Defaulting on your obligations is a clear event. You did not pay when you should, you did not show up when you promised you would, you did not deliver the assets for which you were paid. In financial contracts the list of clear-cut defaults is often expanded by contractually defined additional ‘events of default’. Such events of default could include many things that normal people would not call a default, such as reorganizing the group of which the obligor is part, or if the obligor suffers a credit rating decrease. Normally, these ‘events’ serve to enable the creditor to have a say in restructurings and such. This allows them to avoid their rights being eviscerated by e.g. removing cash out of the legal entity they have a future claim on.

Default reinvented

Banking legislators have also engaged in such reinvention of the term default as applicable to any credit obligation. The starting position is that there are consequences for the amount of financial buffers that a bank needs to hold for each claim on the obligor after it has not been paid for a certain number of days after they became due. Like the drafters of contractual ‘events of default’, legislators have tried to make the calculation of the required amount of financial buffers more forward looking, and include events when there are ‘just’ signs of possible future non-payment. For IRB banks this already happened in the old CRD after the introduction of the Basel II version of the capital accord. Under the new CRR, the forward-looking element also applies to banks that use the standardised models to calculate credit risk capital requirements.

The CRR requires supervisors and banks to treat obligors credit as ‘defaulted’ when there are early warning signs that indicate that the obligor is unlikely to pay in full. If such default as defined in the CRR and its predecessors happens, banks on the standardised approach need to hold more capital against some or even all the claims they have on the obligor (risk weighting them at a headline rate of 150% instead of at the risk weights that would apply on non-defaulted claims of e.g. 0% for sovereign bonds, 20% for unrated banks short term debt, 20% for highly rated banks long term debt, or 100% on unrated corporates; and equivalent changes in the calculation of the probability to default – PD – factor in IRB calculations). Such a default – as in a failure to pay a due claim by an obligor – does not yet trigger obligatory losses. Once losses are certain, they would have to be written down from the bank’s capital. Instead, a default only means that more capital needs to be held against the claim to buffer against unexpected losses. Only if events subsequently or simultaneously progress negatively and losses are relatively certain, such ‘expected loss’ needs to be fully deducted from the CRR-financial buffers. As can be expected, writing down losses is unpopular, but even having to increase financial buffers for a loan after a loan has already been granted can be costly, and thus unpopular with the banks. If the bank is important and thinly capitalised, it may even be unpopular with supervisors.

CRR examples

Luckily for less diligent banks, most of the situations that the CRR subsequently references as examples of ‘unlikeliness’ to pay in full are drafted to be dependent on their own action. If they for example act in a way that acknowledges that the debtor is in problems (for instance by applying for the bankruptcy of the obligor), they also need to increase their financial buffers. As long as the bank itself does not actually take action or draw conclusions, they can avoid triggering the obligation to acknowledge CRR-default until well after an actual default has occurred, namely until 90 days after the obligor has actually failed to pay. For IRB banks it can even be postponed until 180 days have passed without payment after a claim for interest or principal became due in the few member states that use a supervisory discretion to deal with apparently slow payment systems or for instance badly behaved debtors in the public sector. This national discretion expired for the smaller banks that use the standardised approach already in 2011, but the large IRB banks in countries with apparently slow payment traditions such as France and Great Britain can continue to treat slow payers – e.g. municipalities – as if they are solid obligors. Even if the stricter 90 days is applied, this still means that less diligent banks can escape increasing their financial buffers for at least 3 months after a claim became due. This is not very forward looking, unless the bank is proactive in managing its risky exposures and wants to pay attention – as is the CRR obligation – to indications of non-payment.

The indicators for unlikeliness to pay – as copied unchanged from the old IRB provisions in the CRD – include that the bank recognises a significant perceived decline in credit quality, sells (part of) the exposure at a relevant loss, agrees to a distressed restructuring with negative financial adjustments, asks for the bankruptcy (!) of the client, or if the client actually is bankrupt. This fine example of legislative prose means that according to legislators even a court proclaiming the bankruptcy of the debtor is only an indicator of unlikeliness to pay, and still only means that the exposure to the bankrupt client needs to be weighed at 150%, unless the bank itself determines that loss is certain and the exposure written down accordingly (after which they can risk weight the reduced value of the exposure at a lower risk weight again).

