On The Role of Regulatory Banking Capital

1. On The Role of Regulatory Banking Capital Harald Benink Jón Daníelsson Ásgeir Jónsson April 6, 2006

2. Traditional Function of Capital • Buffer, incentives, protection of depositors • Explicit and implicit creditor insurance not correctly priced • Binding capital requirements reduce incentives for taking risk • Potential for regulatory arbitrage

3. Conditions for Effective Capital Requirements • Risk buckets of right size • If risk is exogenous (more on that later) • If risk can be measured accurately • If regulators focus is on the institution and not on financial stability • What about liquidity?

4. Risk Buckets and the Regulators Dilemma • Too broad risk buckets (like Basel I) lead to regulatory arbitrage • If risk buckets are too small (like Basel II ?) • Incentives for improvement removed

5. Is IRB the Solution? • Gaming and manipulation • Difficult for supervisors to assess • Potential for regulatory capture? • QIS4 • Regulators will have to become ever more prescriptive • Or “correct” with supplementary capital (pillar 2 approach)

6. Isambard Kingdom Brunel 1847 on the idea of the government prescribing regulations for bridge design “In other words, embarrass and shackle the progress of improvements of tomorrow by recording and registering as law the prejudices and errors of today”.

7. Endogenous Risk • Market Prices are generated by people, • Hedging affects prices • Prices are not exogenous, like the weather • Crises are amplified if people behave in the same say and have similar believes • Basel II encourages this harmonization • It especially motivates banks to react in the same way to adverse shocks

8. Millennium Bridge • New design • Tested with extensive simulations • All angles covered • No endogenous shocks possible • Riskless • After all, pedestrians are not soldiers who march across bridges

9. What Endogeneity? • Pedestrians had some problems • Bridge closed

10. What happened? • Took the engineers some time time to discover what happened

11. What is the probability of a thousand people walking at random ending up walking exactly in step?

12. If individual steps are independent events… … then the probability is close to zero

13. but given feedback…near certainty! Bridge moves  Adjust stance   Further adjust stance  Push bridge

14. This is endogenous risk Some endogenous risk events • 1987 crash • 1998 LTCM • 1998 Yen/Dollar

15. Accuracy of Risk Measurements • The myth of scientific measurement of risk • Under best case scenarios (when we can actually test) • Inaccuracy ±40% • Very sensitive to assumptions (QIS4?) • 99% annual risk • “Test to model” not “test to data”

16. Capital and Crises • Financial instability enters via the asset side • Unlike many textbook crisis • Liability side (bank runs) • The capital buffer and the maintenance of the buffer becomes source of systemic risk

17. A Crisis on Asset Side(suppose no problem on liability side) • Suppose capital is sufficient prior to a crisis • But not during the crisis • Risk sensitivity and endogenous risk amplifies the crisis • Recovery takes longer • Therefore the capital requirements become a source of systemic risk

18. Options I • Risk sensitivity of capital undesirable • Regulations should incentivize banks to have risk management without using output for capital determination • Regulatory capital is better calculated as a simple fraction of banks activity in broad categories

19. Options II • If the objective of Basel II is financial stability without overly burdening banks • Market discipline (pillar 3), • Minimum standards for risk management • Contingency planning and abandonment of constructive ambiuity