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February 3, 2013

Modelling Capital and Risk: Is a Diversified Ecosystem a Protection against Systemic Risk?

The BIS conducted a survey (http://www.bis.org/publ/bcbs240.pdf) “Regulatory consistency assessment programme (RCAP) – Analysis of risk- weighted assets for market risk”, which in simple terms means a study into how banks calculate regulatory capital, including tests using 26 pre-defined sample portfolios.

If you look at page 34/35 onwards you can see that the outcome of the sample portfolios leads in some cases to a wide distribution of results. This prompted Deus Ex Macchiato to comment (http://blog.rivast.com/?p=6865) that this indicates a dangerous or embarrassing divergence of outcomes, leading to lack of trust in banks capital holdings and ratios.

DEM’s other suggestion was to use the data accumulating in the new OTC SDRs (and other sources) to create a centralised and standardised system for making these calculations.

This in turn prompted a response from Craig in Houston (http://streetwiseprofessor.com/?p=7012) which can be summarised (in a nice way without malice) “No. No. No. No. No fucking no“.

I understand the reasons for SWP’s opinion, being that such large and complex calculations can’t be trusted, so allow banks to diverge and let a crisis sort out the cautious from the brave. But yet I have a centrist tendency to want to try and determine independently what these large calculations should be telling us – and feel like a model implemented outside each bank would have different influences and assumptions.

Perhaps both approaches have merit – adding a ‘central’ calculation would give one more reference point with regard to the banks own calculations, and might also make the regulators get their feet wet in building a big scary complex calculation and explaining their own models, fuelling a debate on the “right” outcome.

I have to confess proposing something quite similar in 2008 (see 2008 article 3 here: https://theotcspace.com/writing/) where I posited more or less the same thing but for market risk – use the data inside the banks to build the mother of all VaR models.

What do readers think? Should we mandate the FSB to build the mother of all RWA calculators, or let the banks experience Darwinian evolution?


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