118
NATIONAL INSTITUTE ECONOMIC REVIEW No. 192 APRIL 2005
FINANCIAL REGULATION, CREDIT RISK AND FINANCIAL
STABILITY
C.A.E. Goodhart*
In contrast to recent successful developments in macro monetary policies, the modelling, measurement and management
of systemic financial stability has remained problematical. Indeed, the focus of most effort has been on improving individual, rather than systemic, bank risk management; the Basel II objective has been to bring regulatory bank capital into
line with the (sophisticated) banks’ assessment of their own economic capital. Even at the individual bank level there are
concerns over (i) appropriate diversification allowances, (ii) differing objectives of banks and regulators, (iii) the need for
a buffer over regulatory minima, and (iv) the distinction between expected and unexpected losses (EL and UL). At the
systemic level the quite complex and prescriptive content of Basel II raises dangers of ‘endogenous risk’ and procyclicality.
Simulations suggest that this latter could be a serious problem.
Keywords: Financial regulation; systemic stability; credit risk; capital adequacy requirements;
Basel II; operational risk; internal risk based models; procyclicality; endogenous risk.
JEL classification: E4, E44, E5, E55, G2, G21, G28
1. Introduction
I have been privileged to have been able to participate,
both as an academic and a central bank official, in a
massive improvement in the theory and practice of macro
monetary policy over the past fifteen, or so, years. A key
starting point was the allocation of inflation targetry,
together with operational independence, to the Reserve
Bank of New Zealand at the end of the 1980s. This
established that the overriding function of a central bank
was to achieve a single, primary target, price stability, by
manipulating its single instrument, short-term interest
rates. Since the effect of interest rates on inflation was
lagged, this involved setting interest rates now on the basis
of forecasts of future output growth and future inflation, a
methodology rather loosely modelled by the ubiquitous
Taylor reaction functions. Meanwhile, the mechanics of
holding short-term interest rates close to their policydetermined level were increasingly being achieved through
the adoption of a narrow corridor between a remunerated
central bank deposit rate and a higher lending rate, to
which commercial banks had automatic access. Again this
process was initiated in New Zealand, but has since then
been adopted by both the ECB and, this last July, by the
Bank of England.
Central bank practitioners have been fortunate in having
had the benefit of analysis and advice from a number of
leading monetary economists, notably Lars Svensson and
Michael Woodford, in these reforms, though more often ex
post, after the reforms had already been initiated, than ex
ante. This has had the consequence that the differences
between theory (as represented for example, by Woodford’s
2003 book, Interest and Prices), and practice, as
represented by what central bankers (now themselves often
professional economists, such as Ben Bernanke, Otmar
Issing and Mervyn King), see themselves doing, has
become vanishingly small. There is consensus now, where
some thirty years ago there was confusion and lack of
communication.
I believe that these structural and theoretical improvements
have led to better policies, and that such better policies
have played a role in the greater stability of our economies
over the past decade, with a reduction both in the level and
volatility of inflation and in the volatility of output growth.
This same enthusiastic paean of praise cannot, however, be
applied to the conduct of either theory or practice in the
area of central bank’s second core purpose, to wit the
maintenance of financial stability (FS). The achievement of
FS is, however, much more difficult and complex than the
accomplishment of price stability, in the guise of inflation
targets (IT). Unlike price stability, financial stability cannot
be readily measured, modelled, or forecast (see also Fell
and Schinasi, 2005, this volume). There is no
* Financial Markets Group, London School of Economics and Political Science. My thanks are due to Jon Danielsson, Andy Mullineux, Miguel
Segoviano, Ashley Taylor and Geoffrey Wood for help and advice in preparing this article, but responsibility remains with me.
GOODHART FINANCIAL REGULATION, CREDIT RISK AND FINANCIAL STABILITY 119
straightforward instrument that a central bank can use to
counter deviations from a desired equilibrium, and such
mechanisms as can be deployed, such as Capital Adequacy
Regulations, have to be agreed at an international level,
largely because of the ease of disintermediation, i.e. in the
guise of locational shifts of business, within a system of free
capital movements, instantaneous electronic transfers, and
a global financial system.
has shown, it makes the implicit assumption that there is
just one single systemic risk factor (other risks being
idiosyncratic), to which all borrowers from any given are,
to a greater or lesser extent, exposed. For banks which
operate within a single country that may be approximately
true, though even in this case there are differing sectoral,
industrial, and in a sizeable country, geographical, risks, so
the benefits of diversification are not being fully rewarded.
