Contributor: Dr. Christopher Marshall

One of the fundamental precepts of Basel II was simple and yet inspired. It argued that as banks adopt more sophisticated (and probably superior) approaches to measuring risk, their regulatory capital charges should decrease. For market risk, capital charges for standardized approaches were greater than those for internal models approaches. For credit risk, internal ratings based approaches required less capital than standardized approaches, and for operational risk, AMA and standardized approaches require less capital than Basic Indicator approaches. But enter crisis driven regulatory changes. Suddenly, capital requirements for market risk within a trading book for internal models approaches are likely to more than triple, as modifications to the basic IMA approach such as stress var, removal of tier 3 capital, and the potential introduction of Incremental Risk Capital dramatically increase the capital required. Add to this the further complication of leverage ratios and liquidity ratio further distancing the capital of the institution from its risk and its ability to manage this risk. It seems to me that these changes destroy the fundamental incentive for institutions to move towards more sophisticated (presumably better) risk models. It’s not simply that regulators finally have acknowledged that they no longer fully trust quantitative risk measures, it’s also that they trust simpler more approximate models more than more sophisticated ones. Why is this? Is it that greater model sophistication means greater model risk and the greater opportunity for banks to bamboozle regulators with apparent accuracy and precision? Or is it just a knee jerk political reaction against quantification of risk and the mathematical finance that underpins it?... read more