The combination of complexity and manipulation has led to a loss of faith by investors in model outputs, and in particular risk weights, over the past few years. Surveys of investors suggest a fairly deep-seated scepticism about risk weights, with only a small fraction believing them trustworthy (Chart 9). From a low base, investor faith in these risk weights has continued to fall fast (Chart 10). These concerns appear to be reflected in the pricing of bank risk. Bank investors appear to have moved towards using simpler metrics, such as leverage ratios, when assessing capital adequacy. There is a positive correlation between banks’ leverage ratios and their market price-to-book ratios (Hoenig (2013)). No such correlation exists for banks’ regulatory capital ratios. Investors seem to have begun pricing the solvency risk they best understand. The lack of transparency about, and investor trust in, risk weights has important implications. For regulators, a lack of transparency can damage the power of market discipline in constraining risk-taking – so-called Pillar III of Basel. Or, put differently, the complexity of Pillar I of the Basel Tower (regulatory rules) risks emasculating Pillar III (market discipline). Pillar I has become Popeye’s forearm, Pillar III his bicep.3 For investors, uncertainty about banks’ true capital adequacy is priced. Where there is uncertainty, they will factor a premium into banks’ cost of capital. That may be one of the reasons many of the world’s largest banks have continued to trade at a discount to their equity book value.
As elsewhere, a regulatory regime of constrained discretion has given way to one with too much unconstrained indiscretion. This calls for regulatory repair. Without change, the current regulatory system risks suffering, like the Chicago teachers and the LIBOR fixers, reputational damage. Fortunately, there are early signs that regulatory change is afoot to place tighter constraints on this (in)discretion. The emergence of self-regulation To understand how we ended up here, it is useful to explore the historical contours of the regulatory debate. This is a history in roughly four chapters. Chapter 1 covers the period prior to the agreement of the first Basel Accord in 1988. Until then, a patchwork of national regulatory frameworks for capital adequacy operated. Some countries set capital adequacy standards based on simple measures of bank equity to assets – a leverage ratio. Others, including in the US, used risk-based standards with risk weights set by regulators for a small set of asset categories. Chapter 2 begins with the introduction of the Basel Accord. This was a landmark agreement: the first-ever genuinely international banking accord, based around an 8% bank capital ratio, with internationally-set risk-weights applied to a small set of banks’ assets. The Accord was explicitly designed to lean against an international “race to the bottom” in capital adequacy standards (Goodhart (2011)). It also helped ensure a level international playing field. Chapter 3 commences with the Market Risk Amendment to Basel I in 1996 and continues through to the Basel II agreement of 2004.