No consistency in application

Remarkably, as part of their monitoring EBA and the SSM supervisors have found that not all banks apply the rules in the same manner, and that the national interpretations (and application of the 180 days of non-payment of past due payments before being forced to acknowledge that the debtor may be troubled) lead to different capital levels for debt portfolios with the same risk profile. Some banks delay finding an event of default, and thus delay applying a higher risk weight or PD to the calculation for the minimum amount of capital they need to hold. Some government bodies are allowed some extra time by the local supervisors to pay their debts, even though the risk is the same or higher than in a similar debt just across the border in another member state. Some less principled banks could even opt to sell almost due bonds owed by a troubled debtor at (fire sale) market prices without formally acknowledging this as an indicator of default, to avoid having to consider whether the rest of the debt of that obligor in default when the debtor fails to fork over the repayment of the short dated bonds. CRR legislators were aware of the issue, but failed to reach a compromise on a solution. Instead, they have added to the existing definition an order to EBA the order to monitor the application of this definition, to come up by 2017 with a report on the 90 or 180 days past due issue, and (without a deadline) to provide non-binding guidelines on how default should be understood and applied by banks in the EU. The SSM has identified the 90/180 days issue as a major impediment to its working practices, and is aiming to pre-empt the 2017 EBA review for the Eurozone member states (of the couple of member state competent authorities that apply this leniency, only the UK supervisors would be able to continue to apply the supervisory discretion, as they will not be bound by the ECB choice on behalf of the Eurozone competent authorities).

As acknowledging the potential for default is core to preparing for recessions and asset based crisis at banks, it is good that EBA has already spent some of its scarce resources to find indicators on how a well set up bank that diligently monitors the credit quality of its debtors should be able to avoid its own future default by taking timely action should do this. Their consultation paper is not a perfect paper yet, but nonetheless it raises the standard for less diligent banks. It for instance implies more clearly that banks cannot limit themselves to the CRR examples of indicators, but actually should look for indicators that the obligor may perhaps not pay to determine whether it is unlikely to pay. Self evident as that sounds, it may be good to reinforce the main rule of heightening financial buffers when it becomes more likely that those are needed, not looking only at the badly written subsequent examples in the CRR provisions, that might lead to fatal delays to shore up buffers when e.g. your sovereign is failing, or when one of the major banks of your country is failing.

(Un)intended consequences?

The consultation paper also raises question, however. Was the spirit of these rules – to prepare for future write-downs by all types of obligors – applied in full in this manner by banks (and their supervisors) when the possibility of default was high in the last few years? For instance when the US government shut down, or when several Eurozone countries were (not yet sure that they would be) bailed out? It is unlikely that this was the case. A part explanation may be that for member states it may have been equally welcome to have optimistic banks that do not apply the indicators of unlikeliness to pay too diligently, and preferably not at all to the government itself, to large banks and to protected sectors. The consultation paper appears to ignore that the same rules should also be applied to these more sensitive types of obligors. The indicators mentioned appear most relevant if thinking of debt of households and loans to smaller companies. They lack clearly defined indicators derived from financial markets that would be much more relevant to larger obligors. The current references to market movements are vague, and thus fail to achieve harmonisation. It would be helpful to e.g. define a certain percentage of losses in share value over a relatively short period of time as a good indicator of potential default (which according to the draft guidelines now need only be considered when fair value in the profit or loss account needs to be reassessed under accounting rules). Rising CDS values would be another good and clear indicator, or high implicit interest rates of bonds traded in the secondary markets, as seen for instance when Fortis or RBS or AIG or Lehman failed, or when Greece defaulted on its original bonds by restructuring those bonds held by private sector banks, insurers, pension funds and consumers.

