Risk Sensitivity and Risk Shifting in Banking Regulation

35 Pages Posted: 14 Dec 2018

Date Written: July 04, 2018

Abstract

The financial crisis exposed enormous failures of risk management by financial institutions and of the authorities’ regulation and supervision of these institutions. Reforms introduced as part of Basel III have tackled some of the most important fault‐lines. As the focus now shifts toward the implementation and evaluation of these reforms, it will be essential to assess where the balance has been struck between the robustness and the risk sensitivity of the capital framework. This paper contributes to this assessment by stepping back from the details of the recent reforms and instead taking a bird’s eye view on the fundamental tradeoffs that may exist between robustness, complexity, and risk sensitivity. We review the history of risk sensitivity in capital standards and assess whether a higher degree of risk sensitivity necessarily leads to a better measurement of risk. We also provide evidence that the more risk‐sensitive Basel II framework may have reduced banks’ incentives to engage in higher‐risk mortgage lending in the UK. Our analysis suggests the need for a robust regulatory framework with several complementary standards interacting and reinforcing each other, even if, prima facie, subjecting banks to a number of regulatory constraints adds to complexity.

Keywords: Basel 2, capital regulation, risk sensitivity, risk shifting

JEL Classification: G01, G18, G21, G28

Suggested Citation

Hinterschweiger, Marc and Neumann, Tobias and Saporta, Victoria, Risk Sensitivity and Risk Shifting in Banking Regulation (July 04, 2018). Bank of England Financial Stability Paper No. 44, Available at SSRN: https://ssrn.com/abstract=3299411

Marc Hinterschweiger (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Tobias Neumann

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Victoria Saporta

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
48
Abstract Views
245
PlumX Metrics