Capital and regulation

Regulators ensure that our financial system is safe while at the same time that it
prospers. To ensure that safety, regulators insist that a bank holds sufficient capital
to absorb losses. This includes losses due to market, credit, and all other risks. The
proper amount of capital raises interesting theoretical and practical questions. (See,
for example, Matten, 1996 or Pratt, 1998.) Losses due to market or credit risk show
up as losses to the bank’s assets. A bank should have sufficient capital to absorb
not only losses during normal times but also losses during stressful times.
In the hope of protecting our financial system and standardizing requirements
around the world the 1988 Basel Capital Accord set minimum requirements for
calculating bank capital. It was also the intent of regulators to make the rules simple.
The Capital Accord specified that regulatory capital is 8% of risk-weighted assets.
The risk weights were 100%, 50%, 20%, or 0% depending on the asset. For example,
a loan to an OECD bank would have a risk weighting of 20%. Even at the time the
regulators knew there were shortcomings in the regulation, but it had the advantage
of being simple.
The changes in banking since 1988 have proved the Capital Accord to be very
inadequate – Jones and Mingo (1998) discuss the problems in detail. Banks use
exotic products to change their regulatory capital requirements independent of their
actual risk. They are arbitraging the regulation. Now there is arbitrage across
banking, trading, and counterparty bank books as well as within individual books
(see Irving, 1997).
One of the proposals from the industry is to allow banks to use their own internal
models to compute regulatory credit risk capital similar to the way they use VaR
models to compute add-ons to regulatory market risk capital. Some of the pros and
cons of internal models are discussed in Irving (1997). The International Swaps and
Derivatives Association (1998) has proposed a model. Their main point is that
regulators should embrace models as soon as possible and they should allow the
models to evolve over time.
Regulators are examining ways to correct the problems in existing capital regulation.
It is a very positive development that the models, and their implementation, will
be scrutinized before making a new decision on regulation.
The biggest mistake the industry could make would be to adopt a one-size-fits all
policy. Arbitrarily adopting any of these models would certainly stifle creativity. More
importantly, it could undermine responsibility and authority of those most capable
of carrying out credit risk management.