The macroprudential repercussions of banks being forced to start increase their financial buffers for larger numbers of small obligors or for the potential default of one or more systemically relevant obligors also do not appear to have been considered. Even though the lack of macroprudential awareness is a design flaw of the CRR-article, the guidelines could have helpfully added text on what to do when a systemically important private or public sector entity shows such signs, or if a specific industrial sector or the whole of the private sector in a member state starts to show signs of stress. In that case supervisors and central banks need to be informed of such signals, and in turn should be able to instruct banks to act both in line with their legal obligations to assess indicators of non-payment, but without doing systemic damage. For instance by orchestrating a joint response so that all banks prepare in the same manner (by acknowledging the potential for default of e.g. the USA under a political shutdown, Greece when the first bail-out appeared to be too optimistically structured, or any troubled bank about which rumours swirl in the financial markets). This same point applies to the proposed rules for keeping an obligor nominally in default – even it has started to pay again – to check that the default indicators have indeed permanently receded before allowing the bank to bring down the required level of capital again. As currently formulated, for instance the fact that the ECB accepts unsecured sovereign bonds of Greece again as collateral, or that a conditional new bail-out programme was politically agreed, would not have meant that the commercial banks of Greece could have brought down their increased capital levels for Greek sovereign debts. Such ECB actions are not mentioned as an indicator that all troubles are permanently over. That also applies to the question whether the USA can return to non-defaulted status quickly when a last minute deal on a budget or higher debt ceiling is agreed.

Perhaps a strict application of the law on systemically important obligors is not the intention of supervisors, and may not have been the intention of some members of the Council of the EU as co-legislator. The CRR definition of default nonetheless applies to all sorts of obligors, not only to those that are relatively irrelevant. A bank or supervisor that blatantly ignores indictors of default, and fails to increase the CRR-mandated minimum of capital in a timely manner sets itself up for liability. It thus may be good to give more clarity on the content of the legal obligation of banks and supervisors, instead of relying of regulatory forbearance and/or politically sensitive application of the CRR rules to avoid amongst others macroprudential consequences of a too strict or too late application of the definition of default.

Also see:

• Art. 110.4, 127, 178, 506 CRR 575/2013 and art. 101.5 CRD IV Directive 2013/36/EU.
• Art. 154.1 and 154.7, Annex VI part 1, chapter 10 (§61-65), Annex VII part 4, chapter 2.1 (§44-48) Recast Banking Directive 2006/48/EC (as replaced by the mentioned CRR provisions)
• EBA, Consultation paper, Guidelines on the application of the definition of default under Article 178 of Regulation (EU) 575/2013, EBA/CP/2015/15, 22 September 2015.
• ECB, Public consultation on a draft regulation of the European Central Bank on the exercise of options and discretions available in Union law, November 2015, article 4.
• EBA, overview of options and discretions.
• EBA, CEBS’s technical advice to the European Commission on options and national discretions, 17 October 2008, amongst other option 70, 113 and 151 (disclosure: at the time I was the chair of the relevant working group).
• EU Banking Supervision, Chapter 8

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There has been a race between banks and regulators to add size and complexity to banking groups on the one hand and to regulations that cover such businesses on the other. It is questionable that smaller and simpler banks and their clients are best served by this development. At the same time, the financial system suffers due to a lack of diversely set up banks, with varied types of loans and interest rates on offer and with business models that are not prone to fail at exactly the same time.

If only it were possible to say in advance which banks will be dangerous in the future. In that case the solution would be simply to abolish most rules for the non-dangerous type. Crystal balls are in short supply, however, and time after time, both big and small banks have surprised regulators by being unpredictably safe, or unsafe, and if unsafe, by suddenly being systemically important (or politically important) at their point of failure. Legislators and supervisors do not like such surprises, and have responded by adding ever more detail to the Basel (and EU) capital framework and the Basel core principles for banking supervision. The original framework was drafted at a time when the ‘big, diversified and internationally active banks’ for which it was written were of the size that small banks are now, and capital markets and markets in financial instruments were relatively simple. Open borders in the EU single market (and around the world for some financial services) have since allowed a consolidation wave between banks operating in ever larger, more complex and interlinked financial markets, for which the original rules no longer appeared to suffice. This consolidation is then reinforced by the need for size to absorb the costs of stricter rules, and in times of crisis by supervisors begging relatively stable banks to take over relatively wobbly banks.

