Prior to the Basel agreement, banks were primarily regulated according to their leverage, as measured by the capital ratio of equity over assets. Beginning in the early 1990s, the adoption of the Basel system introduced a new metric known as the risk-based capital ratio, intended to provide a better measure of bank risk by evaluating the riskiness of different types of bank assets.
To calculate the risk-based capital ratio, each category of bank assets is assigned a different weight according to its level of risk. Riskier assets are assigned higher weights, so banks holding very risky assets or large quantities of risky assets must maintain higher levels of capital.
But economists critical of the Basel regulations see two shortcomings in the system: information and systemic risk. The problem of information is that regulators are assumed to have knowledge about the riskiness of every type of bank asset. They don’t. The original Basel regulators assigned both Greek government bonds and American mortgage-backed securities the very safest risk weighting. This error encouraged banks to hold large quantities and disastrously contributed to financial crises in Europe and the US.
The problem of systemic risk is that diversification is reduced when all banks hold the same types of assets. The US and EU banking crises would have been significantly reduced if bank assets had been well-diversified. But by designating particular assets as risky or safe, the regulators funneled capital into certain types of assets and away from others. When the values of Greek bonds and mortgage-backed securities collapsed, they created systemic effects in Europe and the US.
Supporters of the Basel system say risk-based capital regulation is necessary despite its shortcomings. They claim that the risk-based capital ratio is a better predictor of bank risk than the regular capital ratio, or that some combination might be best. But this claim can be tested empirically.
In our recent Mercatus Center working paper (co-authored with Harry Pan), we set out to evaluate the effectiveness of risk-based capital ratios using data on US banks from 2001 to 2011. Our study compares a bank’s capital and risk-based capital ratios to five measures of bank risk. Three central findings emerge from our work. First, the risk-based capital ratio performs worse than the regular capital ratio against each measure of bank risk. The risk-based capital ratio does not predict bank risk well. Secondly, by itself, the risk-based capital ratio is a poor correlate of bank risk. While a bank’s risk-based capital ratio does correlate with its probability of failure, it does not correlate with other measures of risk. Thirdly, using the risk-based capital ratio and regular capital ratio simultaneously offers no improvement over using the regular capital ratio alone. Our evidence does not support using the risk-based capital ratio and regular capital ratio together to evaluate bank risk. As a central measure of bank risk used in the Basel system, it does not bode well that four of our five measures of bank risk are not significantly predicted by the risk-based capital ratio. It is especially unnerving considering that the regular capital ratio is a strong predictor of all five measures of bank risk. The evidence seems to suggest that the risk-based capital ratio is damaging, while offering no gains.
The Basel system should be simplified by using the regular capital ratio rather than the risk-based capital ratio. Reversing the present course of action would reduce risk in the banking system, lower the chances of a new financial crisis, provide a reason for banks to acquire less risky assets, and yield a better assessment of bank risk. This change would help protect the UK from crises in the US and on the continent. It might also help the world breathe a sigh of relief.
Thomas L Hogan and Neil R Meredith are assistant professors of economics at West Texas A&M University. Their report Evaluating Risk-Based Capital Regulation, co-authored with Harry Pan, can be found at mercatus.org