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

Traditional Function of Capital Buffer, incentives, protection of depositors Buffer, incentives, protection of depositors Explicit and implicit creditor insurance not correctly priced Explicit and implicit creditor insurance not correctly priced Binding capital requirements reduce incentives for taking risk Binding capital requirements reduce incentives for taking risk Potential for regulatory arbitrage Potential 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 accurately If risk can be measured accurately If regulators focus is on the institution and not on financial stability If regulators focus is on the institution and not on financial stability What about liquidity? What about liquidity?

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

Is IRB the Solution? Gaming and manipulation Gaming and manipulation Difficult for supervisors to assess Difficult for supervisors to assess  Potential for regulatory capture? QIS4 QIS4 Regulators will have to become ever more prescriptive Regulators will have to become ever more prescriptive Or “correct” with supplementary capital (pillar 2 approach) Or “correct” with supplementary 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 prices  Prices are not exogenous, like the weather Crises are amplified if people behave in the same say and have similar believes Crises are amplified if people behave in the same say and have similar believes Basel II encourages this harmonization Basel II encourages this harmonization  It especially motivates banks to react in the same way to adverse shocks

Millennium Bridge New design New design Tested with extensive simulations Tested with extensive simulations All angles covered All angles covered No endogenous shocks possible No endogenous shocks possible Riskless Riskless After all, pedestrians are not soldiers who march across bridges After all, pedestrians are not soldiers who march 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 probability is close to zero

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

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

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

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

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

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

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