There is no consensus either between academics and
practitioners, or indeed within either camp, on how the
financial stability objective might best be pursued. In this
context, for example, the recent massive labours of the
Basel Committee on Banking Supervision did not start from
any economic theory of how best to establish Capital
Adequacy Requirements (CARs) in formulating Basel II.
This is not surprising since no such consensus theory exists.
The smaller, and less developed, the country, the more
likely is risk going to be concentrated. The exposure of
banks in Iceland to the continued success of the fishing
industry, in Hong Kong to the local property market, in
Mauritius to the textile industry, will all have been large. In
this context, the worldwide development of the credit
default swap (CDS) market, which allows a separation of
the specialist origination of loans from the need to continue
to bear those loans’ credit risk to maturity may do more to
reduce risk concentrations and resultant financial crises
than all the recent reforms to the CARs. It is such credit
default swaps that in my view will do most to allow banks,
wherever sited, effectively to achieve a desired level of
diversification. But, like all derivatives, they allow those
who use them either to assume, or to lay off, risk; and such
deals may, or may not, be correctly priced. So, like other
powerful instruments they can be used for good or ill; what
is perhaps most needed by regulators is greater
transparency.
What does exist instead are models and measurements for
individual1 bank risk, often developed by the commercial
banks themselves as managerial control tools; VaR and
KMV models are probably now the best known of these. To
some large extent the public sector officials at Basel tried to
piggy-back official CARs on the basis of the (best available)
commercial bank models. Indeed a proud boast of the
authors of Basel II is that this reform has brought regulatory
capital much closer into line with the economic capital that
the more sophisticated banks would have adopted on their
own, and as a desirable by-product helped to educate the
less sophisticated banks about optimal risk management.
2. Some problems with Basel II
Even taken on its own terms, as an approach to make the
individual bank manage risk better, there are a number of
problems. I shall mention four here briefly. These concern:
(i) portfolio theory, (ii) differing requirements, i.e. differing
objective functions between regulators and managers, (iii)
the need for a buffer over required minima, and (iv) the
distinction between expected loss (EL) and unexpected loss
(UL).
Let us start with portfolio theory. Almost the first lesson in
finance is that the risk of a portfolio is determined by the
covariances between its constituent elements, not their
individual variances. After all, if you can find any two
assets with perfect negative covariance, you can combine
them into a riskless asset, irrespective of their individual
variances. In dealing with covariances and correlations
between asset returns, Basel II is certainly far superior to
Basel I, but still leaves much to be desired. Not only does it
ignore non-linear dependence, but also, as Gordy (2003)
But to return to my main topic, outside the EU, in the US for
example, Basel II is seen as most appropriate to large
sophisticated global banks. While it is true that there is
something of a common cycle amongst developed
countries, it is far from general; note the differing time
paths of the USA, Japan and the EU. Moreover the
correlation between fluctuations in GDP in the developed
(Northern) countries and the developing (Southern) world,
and also perhaps now between Western and Eastern EU
states, is even lower. Thus lending to borrowers in
emerging economies is likely to become less attractive to
large international banks, because such borrowers will
probably be unrated, and hence carry a larger riskweighting, without any offset for their effect in diversifying
and lowering the exposure to common developed-country
cycles. On all this, see the papers by Segoviano and Lowe
(2002), Altman et al. (2002) and Griffith-Jones et al. (2002).
Let me turn next to the differing requirements, and
objective (loss) functions, of regulators and bankers.
Bankers are concerned naturally with the fate of their own
individual institution, not of the welfare of the system as a
whole. Moreover, there are institutional arrangements,
120
NATIONAL INSTITUTE ECONOMIC REVIEW No. 192 APRIL 2005
such as limited liability and generous bankruptcy
arrangements, and conditions such as when capital has
already been eroded, that may lead bankers willingly to
assume more risk than regulators would want. It can,
therefore, be problematical for regulators just to piggyback on techniques developed by bankers for their own,
perfectly proper, purposes.
