On The Role of Regulatory Banking Capital

Harald BeninkHarald Benink

Jón DaníelssonJón Daníelsson

Ásgeir JónssonÁsgeir Jónsson

April 6, 2006April 6, 2006

Traditional Function of Capital Buffer, incentives, protection of Buffer, incentives, protection of

depositorsdepositors

Explicit and implicit creditor insurance Explicit and implicit creditor insurance not correctly pricednot correctly priced

Binding capital requirements reduce Binding capital requirements reduce incentives for taking riskincentives for taking risk

Potential for regulatory arbitragePotential for regulatory arbitrage

Conditions for Effective Capital Requirements Risk buckets of right size Risk buckets of right size If risk is exogenous (more on that later)If risk is exogenous (more on that later) If risk can be measured accuratelyIf risk can be measured accurately

If regulators focus is on the institution If regulators focus is on the institution and not on financial stability and not on financial stability

What about liquidity?What about liquidity?

Risk Buckets and the Regulators Dilemma Too broad risk buckets (like Basel Too broad risk buckets (like Basel

I) lead to regulatory arbitrage I) lead to regulatory arbitrage

If risk buckets are too small (like If risk buckets are too small (like Basel II ?)Basel II ?) Incentives for improvement Incentives for improvement

removedremoved

Is IRB the Solution?

Gaming and manipulationGaming and manipulation Difficult for supervisors to assessDifficult for supervisors to assess

Potential for regulatory capture?Potential for regulatory capture? QIS4QIS4 Regulators will have to become Regulators will have to become

ever more prescriptive ever more prescriptive Or “correct” with Or “correct” with supplementarysupplementary

capital (pillar 2 approach)capital (pillar 2 approach)

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”.

Endogenous Risk

Market Prices are generated by people, Market Prices are generated by people, Hedging affects pricesHedging affects prices Prices are not exogenous, like the weatherPrices are not exogenous, like the weather

Crises are amplified if people behave in Crises are amplified if people behave in the same say and have similar believesthe same say and have similar believes

Basel II encourages this harmonization Basel II encourages this harmonization It especially motivates banks to react in the It especially motivates banks to react in the

same way to adverse shockssame way to adverse shocks

Millennium Bridge New designNew design Tested with Tested with

extensive simulationsextensive simulations All angles coveredAll angles covered No endogenous No endogenous

shocks possibleshocks possible RisklessRiskless After all, pedestrians After all, pedestrians

are not soldiers who are not soldiers who march across bridgesmarch across bridges

What Endogeneity?

• Pedestrians had some problems

• Bridge closed

What happened?

• Took the engineers some time time to discover what happened

What is the probability of a thousand people walking at random ending up walking

exactly in step?

If individual steps are independent events…

… … then the then the probability is probability is close to zeroclose to zero

but given feedback…

near certainty!

Bridge moves Adjust stance

Push bridge

Further adjust

stance

Some endogenous risk events

1987 crash1987 crash

1998 LTCM 1998 LTCM

1998 Yen/Dollar1998 Yen/Dollar

This is endogenous risk

Accuracy of Risk Measurements The myth of scientific measurement of The myth of scientific measurement of

riskrisk Under best case scenarios Under best case scenarios (when we can (when we can

actually test)actually test)

Inaccuracy ±40% Inaccuracy ±40% Very sensitive to assumptions Very sensitive to assumptions

(QIS4?)(QIS4?) 99% annual risk 99% annual risk

““Test to model” not “test to data”Test to model” not “test to data”

Capital and Crises

Financial instability enters via the Financial instability enters via the asset sideasset side

Unlike many textbook crisisUnlike many textbook crisis Liability side (bank runs)Liability side (bank runs)

The capital buffer and the The capital buffer and the maintenance of the buffer maintenance of the buffer becomes source of systemic riskbecomes source of systemic risk

A Crisis on Asset Side(suppose no problem on liability side)

Suppose capital is sufficient prior to Suppose capital is sufficient prior to a crisisa crisis

But not during the crisis But not during the crisis Risk sensitivity and endogenous risk Risk sensitivity and endogenous risk

amplifies the crisisamplifies the crisis Recovery takes longerRecovery takes longer

Therefore the capital requirements Therefore the capital requirements become a source of systemic riskbecome a source of systemic risk

Options I

Risk sensitivity of capital Risk sensitivity of capital undesirableundesirable

Regulations should incentivize Regulations should incentivize banks to have risk management banks to have risk management without using output for capital without using output for capital determinationdetermination

Regulatory capital is better Regulatory capital is better calculated as a simple fraction of calculated as a simple fraction of banks activity in broad categoriesbanks activity in broad categories

Options II

If the objective of Basel II is financial If the objective of Basel II is financial stability without overly burdening banksstability without overly burdening banks

Market discipline (pillar 3), Market discipline (pillar 3), Minimum standards for risk Minimum standards for risk

managementmanagement Contingency planning and Contingency planning and

abandonment of constructive ambiuity abandonment of constructive ambiuity