Basel III C: Internal Risk Models

Abstract

For financial regulators seeking to use regulatory requirements to manage risk in a banking system, there can be a concern that such requirements crowd out efforts by banks to develop their own risk management systems. One way in which regulators have attempted to solve this problem is to enable banks to use internal risk models to satisfy regulatory requirements. Beginning with the 1996 Market Risk Amendment, the Basel framework has allowed banks to determine the capital charges associated with certain assets using their own internal risk models. But allowing the use of internal risk models has not been without controversy. Where some see an incentive for the development of internal risk management systems better able to address the unique risk profiles of particular banks, others see excessive complexity and uncertainty. And while some financial regulators are beginning to subject banks’ models to greater scrutiny, questions remain about the ability of financial regulators to provide effective oversight of such models.