January 02, 2014

A philosopher’s questions to the Basel Committee on capital requirements for banks and unexpected-losses.

Sir, Alain de Botton makes "The good case for putting philosophers into company boardrooms”. January 2.

In that respect I would hold that philosophers are also urgently needed elsewhere, like in the Basel Committee for Banking Supervision. Let me explain.

“The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to.”

And the explicit reason for that simplification is:

“This characteristic has been deemed vital in order to make the new IRB framework applicable to a wider range of countries and institutions. Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

And this leads to:

“In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And so, if the Basel Committee had included a philosopher in their team, he might very well have asked the following disturbing and possibly game-changing question.

“Friends, I read here you have decided, primary for reasons of expediency, to make the capital requirements for banks, those that should cover for “unexpected losses”, dependent on the same risk perceptions used to estimate the “expected losses”.

Does that not signify that banks could overdose on perceptions about expected risks, without you regulators doing what you should do about considering the unexpected losses?”

Does that not signify you would be discriminating against “The Risky” those who are already discriminated against because of expected losses, by making them also bear the largest regulatory burden for unexpected losses?