So now we appear to be stuck in a set of complex rules designed for complex banks and complex financial systems. And strangely, in many submarkets such bigger banks are behaving in exactly the same manner, dropping small borrowers as reviewing and monitoring them is too complex, dropping trade finance and USA linked clients because there are too high AML or FATCA administrative burdens associated with them, targeting exactly the same profitable and asset rich clients to offer loans to, and offering depositors the same tawdry deals because for large banks the wholesale funding market is both simpler, more predictable and cheaper than managing a plenitude of surly savers. Especially if having such depositors means higher fees to be paid to deposit guarantee funds, resolution funds, supervisors fees, and likely to local tax authorities.

The traditional EU approach to the capital framework has been that all banks should be on the same level playing field, and that the so-called proportionality principle will provide for enough flexibility to allow smaller and simpler banks to thrive. But how to apply the rules proportionally, when it is not clear for smaller banks that their supervisors will accept anything less than perfection, and for supervisors that leeway granted to their banks will not come back to haunt them when that bank fails? There is no safe haven for either banks and supervisors to hide from liability or bad publicity if something goes wrong that could have been prevented if rules to calculate requirements or set up a check and balances system could have been enforced too.

Now, it could be defended that the complex rules serve a useful purpose for complex banks. Their business is driven by a need to reduce regulatory capital requirements, and to prevent innovative abuse or avoidance the regulators have to be equally innovative to think up new detailed rules or guidance. In the absence of minimum capital requirements their sheer size otherwise might mean that in the eyes of the financial markets they can get away with even more minimal safety measures as long as they appear to be profitable. This is not the case for relatively smaller banks, where the amount of capital needed to be able to attract wholesale funding is often higher than the amount of regulatory capital required under solvency ratio calculations. For these smaller banks, the absolute number of regulatory capital requirements is not so much the burden, but the sheer size of administrative and reporting measures that are needed to be able to calculate this via the solvency ratio. And this burden is difficult to make proportional to their business, as the main elements that support that calculation need to be present in the same manner in both big and small banks to be able to come to a trustworthy outcome of standardised or internal models on which the solvency ratio is based.

Creating a lot of lightly regulated shadow-competitors for banks (such as via e-money, payment institutions, venture capital or social investment fund rules) does not solve the fact that the traditional basis of banking, attracting deposits, making loans, providing facilities, and thus easing the functioning of the economy, is becoming the prerogative of ever larger organisations that can optimize the regulatory burden of solvency ratio calculations.

If regulators and the remaining smaller and simpler banks are truly interested in more competition between banks, more choice for clients (both lenders and borrowers), more diversity in the banking sector, more effective rules, or at least less complex rules, then substantial changes in the prudential regime should be considered. Though it is easy to be married to the status quo of the Basel capital accord, it should be remembered that it is a relatively young framework of barely 40 or 50 years of age, that has been growing organically, and was never intended for the simplest banks, but for the most systemic banks of its day and age. And there are alternatives that still are based on available experience in the way banking was structured in the past, or how it is structured for state licensed banks in the USA, or how supervision is structured in the insurance sector.

In order to be contemplated by regulators, however, any alternative regime will need to be more effective than the current regime in preventing harmful fallout of a banks’ failure. Though the existing set of complex rules has a dismal track record during various crisis, there is a belief (though that belief possibly only exists in press releases) that the various untested add-ons of the last few years will work better in limiting the potential for future crisis. This even though for instance the much admired bail-in instrument has the potential to cause contagion in the bailed-in creditors, and harsher market risk requirements risk reducing the liquidity of markets in certain financial instruments. While waiting for the jury report on the effectiveness of the new add-ons to arrive during the next crisis, that belief in their sturdiness is a political reality. If an alternative simpler regime is even to be contemplated, the alternative simpler banks subject to it should thus be even more ‘safe’. Preferably, any legislator and supervisor that replaces part of the current regime for a simpler alternative should be able to honestly say that they do not care to have e.g. full control and complex data over the bank, because the public interest is fully managed in another way. In my opinion, this other way could be found by making the failure of such simple alternative banks irrelevant for the protection of their clients, and irrelevant to the financial system in which they operate. This will only work if the banks’ full failure hurts no one except the bank itself and its equity providers, not even if similar or related banks would fail at the same time. So if we would like more diversity in the banking sector, and allow some banks to compete on different conditions without undermining safety nor a level playing field, a new balance would need to be struck by deleting the most onerous obligations of the current regime for simple alternative banks, and replacing them with equally safety enhancing but more simple alternative measures.

