NCPA - National Center for Policy Analysis

The Limits of Model-Based Regulation

August 26, 2015

The financial crisis of 2008 induced policymakers to revisit banking regulatory frameworks established by the Basel Accords (Basel I and II) and concentrate their efforts on increasing the safety of individual institutions and the stability of the financial system.

There are two ways in which banks currently regulate their capital and credit risk assessments:

  • The Standard Approach (SA) is a more traditional approach to risk assessment, using ratings from External Credit Rating Agencies to assess account stability and capital risk. This method is often seen as being too coarse and subjective, creating imbalanced and biased lending.
  • Pioneered by Basel II, the Internal Ratings-Based Approach (IRB) is a risk assessment method unique to the bank. The exact models are not usually disclosed to the public, and often involve complex calculations of intangible variables. Each of the IRB models goes through several stages of approval, and only banks meeting certain minimum conditions are allowed to use this approach.

While the Basel II sought to increase bank liquidity and decrease bank leverage, only the larger banks adopted the IRB. They were more easily able to absorb the high compliance costs, and used the reductions in charges and taxes to establish barriers to entry for smaller institutions. As a response to the financial crisis in 2007-2008, the Basel Committee has drafted a third revision of the regulatory framework for banks (Basel III). In an effort to address weaknesses revealed in both Basel I and Basel II, Basel III continues to build on the IRB model, further increasing the intricacy of both the internal and external banking regulations. Further increases in complexity proposed by Basel III will only subsidize large banks and increase probability of default. Simpler and more transparent rules would be more effective in achieving the ultimate goal of financial stability.

Source: Rainer Haselmann and Vikrant Vig, "The Limits of Model-Based Regulation," Cato Institute, April 2015.

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