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Forthcoming challenges to banking regulation (sovereign risk, RWA variability, trading book…) - Resilience of the EU financial sector in the global context

Virtues of supplementary approaches, but build on risk weighting

By Callesen Per - Governor and Member of the Board of Governors, Danmarks Nationalbank

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Risk based pillar 1 capital requirements are fundamental to sound risk management and incentive structures. Risk weights have to be continuously assessed and compared. They should be adjusted if any systematic bias is identified. There are many virtues also of asset quality reviews, stress testing, Pillar 2 requirements and greater transparency (Pillar 3 requirements). These can supplement pillar 1 regulation, but should not act as a substitute for the most reliable calibration of risk weights.

The EU-wide stress tests were initiated against the background of a lack of confidence in financial markets. Whereas the success of earlier stress tests has been disputed, the latest stress test and the Asset Quality Review in 2014 were more effective at restoring market confidence and reducing uncertainty. Improvements were not only related to the design of stress scenarios but also to the enhanced disclosure of individual bank exposures accompanying the results of the stress tests.

On Pillar 2, the development of common EU guidelines on the Supervisory Review and Evaluation Process may pave the way for better harmonisation of supervisory approaches within Europe. However, in most jurisdictions banks are not obliged to disclose their Pillar 2 capital requirement.

Risk weights have to be continuously assessed and compared.

Risk weights will never be able to address every single risk or uncertainty in the financial system. In this regard, stress testing and Pillar 2 are helpful supplements to Pillar 1. But they cannot replace the virtues of appropriate risk weighting, which remain at the core of credible banking regulation. That would distort incentives and reduce comparability and transparency.

Consequently, it is important that supervisors continue to challenge the calculations and models used by banks and that regulators continue to develop and refine the framework of Pillar 1. The challenge is to enhance consistency of the methods used at the same time allowing for variability in the outcome of models reflecting differences in actual risks. This is the essence of a truly risk-based capital framework.