Smaller and simpler banks appear to suffer most from the calculation, supporting organisational requirements, and pillar 3 and regulatory reporting requirements that relate to the solvency ratio. For non-complex banks, as indicated above, these requirements actually do not even result in a credible minimum capital level in the opinion of the banks themselves and/or the markets (small banks operate at higher capital levels than the minimum required). These solvency ratio calculations thus appear to be surplus to annual accounting calculations. While these regulatory requirements do not bind them, they still induce costs and force banks into specific business models. But ditching the solvency ratio requirements and all adherent organisation and reporting burdens, would be a large shift from the current regime, and would force supervisors out of their comfort zone. Even when the results of imposing the solvency ratio are thus far underwhelming and their limitations badly understood; their usefulness as one of the few means of control and – even if ex post – verification is at the moment not paralleled by other measures.

Nevertheless, I would propose deleting the solvency ratio calculation and all supporting requirements in full for a subset of simple alternative banks, subject to a range of conditions. Any tinkering with the solvency ratio – which evidently is in the comfort zone of regulators and supervisors – would not result in a measurable reduction in burdens, while only adding to the small forest of trees cut down to be able to print the so-called single rulebook now. The conditions for escaping the solvency ratio obligations should be simple and at the same time compensate for its loss, and prevent abuse. They should thus include the majority of the following:

• Personal liability of all current and (recent) past members of management and anyone ‘owning’ or ‘controlling’ the bank e.g. by having a stake of more than 10% of equity. Introducing collective responsibility in this manner would make banks again more similar to the out of fashion partnership-based banks, and force key influencers to face up to potential negative consequences of their or their partners’ decisions. An alternative could be a non-profit bank with mandatory low salaries and a prohibition on dividends and bonuses, but this would require some talented people to be willing to work for a fraction of their commercial salary solely for idealistic reasons.
• A leverage ratio based solely on comparing existing annual account information set at a high number (e.g. 10% or more, to be calibrated at the high capital levels smaller banks now have), combined with an FDIC style prompt corrective action tool. This could be supplemented by other indicators of health, but only if those are based on already available public annual accounts data.
• Limiting the asset side of the bank, by reintroducing the habit to issue limited banking licenses. For instance licensing such banks to be focused on SME finance, or on trade finance, or on infrastructure investing, or on mortgage loans. This is still an existing feature in the insurance sector, where the main type of insurance written by any specific licensed entity has to quite similar, e.g. limited to car insurance, or to fire insurance. Apart from their specialisation on the asset side, their business should only consist of deposit taking and offering payment accounts. This would clarify their transformation function, and ensure that their management can be focused on a specific business.
• General demands on management, valuation and bookkeeping sufficient for annual accounts and conduct of business purposes could remain in place.
• No deposits or credits should be accepted that are not fully guaranteed by a public deposit guarantee fund; or that are fully collateralized/insured by repo’s, covered bonds, credit default swaps or by other credit insurance. It could be contemplated to prescribe that a proportion of the deposits should be term deposits, though any simple alternative bank with a personally liable management is certain to keep a good liquidity buffer if they have immediately redeemable deposits.
• The maximum market share of such simple alternative banks in each specified banking activity they can be active in under their licenses, should be set at a level that ensures that both the deposit guarantee fund and the financial system could relatively easily absorb the net losses that will be suffered due to their potential for – even collective – failure (in a more strict version of the USA concentration limits).
• Such a bank should have all its activities within the same legal entity. It should be prohibited from having subsidiaries, should not be allowed to make loans to group entities, and should only be allowed to outsource to non-related entities that would not fail in case of its failure. If it is part of a group (e.g. a automotive group, or even a financial group), such a license can only be issued to one simple alternative bank per group. It should be supervised solely on a solo and stand-alone basis, and the parent group should be ignored except as an ex-post suable party in case of the demise of the bank. The equity share in a alternative simple bank by any ‘normal’ parent bank should be weighed solely as a capital investment both for solo and consolidated supervision purposes on its parent bank (to avoid solvency ratio requirements landing indirectly at the alternative simple bank).
• Instead of a supplementary pillar 2 regime, it should have a stand-alone annual obligation to write a business plan with its main business options and risks, and what it plans to do on both accounts.
• Its resolution plan should be simple: full liquidation, repaying the deposit guarantee fund for protecting its depositors, combined with the liquidator maximising the size of the estate by suing the liable persons within its structure for any deficit in repaying the DGS and other (collateralized) creditors.
• They should be identified by a separate name that highlights frailty (bank light, mini bank, high risk bank, or even alternative simple bank).

