Risk sensitive bank capital as implemented in the Basel II accord is a failed idea

Posted by on 27 January 2009

In my commentary I focus on international aspects of banking regulations - in particular risk sensitive capital.

The reason for the rather pathetic state of many of the world’s formerly prominent financial institutions is that they took on too much risk. They made their investments so complicated that neither their supervisors, nor their clients, nor even themselves had a clear idea what they were up to. They did this in spite of their state-of-the-art regulatory systems, risk sensitive capital, and pillars one and two of the Basel II Accord.

Now we find ourselves in the rather strange situation where the banks are behaving prudently according to financial regulations but not lending enough according to the politicians. In this, the politicians are right.

One of the main elements in financial regulation, at least of the macro potential or systemic variety is risk sensitivity, the key principle of Basel two. Throughout the Basel II consultation and design process, risk sensitivity has been criticized; it is destabilizing, pro-cyclical and dependent on an overly optimistic view of the ability to forecast risk.

Pro-cyclicality

Banking by its very nature is pro-cyclical, banks tend to lend excessively in booms – there lending is encouraged by and encourages rising asset prices. Eventually, when it all comes to tears, some banks fail and the remainder cut back on lending. Banks lend too much at the top of the business cycle, too little at the bottom.

Risk sensitive bank capital, à la Basel II amplifies this – an observation made by Danielsson et. al (2001), and widely discussed elsewhere. In spite of this awareness, it has had little impact on regulatory design, with the notable exception of Spain. Indeed, one of the main reasons for the Spanish banks appearing to be doing relatively well is the countercyclical nature of their capital charges. The notion of countercyclical capital is now gaining considerable traction amongst regulators, see e.g. a recent speech by Philipp Hildebrand of the Swiss National Bank, given at the London School of Economics.

Don’t switch now

Switching to a regime of countercyclical capital may provide some relief at the moment, but I suspect its intermediate benefits would be limited. We can, of course, reduce regulatory capital at the stroke of a pen, but doing so in the middle of a recession smacks of desperation, and reduces confidence in banks. The perverse result could be that rating agencies, counterparties, and other interested parties might demand even higher capital.

Why the banks are not lending

A fundamental element in the notion of risk sensitivity is that financial institutions are supposed to reduce risky activities when the models tell them the risk is increasing. Danielsson and Zigrand (2008) model this process with a general equilibrium model and find that regulatory risk constraints of the Basel II type induce banks to reduce risk at times of uncertainty, e.g. by selling risky assets and reducing lending. At the same time such regulations harmonize bank behaviour, causing them to act in an increasingly similar manner. During crisis both outcomes are undesirable, we want banks to increase risky lending and stop acting as in a herd.

Indeed, the banks are now doing what they are supposed to do. They are being prudent. It is disingenuous of regulators and politicians to be demanding that the banks increase lending when the banks are simply following the regulations approved by the very same politicians.

The myth of the riskometer

Risk sensitivity also depends on accurate measurements of risk. Unfortunately risk forecasting is harder than often assumed, a phenomenon I called in a recent VoxEu column “The myth of the riskometer”, adding:

“There is a widely held belief that financial risk is easily measured, that we can stick some sort of riskometer deep into the bowels of the financial system and get an accurate measurement of the risk of complex financial instruments. Such misguided belief in this riskometer played a key role in getting the financial system into the mess it is in.”

“We can create the most sophisticated financial models, but immediately when they are put to use, the financial system changes. Outcomes in the financial system aggregate intelligent human behaviour. Therefore attempting to forecast prices or risk using past observations is generally impossible.”

Conclusion

Risk sensitive bank capital as implemented in the Basel II accord is a failed idea; alternatives are needed, and fortunately many good proposals are being made. Two noteworthy examples are: 1) requiring banks to meet simultaneously both the Basel II and the leverage ratio capital measures, 2) state contingent capital linked to Basel II and other measures. Conceptually both proposals are good, but further analysis and research is needed.




 

Jon Danielsson
London School of Economics

 

 

Bibliography

Danielsson, Jon, Paul Embrechts, Charles Goodhart, Con Keating, Felix Muennich, Olivier Renault and Hyun Song Shin (2001) “An Academic Response to Basel II”, 2001.

Danielsson, Jon and Jean-Pierre Zigrand (2008) “Equilibrium Asset Pricing with Systemic Risk”, in Economic Theory, vol. 35(2), pages 293-319, May.

Hildebrand, Philipp M. (2008) “Is Basel II Enough? The Benefits of a Leverage Ratio”, Financial Markets Group Lecture, LSE .