On 19 April 2021 the European Central Bank released its review of the reliability and comparability of internal risk models used by the larger banks for their risk weighted assets. Although the summary headline on their website seems to be a relatively positive message, digging into the details suggests that there are real issues in the use of these models. The review of the individual bank models “resulted in a 12% increase, or about €275 billion, of risk-weighted assets for the investigated models” which reduced the capital adequacy for these banks by 70 basis points. That is not an insignificant change in the capital levels.
There are of course two questions that remain open. The first was well captured in a speech by Andrew Haldane in 2012 at Jackson Hole, Wyoming, USA titled “The dog and the frisbee.” This speech is well worth reading on a regular basis. In looking at risk models, the research behind the speech comes to the following conclusion: “Complexity of models or portfolios generates robustness problems when understanding a complex financial system over plausible sample sizes. More than that, simplicity rather than complexity may be better capable of solving these robustness problems.”
The second question relates to the fundamental nature of human beings. Or rather foxes. Do we want the foxes in the banking system guarding the henhouses (e.g. risk and capital adequacy)?