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If the bank or its equity providers want to abandon these restrictions, they can of course opt into the solvency ratio regime, perhaps with even the liability for new obligations incurred after the transfer slowly tapering off (though some form of collective liability of all key influencers would be good at any bank). For new start ups, this would have the benefit that by the time they would like to do so, they have had the chance to build up both their organisation and their expertise up to the required level to be able to work in that more complex environment. During a try-out phase for this new regime, it could be envisaged that such alternative simple banks should not operate on a cross border basis. Anything longer than during a try-out period would, however, irreparably damage the concept of the EU single market.

Whether such a regime-change is credible remains to be seen. It is out of the comfort zone of EU and Basel regulators (no more solvency ratio?) and latter day bankers (liability?). If banks and regulators are indeed serious in their concerns about the current regime and its impact on the way the banking sector performs its functions to the benefit of all of us, it should nonetheless be considered.

Also see:

Are EU Banks Safe?

Actal advice to the Dutch Minister of finance, Regulatory burdens on credit, 23 July 2015, plus the accompanying EY report of May 2015 (both in Dutch)

CEBS, results of the comprehensive quantitative impact study, 16 December 2010, www.eba.europa.eu. Also see BCBS, An Assessment of the Long-Term Economic Impact of Stronger Capital and Liquidity Requirements, August 2010, www.bis.org.

The VW manipulation of its emissions testing results provides lessons for banks, insurers and their supervisors. Testlab results bear no similarity to real life survival or failure is a simple one. Bad governance structures can lead to bad decisions (as highlighted by John Plender in the FT and supported by a wide range of examples such as the DSB Bank failure in the Netherlands). Another lesson is that the testlab/models that are the basis for calculating capital requirements are prone to pressure and manipulation.

There appear to have been two stages that shifted the results in response to high-level orders to pass environmental tests and improve sales. The first is the – as I understand – industry standard in the EU that emissions are only tested in laboratory conditions on vehicles that are specially selected and prepared for this testing by stripping off all inconvenient aspects (rear view mirrors, wipers, and anything that weighs anything in the car that is not needed to make it run, such as the standard airconditioning or audio equipment). For some this is the minor league of evasion or fraud as it ‘only’ changes the hardware, and anyone actually looking would notice. Even for this type of lab-adaptation there is little relation between the car in the lab and on the road, but some people would say it remains in the nudge and wink category of how smart it is to evade the vague requirements and the light touch oversight, and the general contours of the car tested remain the same. The second stage is now provoking more outrage, as the manipulation is not in the visible hardware, but in lines of code in the software. Any instrument that supposedly cleans up the emissions but was a drag on ease of handling on the road was automatically switched off by the design of the software, except when the exact conditions of the laboratory test were found.

Though it is unlikely that executives removed the hardware from the testlab-models or wrote the software that changed the car from fake circumstances to real life riding and back, it is likely that they created the incentives to do so by demanding relative growth as compared to competitors, in the cars case by simultaneously demanding low emissions during tests so that the cars could legally be sold, and high performance so that customers would actually want to buy them, and did not bother to sufficiently check whether the product sold fit the description on issues that customers did not bother to verify or sue on, and regulators did not bother to/were not able to check.

