Arnold Kling  

Can Risk Buckets Work?

Speaking of Health Care Reform... Thumbs Up for Portfolios of...

James Kwak writes,

In short, we need a system for risk weighting that is harder to "game" than the current one - and a set of regulators who will enforce it. Given how long Basel II has been going on, and what it has come up with, this is asking for a lot.

For more than twenty years, ever since Basel I, a group of economists called the Shadow Regulatory Committee has been skeptical of the risk-bucket approach. One problem is that risk is more complicated than in any scheme that can be captured by arbitrary risk buckets. A second problem is that regulators necessarily react slowly, particularly in the case of the Basel Accords, where the goal is international harmonization, which slows down the adjustment process considerably. As a result, what I call the regulatory chess game is stacked against the regulators. The private sector can adapt to game the system faster than the regulators can react.

The Shadow Regulatory Committee's economists want to require banks to issue subordinated debt, meaning debt that it is at risk if the bank is insolvent. The thinking is that the price of that debt can serve as a market indicator of the bank's solvency. A similar idea is to use the price of credit default swaps on bank debt to serve that purpose.

My guess is that subordinated debt would not prove to be a panacea. There will turn out to be unforeseen contingencies in which the subordinated debt fails to act as a timely signal and/or becomes a complicating factor at the point of crisis. But there is no perfect regulatory solution, and we probably need a portfolio of approaches to dealing with safety and soundness.

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COMMENTS (2 to date)
Sunil writes:

A fundamental question to ask here is: Why are capital adequacy ratios even required? If banking is a business like any other, then why should a regulatory body arbitrarily impose minimum capital requirements on banks/financial institutions?

All businesses have risk. But we dont see the SEC trying to assess the risk for each business and mandating some minimum equity ratio?

If the aim is to protect the depositors, then the best way to do that is to force the banks to buy their own deposit insurance. FDIC is a sham, as the risk is not priced correctly. Also, the FDIC itself does not hold adequate capital, being a government entity, and introduces much greater systemic risk. If the banks are forced to buy deposit insurance from private insurers, then there will be a greater incentive for them to maintain their financial health by having adequate reserves and sufficient risk capital. If they dont, then the price of insuring their deposits will go up, and such banks will find it very difficult to attract deposits.

Jesse writes:

Sunil, so you want to get rid of capital requirements for banks by having them buy private insurance from heavily regulated insurance companies that face their own minimum capital requirements? OK.

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