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

Explicit and implicit creditor insurance
not correctly priced

Binding capital requirements reduce
incentives for taking risk
Potential for regulatory arbitrage

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?
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
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)

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,

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
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
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 

Further adjust
stance
Adjust stance

 Push bridge
This is endogenous risk
Some endogenous
risk events

1987 crash

1998 LTCM

1998 Yen/Dollar
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”


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

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
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

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

