Models-Based Regulation of Bank Capital
HAL S. SCOTT
American bank regulation has typically been based on a command and control approach. Law-makers or regulators formulate both the regulatory objectives, e.g. safety and soundness, and the means to achieve them, e.g. requiring 8 per cent. risk-based capital with detailed rules of calculation. In contrast, in a system of performance-based regulation, regulators only formulate objectives, leaving to those regulated the choice of how to achieve them. Thus, in various areas of environmental regulation, firms are only told what levels of emission of pollutants are acceptable and are left free to decide how best to meet them.1
Bank regulators have recently adopted a new approach, models-based regulation ('MBR'), to deal with capital required to cover market risk. Banks are left free to devise their own models for determining the needed level of capital to deal with potential price changes in securities and derivatives, subject to parameters set by the regulators. While this clearly represents a departure from command and control regulation, it does not move all the way to performance regulation given the imposition of parameters. The decision to impose parameters has been a subject of some dispute. The banking industry would prefer a total performance approach. However, the measurement of performance of self-adopted bank capital imposes different problems than in many other areas of regulation.
Once performance falls below the standard 'no bank failure' it is too late; the bank has failed. Given the omnipresent possibility of large costs associated with systemic risk, the failure of one bank triggering a multiplicity of others, regulators are unlikely to permit pure performance standards. In other areas, like pollution control, a one-day or even one-month failure to meet standards is not necessarily a disaster; past performance can be largely remedied.
What explains the development of MBR? With respect to regulation of capital for market risk it is mainly the complexity of the task. Regulators are____________________