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regulators typically do not provide the depth of analysis necessary
to explain model variances, though international working groups
have consistently requested that they do so.
Yogi Berra summed it up pretty well, when he said, “If you don’t
know where you are going, you might end up someplace else.” For
some, the idea of accuracy may have been more palatable before
the propensity for dispersion was made plain.
To get back to that place they had imagined the regulators have a
couple of tools at their disposal. Firstly, they can seek convergence
through the stress tests by encouraging the banks to agree to more
conservative charge-off assumptions. Since their introduction in
2009, the stress tests effectively guided capital estimates higher
by forcing banks to use compromise assumptions that blend peak
and trough conditions. Secondly, for more consistency in the capital
regime ongoing and across a greater number of institutions, the
regulators are also preparing to interject a set of floors into the
internal models approach for Basel III risk-based capital. Going
forward, the Basel floors would effectively set a bottom limit on
the amount of capital that could be assessed, no matter what an
internal model might suggest.
While the regulators clearly believe that further conservatism at the
banks is necessary, there is a growing concern that the authorities
are breaching an historic and foundational divide between themselves
and industry. Even without further adjustments to the capital
regime, regulators have become integrally involved in balance
sheet allocation decisions and are therefore influencing strategic
decision-making.
Extending this idea out, regulators across jurisdictions are encouraging
decision-making at the banks that will lead to a new set of challenges
for the financial system:
• At the asset class level, the regulators will likely seek more
conservative charge-off assumptions for CRE in the 2016 stress
test, since they went out of their way to point out these particular
variances. Earnings are a source of stability in and of themselves
and there is little proof that the regulatory methodologies are
more accurate than the industry’s.
• At the banking system level, model convergence can encourage
risk concentrations of assets, maturities and counterparties, all
of which can serve as triggers for herding behaviors.
• At the systemic level, the transfer of CRE lending from the banking
sector to the nonbanks should gain additional momentum. At
the same time, regulators have highlighted this shift in recent
speeches and papers, including those delivered at the spring
World Bank — IMF meetings, emphasizing that disintermediation
requires careful monitoring.
Offsetting variances in internal models will come at a price of
additional regulatory burden and changes in the nature of risk.
The decision to make convergence the norm risks compromising
the progression toward model accuracy and the diversity of behaviors
in CRE lending. Without better justification, especially while so many
other pieces of regulation are still washing through the system, this
is the time to step back and to observe market reactions before
fixing reforms that have yet to be fully implemented.
CRE as a Source of Systemic Risk: How Normative Should the New Regulatory Norms Be?