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(ALM), market risk and credit risk.

      2.1 Regulation Principles

      The primary purpose of risk regulations is to prevent systemic risk, or the risk of collapse of the entire system due to interconnections between financial firms. However, regulators face dilemmas when attempting to control risks.

      Providing more freedom to financial firms has been a long-standing argument for avoiding too many regulations. But relying on codes of conduct, rather than rules, would imply relying on self-discipline, or “self-regulation”, which would not inspire trust in the system.

      The financial system is subject to moral hazard. Moral hazard is a situation in which a party is more likely to take risks because the costs that could result will not be borne by the party taking the risk. It results in a tendency to be more willing to take a risk, knowing that the potential costs or burdens of taking such risk will be borne, in whole or in part, by others.

      Any insurance mechanism potentially generates moral hazard. One the oldest regulations is deposit insurance. Under deposit insurance, depositors are guaranteed the value of their holdings in banks, subject to a cap, that varies across jurisdictions. The regulation provides some safety to depositors, but it does not have much effect on the risk-taking behavior of banks, as depositors are not able to impose a discipline on banks. The protection of bank depositors is an insurance potentially generating moral hazard in the absence of prior penalty for taking risks.

      The limited liability of shareholders is another source of the lack of self-discipline. A signi-ficant increase of risk can potentially lead to a risk-maximizing behavior. When risks are already high, shareholders have not much to lose and they might prefer to make riskier bets that increase the chances of failing. When banks face serious difficulties, the barriers that limit risks disappear.

      The “too big to fail” issue is a potential source of moral hazard. It refers to a situation where no large institution can be allowed to fail for fear of contagion to many others. Many big firms are lending to large financial firms, and would incur large losses if these fail. The domino effect refers to the cascading effect of the failure of large institutions, triggering the failure of others, which, in turn, triggers another wave of failures. Because of fear of such domino effect, the regulators might not allow large institutions to fail, generating moral hazard for the major financial firms. The issue arises from the “interconnectedness” of large financial institutions.

      The financial crisis demonstrated that such issues were not hypothetical. In the United States, after assisting in the bail-out of some large financial firms, the financial authorities let Lehman Brothers down in 2008, which is considered as the critical event in the development of the financial crisis. Perhaps the authorities wished to demonstrate that no one single firm was too big to fail. But it ended up in a situation where systemic risk materialized.

      Regulations aiming at resolving issues occurring in the event of failure, such as deposit insurance, help to ensure some trust in the system. The resolution plans for an orderly dismantling of large firms, promoted by regulators following the crisis, are another example. But they are after-the-fact rules that do not prevent banks from taking too much risk.

      The core concept of risk regulations is the “capital adequacy” principle, which imposes a capital base commensurate with risks to which each bank is exposed. Instead of “dos and don'ts”, banks need to have enough capital to make their risks sustainable.

      If capital is high enough to absorb large losses, the banks would be safe. The size of the capital base depends on how much risk banks are taking. Capital-based rules raise implementation issues, as the capital charges of banks turn out to be a quantified assessment of their risks. Guidelines for regulations are defined by a group of regulators meeting in Basel at the Bank of International Settlement (BIS), hence the name of “Basel” Accords for the successive rounds of regulations since the initial Basel 1 Accord.

      2.2 Capital Adequacy

      Under the capital adequacy principle, capital is the last “line of defense” for avoiding failure in stressed conditions. The solvency of banks cannot be impaired unless the firm incurs losses in excess of capital. The higher is the capital buffer against losses, the higher is the protection. The capital adequacy principle is a preemptive protection against failure. Capital-based regulations impose that the losses from risks be quantified. The quantification of risk evolved from the simple rules of the 1988 Accord for credit risk, up to more elaborated and complex rules of the current Accords.

      The first implementation of capital-based regulations was enforced in 1988 for credit risk with the well-known Cooke ratio, initiated with the Basel 1 Accord.4 The first Accord focused on credit risk. The Cooke ratio sets the minimum required capital as a fixed percentage of assets weighted according to their credit quality. The capital base included any debt subordinated to other commitments by the bank. Equity represented at least 50 % of the total capital base for credit risk, also called the “tier 1” of capital or “core capital”. The available capital puts a limit to risk taking, which, in turn, limits the ability to develop business. Under a deficiency of capital, the constraint requires raising new equity, or liquidation of assets, or taking risk-mitigating actions.

      The original Cooke ratio of the 1988 Accord stipulates that the capital base should be at least 8 % of weighted assets. Risk-weighted assets (RWA) are calculated as the product of the size of loans with risk weights. The risk weights serve for differentiating the capital load according to the credit quality of borrowers. The calculation of the capital, which is still implemented today, is:

      Capital=8 %×Risk weight×Asset size

      The 8 % is the capital adequacy ratio, which is evolving with regulations and getting closer to around 10 % as new regulations are gradually enforced. The regulators' 8 % capital adequacy ratio can be interpreted as a view that banks could not lose more than 8 % of their total risk-weighted portfolio of loans for credit risk, thanks to risk diversification. With this value of the ratio, the debt-equity ratio is: 92/8=11.5

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      The original Basel 1 Accord was designed for keeping calculations simple and allowing an easy implementation. For example, a loan of value 1000 with a risk weight of 100 % has a capital charge of 80; if the loan is a mortgage, backed by property, it would have a capital charge of: 50 %×8%×1000=40

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      The weight scale started from zero, for commitments with sovereign counterparties within the OECD, at the time when Basel 1 was implemented, and up to 100 % for non-public businesses. Other weights were: 20 % for banks and municipalities within OECD countries, and 50 % for residential mortgage-backed loans. Some off-balance sheet commitments, the commitments without any outlay of cash, were weighted 50 %, in conjunction with these risk weights.

      Today, the same general concepts prevail, using a capital ratio that is a percentage of risk-weighted assets and risk weights being far more risk sensitive.

      Regulations do not imply that the true risk of a portfolio is exactly measured by the capital charges. They determine capital charges for portfolios representative of the industry as a whole, not of the specifics of the portfolios of individual banks. Regulators recommended that banks develop their own estimates of credit risk through models. Economic capital refers to better measures of the specific risk of the banks' portfolios.

      The 1988 Accord was followed by capital regulations on market risk in 1996, amended in 1997. The extension to market risk was a major step in 1996/97 as it allowed banks to use models for assessing capital charge for market risk. Since traded assets can be liquidated over short periods, the relevant losses are due to market movements over the same horizon. Capital for market risk should provide a protection against the loss of value that could occur over the liquidation horizon. The regulation promoted the value-at-risk concept. The value-at-risk, or VaR, is the potential future loss for a given portfolio and a given horizon, which is not exceeded in more than a small fraction of outcomes, which is the confidence level. The basic idea is the same, defining the minimum amount of the capital charge, as a function

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