Self-grading has obvious limitations in education. Now, a senior regulator at the Federal Reserve wants to banish it from bank regulation.
Under international banking rules, large banks are allowed to use their own tests to assess the riskiness of their assets and activities. Even after the financial crisis, these internal measurements play a role in setting capital requirements, the crucial financial buffer that helps a bank withstand losses and disruptions in the markets.
But in a speech on Thursday, Daniel K. Tarullo, the Fed governor who oversees regulation, said he believed that regulators should consider stopping the banks from using their own estimates. “The I.R.B. approach has little useful role to play,” he said, referring to the internal ratings-based approach, the official term for this self-assessment.
This suggestion represents another big shift away from a regulatory regime that left the financial system vulnerable to collapse in the 2008 crisis.
The practice of self-grading was part of a wider shift in bank regulation that came into existence before 2008. At that time, most regulators around the world thought banks should be able to hold less capital against assets that were judged to be less risky. Much capital regulation still revolves around this philosophy, called risk-weighting.
But Mr. Tarullo’s call shows that the Fed wants to sharply pare back the banks’ own contributions to the risk-weighting process.
Other rules imposed since the crisis have already significantly reduced the influence of the banks’ own risk calculations. Still, some banking experts said that they agreed with Mr. Tarullo’s call to go even further and to stop allowing banks to use their internal models to set capital levels.
“There seems to be no good justification for keeping an official role for this regulation,” said Marcus Stanley, policy director of Americans for Financial Reform, an advocacy group that has pushed for more stringent regulation of banks.
International regulators will look closely at Mr. Tarullo’s remarks. Many of America’s banking rules originate with the Basel Committee on Banking Supervision, a global body of national regulators that has long promoted risk-weighting.
Margaret Critchlow, a spokeswoman for the committee, declined to comment on Mr. Tarullo’s remarks, and instead referred to a speech in March by Stefan Ingves, the committee’s chairman. In it, Mr. Ingves acknowledged that there were problems with the self-assessment approach.
A recent survey by the committee showed that different banks were reporting varied results for exactly the same assets, suggesting that the banks were using the practice of self-grading to their own advantage. In the speech, however, Mr. Ingves seemed to want to overhaul the self-assessment rules, not get rid of them. “We want to develop a set of simplifications and safeguards that will help limit variability,” he said.
A practice introduced since the crisis played a big role in convincing Mr. Tarullo that it was time to move away from using the banks’ own calculations. The largest banks in the United States now have to undergo regulator-administered stress tests that are aimed at determining how much capital a bank would have left after dire economic and market shocks. The regulators then use the test results when deciding whether to approve a bank’s dividend or stock buyback plans.
“The supervisory stress tests developed by the Federal Reserve over the past five years provide a much better risk-sensitive basis for setting minimum capital requirements,” Mr. Tarullo said in his speech. “They do not rely on firms’ own loss estimates.”
He added that the final results of the stress tests are public, unlike the data from the banks’ internal self-assessments. The disclosure of the stress test results helps the banks’ shareholders and creditors better understand the institutions, increasing market discipline, he said.
Some banking experts, however, reacted somewhat cautiously to Mr. Tarullo’s idea.
They noted that the regulators have had to approve the banks’ internal models. The process of scrutinizing the banks’ internal calculations, and asking for data to be produced in certain ways, has helped both the banks and regulators, they said.
“The process of qualification, and everything you have to have, certainly strengthens risk management and data management,” said Alok Sinha, a principal at Deloitte & Touche. “It provides you with the mechanisms to look at the bank in a more structured manner.”
Supporters of Mr. Tarullo’s idea contend, however, that the stress tests are a better way for regulators to gain clear and helpful data.
In one way, the banks may welcome getting rid of self-assessments. They are expensive and complex. And life may be simpler for the regulators.
“Clearing aside some of the paperwork requirements can help people focus on what’s important,” said Mr. Stanley, the advocate.