16 May 2013

BoE publishes Haldane paper on constraining discretion in bank regulation

Speaking at the conference, 'Maintaining Financial Stability: Holding a Tiger by the Tail(s)', Haldane said that making greater use of simple, prudent regulatory metrics could restore faith, hope and clarity to the financial system - to the benefit of banks, investors and regulators alike.

The Libor scandal has exposed many of the same self-regulatory problems. The incentives to shade their self-assessed Libor exam grades proved too much for too many for too long. As it is now known, systematic misreporting resulted. The self-regulatory model was again found wanting.

Yet there is one area of finance where self-regulation continues to stage a last stand – bank capital standards. Since the mid-1990s, banking regulators globally have allowed banks the discretion to use their own models to calculate capital needs. Most large banks today use these models to scale their regulatory capital. In doing so they are, in essence, marking their own exams.

This self-regulatory shift was made with the best of intentions. Yet its consequences have been predictable. Self-assessment has created incentives to shade reported capital ratios. As elsewhere, a regulatory regime of constrained discretion has given way to one with too much unconstrained indiscretion.

This calls for regulatory repair. Without change, the current regulatory system risks suffering, like the Chicago teachers and the Libor fixers, reputational damage. Fortunately, there are early signs that regulatory change is afoot to place tighter constraints on this (in)discretion.

To understand how we ended up here, it is useful to explore the historical contours of the regulatory debate. This is a history in roughly four chapters:

• Chapter 1 covers the period prior to the agreement of the first Basel Accord in 1988. Until then, a patchwork of national regulatory frameworks for capital adequacy operated. Some countries set capital adequacy standards based on simple measures of bank equity to assets – a leverage ratio. Others, including in the US, used risk-based standards with risk weights set by regulators for a small set of asset categories.
• Chapter 2 begins with the introduction of the Basel Accord. This was a landmark agreement: the first-ever genuinely international banking accord, based around an 8 per cent bank capital ratio, with internationally-set risk-weights applied to a small set of banks’ assets. The Accord was explicitly designed to lean against an international “race to the bottom” in capital adequacy standards (Goodhart (2011)). It also helped ensure a level international playing field.
• Chapter 3 commences with the Market Risk Amendment to Basel I in 1996 and continues through to the Basel II agreement of 2004. These were a direct response to the perceived failings of Basel I. In particular, the lack of granularity in risk weights under Basel I was felt to have created arbitrage possibilities, with risk migrating to lower risk-weighted asset categories.
• The final Chapter, Basel III, commences in 2010. Experience during the financial crisis demonstrated both that capital had been set too low and that it had been defined too broadly. Basel III raised the level, and narrowed the definition, of bank capital. In those respects, it was a very significant improvement over its predecessors. At the same time, the complexity and self-regulatory aspects of Basel II remained in Basel III.

Each of these historical chapters was a logical response to the perceived problems of the day. Even with the benefit of hindsight, these steps seem like sensible ones. In particular, there appear to have been three key objectives behind the evolution of international bank regulation over the period:

• First, to level the international playing field and prevent a race to the bottom in capital adequacy standards, in particular under Basel I.
• Second, to align regulatory capital with risk by improving the risk-sensitivity of capital standards, in particular under Basel II and III.
• And third, to reduce incentives to engage in regulatory arbitrage and create incentives to upgrade risk management, in particular under Basel II and III.

All of these responses were understandable and, in concept, laudable. The question is whether, with the benefit of hindsight, they have been successful.

Over the course of the past 20 years, banking regulation has edged in a self-regulatory direction for understandable, but self-defeating, reasons. The regulatory regime has tilted from constrained discretion to unconstrained indiscretion. It will be a long journey home, but that journey has started. Making greater use of simple, prudent regulatory metrics could restore faith, hope and clarity to the financial system to the benefit of banks, investors and regulators alike.

Full speech

© Bank of England