There is an emerging consensus that banks had insufficient capital (reserves set aside for a rainy day, held in the safest instruments like government bonds) and that they should be required to hold more capital for credit risks, more capital for liquidity risks, more capital for operational risks, more capital for risks as a result of compensation practices, in short, more capital for anything that moves. And banks are in no position today to argue otherwise. However the effectiveness of more capital at improving the resilience of the financial system will be minimal, if we do not also better allocate risk to risk-capacity. More capital will not save a system that misallocates risk.
At the heart of the failure of the ?Basel? system of financial regulation that India and most other countries signed up to in spirit if not always in practice, was a mis-guided view of risk. The prevailing view, that regulators in most places bought hook, line and sinker was that financial risk was one, inherent, measurable, thing that could be sliced and diced and transferred and that each holder of risk could use standard techniques to measure it and combine it to reduce their exposure to it. This is an elegant view of risk that can be found in financial journals. It is also entirely artificial and has no bearing on what risk actually is. It is not clear where this view came from, whether it was from the former Soviet physicists who were snapped up by the bankers to run their risk models and could be excused for not being familiar with market risk, or more conspiratorially whether it was pushed by the risk-consultancies who liked the idea because it allowed them to sell ?off-the-peg? risk models or the bankers who liked the idea because it helped them argue that the old ?Glass Steagall? restrictions to their expansion made no sense.
In reality, there is not one risk. There are different risks. The three broad financial risks are credit risk, liquidity risk and market risk. These risks are very different and they are not inherent in instruments. The idea of ?risky? instruments or ?safe? instruments reflects a misunderstanding of risk. The riskiness of an instrument depends on who is holding it and how they are using it. You can do a lot of damage with a standard mortgage. Different holders have different capacities for risk. An instrument that is a high quality credit with poor liquidity?such as a 10-year bond to finance a toll bridge is ?risky? for a bank with short-term funding, but ?safe? for an insurance company with long-term liabilities.
The way to reduce systemic risks, therefore, is not to pile up capital upon capital, but to ensure that risks flow to where there is capacity for those risks. Unfortunately, a fair amount of regulation disrupts this flow. By not requiring firms to put aside capital for liquidity risk and by encouraging market-to-market valuation of all assets whoever is holding them, regulators took liquidity risks out of the insurance and pension funds who had a superior capacity to hedge liquidity risks, and pushed it into the banks, bank-owned funds and hedge funds who did not. By requiring banks to hold capital against credit risks, but not non-banks, regulators took credit risk away from banks who have a superior capacity to hedge credit risks and gave it to those like short-term hedge funds who do not.
The solution is threefold. First, we should require capital to be set aside for different risks (liquidity, market and credit) that are not naturally hedged, thereby encouraging risks to flow to where they will be naturally hedged. Second, we should ensure that reporting, valuation and risk management techniques support institutions holding risks for which they can naturally hedge. Institutions with long-term funding and liabilities should not be required to adopt short-term valuations in their reporting and risk management. This requires a re-examination of insurance and pension fund regulation and of the use of accounting standards. Third, in assessing the non-hedged risks, we can only use market measures of these risks if we also supplement them with a counter-cyclical multiple to offset the tendency of markets to underestimate risks in a boom and over-estimate them in a bust.
In 2006, banks held far more capital than their minimum requirements. This proved inadequate for two reasons. First, the measure of capital used market-prices of assets and risks, which overstated assets and understated risks. Second, risk was put in places that had no capacity for it. A deterioration in risks in a small sector, which spilled over into a more general increase in risk and reduction in risk appetite, was able to undermine the entire financial system. It?s not just about capital, it?s also about macro, risk management.
The author is chairman of Intelligence Capital Ltd, emeritus professor of Gresham College, chairman of the Warwick Commission and member of the UN Commission of Experts on International Financial Reform