A regime which inadequately evaluated trading book risks was, therefore, fundamental to RBS’s failure. This inadequacy was particularly significant for RBS, given that the purchase of ABN AMRO significantly increased RBS’s trading book assets. RBS was allowed by the existing regulations massively to increase its trading risk exposure counterbalanced only by a small increase in capital buffers available to absorb loss.” The Basel Committee recognised that across internationally active banks, Basel II would likely lead to an overall reduction in the required capital compared with that required under Basel I and that the reduction in required capital would be larger for banks adopting the more advanced modelling options for credit risk.2 In other words, other things equal reported capital ratios would tend to be higher under Basel II than Basel I. Our own work suggests that Basel I would have required major UK banks to hold approximately £ more capital than Basel II against the credit and counterparty credit risks in their end-2013 balance sheets. This amounts to a decrease of about 25% under Basel II compared with Basel I. Another way of looking at this is to examine the pattern of average risk weights. For a set of 17 major international banks (designated as G-SIBs)3 average risk weights fell almost continuously from 70% in 1993 to below 40% in 2012. But this fall in average risk weights did not represent a systematic reduction in risk within the banking system.
In another case, the supervisor could withdraw permission for whole types of models, as the FSA/PRA did for the commercial property models of UK Banks by requiring a substitute “simple slotting approach” to be used – which is still a model, but a very simple one. Then I think the debate becomes more around whether the relevant risks can be modelled, how easy it is for supervisors and firms to observe the performance of models, and the ability of supervisors to police the performance of models. None of this is easy. There is also a very good question around whether supervisors should supplement the use of firms’ models by developing their own models. In the US, the Federal Reserve has gone down this road, and in doing so advanced their use of stress testing. So far, we have gone down the road of pushing banks to improve their models, and to be more realistic about what the models can and cannot do. My guess is that we may eventually end up with greater international convergence of supervisory approaches on the use of models, and that would be a good thing in terms of more efficient supervision and use of our scarce resources. But I would note that today I have an open mind as to where that convergence will lead to in terms of the capital adequacy regime. Much of this speech has been about the incentives in the regime of capital adequacy for banks. I want to end with a few words on transparency.