November 7, 2012 5:05 pm

Bank supervisor defends risk models

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Regulators cannot ignore risk models but must also be strong about standing up to bankers to insist on tough capital, liquidity and borrowing standards, Andrew Bailey, a top bank supervisor, has said.

Some US and UK officials have called recently for scrapping the Basel III bank capital rules in favour of a much simpler regime that relies on a single measure of total bank borrowing known as a leverage ratio.

But Mr Bailey, who heads bank and insurance regulation at the Financial Services Authority, said he opposed that approach, in a speech to a Bank of America Merrill Lynch conference in London.

Mr Bailey acknowledged that the current system of allowing banks to use their own models of risk to set capital requirements could be vulnerable to manipulation, but his proposed solution was to augment the risk-based rules, rather than scrap them.

“Simplicity is not about one-club golf and it is not about abandoning risk-based regulation,” he said.

Models made sense, he said, for assets such as residential mortgages where there were millions of loans and decades of history. But he said he was far more sceptical of that approach for commercial property, where lending was “lumpier” and much more idiosyncratic. The FSA was moving towards more standardised risk-weights, known as slotting, to set capital requirements for that kind of lending, he said.

Mr Bailey, who is considered the leading candidate to head the UK’s new Prudential Regulation Authority when it starts supervising banks next year, also had a message for bankers who are hoping to ride out the storm of tighter regulation then return to business as usual.

“The high return on equity with low cost of equity business model is dead,” he said. “It should never have been alive because it could only exist through a misunderstanding of risks.”

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