The ascent and descent of banks’ risk-based capital regulation

Abstract

The emergence of risk-based capital regulation that is allowing banks to use their internal risk models for regulatory purposes was among the main regulatory developments prior to the financial crisis. During the crisis, it became evident these models underestimated the level of risk. The post-crisis regulatory approach brought a reversal of policy by significantly reducing the scope of risk-based capital regulation and making regulations less risk-sensitive. At first glance, this appears to be a step back toward an antiquated, less sophisticated regulatory regime. This article analyses these two regulatory policy transformations: from less risk-sensitive to risk-based before the crisis and from risk-based to less risk-sensitive subsequently. Its main conclusion is that a mixed regulatory system is superior to either purely non-risk-sensitive or purely risk-based regulation, because a mixed system can help mitigate the negative incentives of both non-risk-sensitive and risk-based regulation.