The calculation of capital requirements is open to similar pressures. It is abstract, only important if thousands of products fail to perform at the same time, only important in the long term, and customers do not like it while the bank or insurer is alive because it heightens their costs if the bank or insurer would take it seriously. The old standardised approach for capital requirements calculation was abandoned for complex institutions because the choices made in investments were optimized by these institutions to take the highest risk/reward road within each wide basket of types of assets, such as corporate bonds. This maximized returns while minimizing costly capital requirements. The newly invented ‘internal’ models that have been introduced for banks in the 2004 Basel II accord (in the EU implemented via the 2006 version of the CRD) and will be introduced for insurers in 2016 under Solvency II allow more leeway to reward the bank or insurer if they choose a less risky product to invest in, but does expect them to take better regard of the more risky products too. Some banks are indeed relatively conservative or are being forced to be relative conservative by their supervisors, and estimate the riskiness of the assets they hold higher than the models used by their competitors estimate the same or the same type of assets. Some banks, however, are removing the airconditioning and audio systems by abandoning newly capital-costly areas such as trade finance or investment banking, while plunging collectively into low capital-costly areas, or professing high confidence in their clients or risk management systems. The result is that banks’ internal models show wildly different results, which is an indicator that some may be too lightly capitalised for the risks they run in their entire business. An additional result is that worthy areas of services are no longer provided by banks, but are either not provided, or are now provided by less regulated service providers. It is likely that more conservatively calculating banks are under pressure to become more ‘capital efficient’ in order to retain profitability and competitiveness.

The temptation to adapt the outcomes of test-results is easy to understand. Lower capital requirements (emissions) lead to the potential for acquiring more assets (making more sales) that generate higher profits and higher status for the CEO. And a slight tweak in one area that makes the boss happy does not really impact a lot on the overall capital; except of course if this happens in all areas the bank or insurer is active in. These tweaks stimulate the financial company, their shareholders and the economy as long as the bank or insurer makes no losses yet. And the internal models used by complex banks do not show with a big blinking warning whether there is internal pressure to always lean in the same direction. Fundamental attitudes towards the need for buffers or the need for speed and profits are neither measured nor checked easily, especially if the number of experts is vastly larger on the bank’s side than on the supervisors’ side. But if the general attitude at a financial company is that it is acceptable to have slight manipulations, or just slightly reducing the riskiness of the asset just by removing the dragging mirrors from the test-lab model, this risks the continued survival of the firm once it comes out. Removing trade finance already does not make the bank safer. It just makes it less well capitalised, and diminishes the value of the bank to society similar to cars with high Nox emissions in real life. Especially harmful would be if it turns out that the models used by banks are deliberately built to optimise testlab results that bear no relation to known market and firm behaviour when risks materialise. Bankers/Insurers would, however, not be unique in such manipulation. The regulated bits of internal models and the standardised models are riddled with such deliberate misdesign by lawmakers, e.g. to underestimate the riskiness of SME-loans, or to hugely underestimate the riskiness of sovereign bonds. In the end, if banks add to this, and do not compensate for design-faults in the laws that rule the design of models to calculate capital by adding voluntary layers of safety themselves, it remains deceit towards clients, investors, and society as a whole.

Though supervisors are aware of the discrepancies, they have been kicking the can down the road for a while, and there are no signs yet of an official line. The amount of capital needed for the most derelict banks – and the financial stability consequences of exposing them – may pressure them into regulatory forbearance. Though this is both understandable and damnable at the same time, such regulatory forbearance does not impact on the own responsibility of bank and insurance boards on whose watch such collective leaning or manipulation takes place by underlings who aim to please their bosses by improved headline numbers.

Safety should not be tampered with, and will not be tampered with in the long run, as the sheltered executives of VW already found out.

Also see:

• Plender, John, Poor governance at VW should have been a warning to investors, FT 30 September 2015
• Noonan, Laura, ECB doubles the time needed to review banks’ risk models, FT 16 August 2015
• EBA reports of 22 July 2015 on eba.europa.eu
• BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Market Risk, January 2013 (rev February 2013)
• BCBS, Regulatory Consistency Assessment Programme (RCAP) Analysis of Risk-Weighted Assets for Credit Risk in the Banking Book, July 2013
• UK FSA, A Regulatory Response to the Global Banking Crisis; Discussion Paper 09/2, March 2009, page 71-73

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• EU Banking Supervision, chapter 6.3
• Are EU Banks Safe?, chapter 4.5