Streetwise Professor

June 6, 2014

A Model Solution?

Filed under: Economics,Financial crisis,Regulation — The Professor @ 5:55 am

Europe and the US have diverged in significant ways on post-crisis financial regulation. This has had myriad consequences, including fragmentation of liquidity (especially in the swaps market), which in turn leads to less competition as it is harder for US banks to compete for the business of European clients and vice versa; greater cost; and greater complexity.

One area where there was some prospect of a unified global framework was capital rules for banks, where it was hoped that the US would adopt Basel III. But evidently the Fed is resisting that, and will move forward with its own stress test-based framework, rather than the Basel III framework which permits banks to utilize their own models to evaluate risk and hence capital.

Not that Basel III is perfect, by any means, but this approach creates the problems mentioned above, plus some more in the bargain. One is mentioned in the article: a one-model-fits all approach creates a monoculture problem that is vulnerable to catastrophic failure. I wrote about this problem quite a bit in 2009.

There is another problem as well. Although the stress test has some merits as a way of periodically evaluating capital adequacy, it ┬áis not immediately clear how banks can evaluate the capital implications of particular transactions on a day-to-day basis in this system. If you can’t do that, you can’t price deals right or make capital allocation decisions. This is especially true if the details of the Fed model are kept secret, as will almost certainly be the case.

If you have a Basel III compliant capital model you can calculate the impact on capital due to an incremental change in a portfolio, and can hence price deals rationally and structure portfolios to achieve capital efficiency. This will be harder to do in a black-box stress test model. Not impossible but not easy either.

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4 Comments »

  1. Not being able to price daily deals reminds me of “marginal versus average”. Is that right? Risk models that only let me understand average risk neglect the need for marginal risk for decision making.

    Comment by Highgamma — June 6, 2014 @ 6:50 am

  2. Not being able to price daily deals reminds me of “marginal versus average”. Is that right? Risk models that only let me understand average risk neglect the need for marginal risk for decision making.

    Comment by Highgamma — June 6, 2014 @ 6:50 am

  3. @Highgamma-Yes, it’s always the marginal that matters. Since a main objective of capital requirements is to provide incentives and information to take risk prudently, I don’t see how this can work if you can’t calculate marginal impacts and decide accordingly.

    The ProfessorComment by The Professor — June 6, 2014 @ 12:50 pm

  4. I agree but we have to be careful about what we mean by the margin. Intermediation of any kind has usually involved creating liquid liabilities and investing, at leas in part, in less liquid assets. The major problem with risk models of any kind is that the liquidity risks during times of high stress are not really dealt with, particularly when looking at large positions relative to market activity. The issue with letting banks use their own models is that he regulators have to become experts in evaluating their adequacy, something that looks to much like work to the US, and something that in the past the Euro’s have been notoriously bad at.

    The real problem with a black box is that it won’t stay a black box – people will figure it out and figure how to game it, possibly actually building in a lot of distortions that might be worse than a few banks having dodgy models.

    Comment by Sotos — June 6, 2014 @ 2:01 pm

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