Symposium 2015

Virtual Library File - Capital adequacy and hidden risk

The Challenge

In the aftermath of the global financial crisis, most countries have seen a wave of new regulatory initiatives aimed at increasing financial stability and resilience. However, the implementation of re ...

In the aftermath of the global financial crisis, most countries have seen a wave of new regulatory initiatives aimed at increasing financial stability and resilience. However, the implementation of reforms is still in progress, and financial systems worldwide are far from being immune to another financial crisis.

The implementation of Basel III, for instance, leads to a gradual increase in capital requirements for banks, though many economists still consider these requirements as too low. Another envisioned goal, the partial separation of "traditional" and "hedge" banking, has not yet been achieved. We are also far away from a global harmonization of standards, best practices, and supervision. Moreover, there might even be the temptation to misjudge the partial implementation of regulatory reforms as finished. In fact, we might need more fundamental changes in the structure of the financial sector to prevent a future financial crisis.

In this column, Mike Mariathasan and Ouarda Merrouche argue that the way we implement capital regulation needs to be reconsidered because banks under-report risk, thereby escaping government intervention and maintaining market access. One possible way forward, something already implemented under Basel III, is to ask banks to satisfy a capital requirement relative to total (rather than risk-weighted) assets. Overall, simple, transparent, workable rules are what we should be aiming for.