Closing on the impossible May 3, 2012 at 7:38 am
A recent post by the Streetwise Professor made me wonder: how risk sensitive do we want capital requirements to be? Or to try to be?
Let me explain.
In the 1980s and 90s, it was a tenet of both regulators and banks that capital requirements should be risk sensitive. More risk requires more capital. That’s a good thing, right?
Well, yes and no. There are (at least) four problems.
- Capital rules are always behind, and sometimes far behind, industry progress in risk measurement. The goal cannot be attained.
- Relative risk equality is important, by which I mean that the same risk taken in different ways should attract the same capital charge. The Basel capital rules (increasingly) don’t meet this basic goal. Let’s fix this before we try and figure out the harder task of charging appropriately for different risks.
- Risk measures are procyclical. That’s an inherent property of a good risk measure. There is a strong argument against procyclical capital rules.
- Risk models can turn out to be flawed, or mis-calibrated. Therefore there needs to be some kind of backstop to prevent the massive growth of products which look low risk according to a (as it will turn out) flawed methodology.
Given this, I am tempted to ask (but not – notice – answer) a difficult question.
Is the task of trying to create a risk-sensitive capital framework worth attempting, given that it is not achievable, and failure necessarily leads to arbitrage?
Your thoughts, as always, are welcome.