Let me take two examples. The first, which has been
splendidly dissected by my colleague, Jon Danielsson,
(2002), relates to the VaR, value at risk technique. This was
developed, entirely sensibly, by commercial bankers to
give them a metric of their market risk under normal
conditions. In most applications, excluding those using
long historical data sets, it is used on the conditional
assumption of a normal distribution of asset returns (log
normal prices). But asset market returns have fat tails; that
is, the probability of really large jumps in asset prices
(remember October 1987) is far greater than in a normal
distribution. Thus while a VaR metric is a perfectly
respectable technique for bankers, it is not for regulators
who need to focus on adverse tail events, for which the
appropriate measurement technologies are quite different.
One reason why we have official regulations at all is that
there may be externalities, so the social costs may differ
from the private costs. The externality that regulators fear
above all in banking is that of contagion, that the collapse
of one institution may have a domino effect on others, and
possibly on financial markets and systems, such as the
payment system. As already noted, a particular problem
about credit risk is that this does tend to be systemic, so the
failure of one bank will tend to be correlated with fragility
in others; and so that initial failure will, for a variety of
reasons, via direct interconnections and also through
reputational effects, drive other banks to the brink. Hence
the social cost of failure may well be greater than the
private.
It is far from clear whether any such externalities attend
operational risks and, in those few cases where they may
do so, whether more capital is a suitable remedy. Such
risks, of credit card fraud, computer failure, trader fraud,
mis-pricing, etc., certainly exist, and banks are indeed right
to apply their own internal capital against those of such
risks (not all) that can be reasonably quantified, e.g. credit
card fraud. But it is difficult, at least for me, to see why a
Nick Leeson at Barings or the reputational failure of a bank
involved in an Enron, or Parmalat, scandal has any
obvious potential downside effects on other commercial
banks, or even why internal capital represents a sensible
prophylactic in such cases.2 If the costs of operational risks
are fully internalised, what then is the case for having a
socially imposed minimum requirement? Just because
operational capital is applied by good international banks
does not of itself provide any justification for it to be a
public requirement.
There are a few cases where operational risk does have
externalities. A computer failure, and/or the absence of a
secure back-up after such a failure (perhaps due to
terrorism or natural causes), can prevent a bank from
making payments, and thereby adversely affect the
liquidity of other banks. Indeed so, but insofar as capital
has any relevance in such an example (in contrast to
lending by the central bank which does), the capital of a
bank needs to rise the greater the threat of such operational
failures in other banks. Moreover, if the central bank does
provide the necessary liquidity, as in the case of 9/11 and
the Bank of New York computer failure at an earlier date,
then there would be no need for capital in such cases.
A critic might, indeed, argue that the claim that one aim of
Basel II was to make regulatory capital requirements
accord closer to economic capital implied, ipso facto, that
those involved had not stopped to ask themselves on what
underlying principles public regulation could, and should,
be justified. Moreover, it is just not possible to make
regulatory capital equate to voluntary desired economic
capital. Regulation implies by definition that the
designated capital levels are required. If they are thereby
required to be maintained, there must be some form of
sanction, if only reputational or levied in terms of
additional visitations from the supervisors, in those cases
where the minimum requirement is breached. In the context
of the Basel approach, which involves discussions between
a small group of self-appointed regulators, central banks
and specialised supervisors, not a treaty between countries,
it has not, however, been possible to establish a common
approach towards sanctions. Indeed one of the main
weaknesses of the Basel approach is that the Committee
focuses on best practice without any discussion on how to
respond to shortfalls from such best practice. In that the
Basel approach differs sharply from the American Federal
Deposit Insurance Corporation Improvement Act (FDICIA)
of 1991, which is much more broad brush on capital
requirements, but detailed and prescriptive on a ladder of
sanctions as shortfalls increase.
