Some internal model-based banks attach a risk weight to mortgages of as little as 5%. A standardised-approach bank would need to hold at least nine times that amount in capital. These design features of Basel II were intended to provide incentives to banks to move to internal models and thereby improve their risk management. The link from use of models to improved risk management is at best tenuous. But more fundamentally, this design feature may also have potentially perverse consequences for systemic risk and competition. Under the existing approach, capital charges will tend to be highest for those small, simple banks posing least risk to the financial system as a whole. The systemic risk tax is regressive. This regressivity will tend to worsen the too-big-to-fail problem, by providing regulatory incentives for the large to become larger still. The capital surcharges recently agreed for systemically important institutions, while helpful, are unlikely to retilt this balance. Capital regulation may also have acted as a barrier to banking entry, raising the bar for new entrants. Neither outcome (higher risk and lower competition) are desirable from a societal perspective. BIS central bankers’ speeches  7  (c) Transparency and market discipline A final unintended consequence is lack of transparency. A large bank may have literally thousands of models, hundreds of thousands of outputs and several million inputs. The height of this information mountain makes scrutiny and aggregation of regulatory capital calculations near-impossible for either investors or regulators.
In a setting as august as this one – on the eve of the 600th anniversary of this great academy – and speaking on the day marking the 129th anniversary of the birth of John Maynard Keynes and the 289th anniversary of the baptism of Adam Smith in nearby Kirkcaldy – I should disclose up front that I am the least formally trained among the mostly academic economists who sit at the table where we make monetary policy at the Federal Reserve, the 19-person forum known as the Federal Open Market Committee, or FOMC. I have an MBA, not a PhD. I am an autodidact when it comes to monetary theory. On the other hand, I am the only participant in our policy deliberations who has been both a banker and a professional money manager – the only one who has been a market operator. What the credentialing gods denied me, the practitioner angels kindly granted me: another skill set that provides a complementary perspective to those of my more learned colleagues. I shall speak today, as I always do, only from my perspective; nothing I say represents the thinking or proclivities of other members of the FOMC. And most of what I will say will confront theory with my interpretation of the rude reality of the marketplace. A quick primer on the Federal Reserve’s structure For those of you who do not know well our central bank’s structure, a quick primer. The Federal Reserve is the third central bank in American history.