (IRB) Approach to Regulatory Capital

Today, Federal Reserve Governor Daniel K. Tarullo delivered a speech that, among other things, argued for discarding the advanced internal ratings-based (IRB) approach for calculating risk-based capital requirements.  Currently, under U.S. Basel III, the advanced IRB approach applies to U.S. banking organizations with at least $250 billion in total consolidated assets or at least $10 billion in on-balance-sheet foreign exposures.  Governor Tarullo also argued for increasing the $50 billion applicability threshold for Dodd-Frank enhanced prudential standards to a higher asset level, such as $100 billion.  Key excerpts from the speech are set forth below.

Excerpt from Governor Tarullo’s speech on discarding the advanced IRB approach for calculating risk-weighted assets (RWAs):

“But there are some opportunities for rationalization even with respect to regulation of the larger institutions. While necessary new rules will now be applied to these institutions, vestiges of the pre-crisis regulatory approach that did not rest on well-specified regulatory aims are still in place and might sensibly be modified or removed. Most prominent in this regard is the Basel II IRB approach for risk-weighted capital requirements. The IRB approach, which generally applies in the United States to all bank holding companies with $250 billion or more in assets, was developed a decade ago in an effort to align risk weightings more closely to the increasingly sophisticated quantitative risk-assessment techniques in the financial industry.

At the time of its development, the IRB approach seemed intended to result in a modest decline in risk-weighted capital requirements, a goal that the financial crisis revealed to be badly misguided. But even with the higher capital ratios required by Basel III, the IRB approach is problematic. The combined complexity and opacity of risk weights generated by each banking organization for purposes of its regulatory capital requirement create manifold risks of gaming, mistake, and monitoring difficulty. The IRB approach contributes little to market understanding of large banks’ balance sheets, and thus fails to strengthen market discipline. And the relatively short, backward-looking basis for generating risk weights makes the resulting capital standards likely to be excessively pro-cyclical and insufficiently sensitive to tail risk. That is, the IRB approach–for all its complexity and expense–does not do a very good job of advancing the financial stability and macroprudential aims of prudential regulation. Yet a capital measure that incorporates these aims is precisely what is needed to complement the traditional microprudential elements of our capital standards.

The supervisory stress tests developed by the Federal Reserve over the past five years provide a much better risk-sensitive basis for setting minimum capital requirements. They do not rely on firms’ own loss estimates. They are based on adverse scenarios that would affect the entire economy and take correlated asset holdings into account. As we gain experience, we have been enhancing the macroprudential features of the annual stress test exercise. And, of course, the disclosure of the results helps inform counterparties and investors, thereby increasing market discipline. They are undoubtedly a substantial amount of work for both the banks and supervisors but, unlike the IRB approach, the benefits seem worth the work.

 For all these reasons, I believe we should consider discarding the IRB approach to risk-weighted capital requirements. With the Collins Amendment providing a standardized, statutory floor for risk-based capital; the enhanced supplementary leverage ratio providing a stronger back-up capital measure; and the stress tests providing a better risk-sensitive measure that incorporates a macroprudential dimension, the IRB approach has little useful role to play. We would continue to expect that firms practice sound quantitative risk management using internal models and other techniques. Indeed, the qualitative assessment included in our annual Comprehensive Capital Analysis and Review (CCAR) exercise is designed to ensure that the firms have this capacity. But, in light of all that has happened in the last decade, I see little reason to maintain the requirements of the IRB approach for our largest banks.

Of course, the IRB approach was agreed internationally as part of the Basel II framework concluded in 2004. It would be best if all the Basel Committee countries moved together to adopt standardized risk-weighted and supervisory stress testing requirements for all internationally active banks. This would be a somewhat complicated shift for a number of reasons, including the likely appropriateness of applying different adverse scenarios for different parts of the world and the challenges in conducting a peer review at the Basel Committee of supervisory stress tests by member countries. Yet, as documented by the Basel Committee’s work on divergence in risk weightings by banks applying IRB methods, Basel II created its own problems of consistency and transparency. There is no reason to believe that the task of creating an oversight and review framework for supervisory stress testing would be any more difficult.” (emphasis added).

 

Excerpt from Governor Tarullo’s speech on increasing the $50 billion applicability threshold for Dodd-Frank enhanced prudential standards to a higher asset level, such as $100 billion:

“Experience to date suggests to me, at least, that the line might better be drawn at a higher asset level–$100 billion, perhaps. Requirements such as resolution planning and the quite elaborate requirements of our supervisory stress testing process do not seem to me to be necessary for banks between $50 billion and $100 billion in assets. If the line were redrawn at a higher figure, we might explore simpler methods for promoting macroprudential aims with respect to banks above $10 billion in assets but below the new threshold.

Were such a change to be adopted, bank holding companies with less than $100 billion in assets would not be subject to any of the enhanced prudential requirements of section 165 of Dodd-Frank; bank holding companies with assets between $100 billion and $250 billion would be subject to supervisory stress testing and a basic set of the section 165 requirements; and holding companies with $250 billion or more in assets would be subject to the supplementary leverage ratio, the full LCR, and the countercyclical capital buffer provision. Of course, this is not the only way to draw the lines, and there could be reasons for applying additional requirements to specific banks, even if they fall below the presumptive asset threshold. But I use this example to illustrate how the specification of aims and the progressive stringency of section 165 could be usefully combined.”

 

Materials

Governor Daniel K. Tarullo, Rethinking the Aims of Prudential Regulation (May 8, 2014) available here: http://www.federalreserve.gov/newsevents/speech/tarullo20140508a.pdf.

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