Risk Sensitivity and Risk Shifting in Banking Regulation

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