Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Pre-Commitment Approach in a Model of Regulatory Banking Capital

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Pre-Commitment Approach in a Model of Regulatory Banking Capital

Article excerpt

The pre-commitment approach to bank capital regulation is a radical departure from existing bank regulatory methods. First proposed in Kupiec and O'Brien (1995c), the approach advocates letting banks choose their capital levels and fining them if losses exceed this level. The essence of the proposal is to use fines (or other penalties) to encourage risky banks to hold more capital than safer ones.

Since a change in regulatory method will affect the banking sector, it is crucial to ascertain what will happen if the proposal is implemented. Because the approach is so new, there exists only a small literature explaining and evaluating it. Accordingly, the goal of this paper is to produce understanding of the pre-commitment approach and to determine its effectiveness as a regulatory tool.

Regulators care about banks' capital levels because the deposit insurance fund is liable in the event a bank is unable to repay its depositors. For a given portfolio, a higher ratio of capital to assets reduces the insurance fund's exposure to losses because there are proportionally fewer deposits to repay in the event of a loss. Along with the monitoring of banks and deposit insurance premiums, capital requirements are an essential part of the mechanism used by regulators to insure deposits.

Since 1988, regulators have used capital requirements to protect against credit risk, that is, against the event of borrower default. They have done so by categorizing bank assets into different risk categories, taking the risk-weighted sum of the assets, and then requiring capital to be roughly 8 percent of the total.l These rules, however, did not consider other sources of risk such as those from movements in market prices. Changes in market prices are particularly important sources of risk to banks that have large trading portfolios of derivatives and other financial securities.

Concern that these sources of risk are a hazard to the banking system and to the insurance fund produced three different proposals for using capital to protect against the risk in banks' trading portfolios: the standardized approach, the internal models approach, and the pre-commitment approach. The result of the ensuing public discussion was the adoption of the internal models approach, scheduled to take effect January 1, 1998. However, this decision has not precluded continued consideration of future regulatory changes. In particular, the pre-commitment approach continues to be studied by the Federal Reserve Board. (See Greenspan [1996].)

Before analyzing the pre-commitment approach, it is helpful to summarize the other two approaches. The reader interested in more details should consult Kupiec and O'Brien (1995a) or Bliss (1995). The standardized approach, very roughly, requires regulators to handle market risk in the same way credit risk is handled: Assets are categorized, and capital charges corresponding to the riskiness of each category are imposed. A criticism of this approach is that trading accounts are complicated and regulators do not have the resources or knowledge to thoroughly evaluate these complications. Consequently, any uniform formula would probably do a poor job of evaluating banks' risks.

In contrast, both the internal models approach and the pre-commitment approach try to use banks' superior knowledge and expertise to deduce appropriate capital levels. The internal models approach works, as the name suggests, by using banks' own models. Each bank's model is used to estimate a statistic called value-at-risk (VAR). Value-at-risk is a measure of potential losses. It satisfies the following condition: losses will only exceed it a given function at a time. For example, a 1 percent VAR of 3 million dollars means that losses will only exceed 3 million dollars 1 percent of the time.

In theory, the approach requires capital to be set equal to the 1 percent VAR. In practice, the approach calculates a 1 percent VAR for a ten-day trading period and then multiplies the result by three. …

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