This resource allocation effect of capital regulations is seen most clearly by comparing the Basle standard with the internal “economic capital” allocation processes of some of our largest banking companies. For internal purposes, these large institutions attempt explicitly to quantify their credit, market, and operating risks, by estimating loss probability distributions for various risk positions.
But, it has also been reinforced by a combination of global monetary accommodation and the concomitant expansion in domestic credit. History tells us that bubbles often arise when people’s expectations become bullish due to the experience of continued high growth and domestic demand expansion. Examples of such situations where domestic demand growth became excessive and ill-balanced are now all too familiar.