Be that as it may, there will in each country be some,
though country-specific, expectation of sanction for
breaching the CARs. Consequently an (optimising) bank
will want to maintain some buffer of free (or, though the
word is inappropriate, excess) margin of spare capital over
GOODHART FINANCIAL REGULATION, CREDIT RISK AND FINANCIAL STABILITY 121
the regulatory minima. While in some cases I have heard
claims that Basel II will have the, supposedly desirable,
effect of equating regulatory and economic capital, in other
cases I have heard the claim that, since most banks already
hold capital quite well in excess of likely Basel II
requirements, its introduction will have no effect
whatsoever. Neither of those positions is correct. A recent
empirical study by the FSA (Alfon et al., 2004) found that
an increase in the regulatory requirement of, say 10 per
cent, was matched in the longer term by a change of about
7 per cent in the desired level of capital, i.e. part, about one
third, of the regulatory change is absorbed in a change in
the desired level of the buffer, but the greater part, around
two thirds or more, feeds through to the desired level of
capital.3
Let me turn next to the fourth problem that I want to
highlight, which is the distinction between expected and
unexpected loss, EL and UL. As we are well aware, a key
feature of Basel II is the focus on the probability of default,
PD. Let me show a diagram of simulated distributions over
time of PD for two different types of credit extension,
perhaps credit card lending as contrasted with lending to
foreign sovereigns (see chart 1). The distribution for credit
card lending is A, that for sovereign lending is B. For which
type of loan should a bank hold more capital? If you just
look at average PD the answer is obviously A, credit card
lending.
But note that, with credit card lending, the expectation of
default losses can, as assumed here, be estimated quite
closely in advance. If default probability can thus be
estimated in advance, the appropriate default premia can,
and should, be included in the interest rate charged. If the
relative ex ante interest rate differential does take account
of the mean expected default probability, then capital
should be required not against mean expected PD, but
against the variance and skew of the expected distribution
of PD. Indeed, on this assumed simulation, banks should be
Chart 1.
% occurrence
A
0
B
5
10
15
Distribution of expected loss
20
required to hold much more capital against sovereign
lending than against credit card lending, which should
require hardly any capital backing.
This issue did arise, although it seems rather late in the day,
at Basel in the guise of the discussion whether capital
should be applied against expected loss (EL) or just against
unexpected loss (UL), and in which particular cases. But,
once again, I did not note any generic discussion on the
economic principles determining the need for capital, and
in particular the relative roles of default risk premia in
interest rates on the one hand as compared with capital on
the other.
There is no question but that regulators and supervisors are
closely concerned about such credit risk premia. There is,
for example, often a fear in such quarters that such premia
are excessively volatile, going down too far in boom, and
calmer, times, and rising so far during periods of crisis as to
interrupt completely flows of new loans to those sectors and
countries perceived as now suddenly risky. A diagram of
spreads, over US Treasuries, on bonds of emerging
countries illustrates this point (see chart 2).
One reason regulators and supervisors are hesitant about
going all the way towards the UL concept, that is to focus
on the expected distribution, not the mean, of PD, is that
they fear that, whereas expected PD could in principle be
met by an appropriate interest differential, in practice it
will not be. There have been numerous occasions when
regulators have complained that various factors, e.g.
excessive competition, state support for certain banks,
especially of public sector intermediaries, such as the Post
Office Savings Bank in Japan, have held down interest
margins below the level consistent with a healthy banking
system.
Given that regulators have not felt themselves able to
interfere, or to intervene directly, in the interest rate setting
decisions of banks, this has meant that the regulators have
felt the need to maintain capital requirements in most cases
against EL, rather than UL. When there is a higher capital
requirement per unit of lending, there should be some
pressure on banks to raise interest rate margins on average
to maintain the return on equity. But a likely effect of Basel
II will be to lower capital requirements for the largest
international banks, which may be a reason why they
supported its introduction, and they are likely to take the
lead in setting interest rates. Moreover, the possibly greater
procyclicality of CARs under Basel II, a subject to which we
shall turn shortly, may also have the effect of enhancing the
procyclicality of credit default spreads, which is already a
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NATIONAL INSTITUTE ECONOMIC REVIEW No. 192 APRIL 2005
Chart 2. Emerging market sovereign bond yield
spreads
Basis points
1,000
900
800
700
600
500
400
300
200
100
0
Jan. 02 July 02 Jan. 03 July 03 Jan. 04 July 04
Source: JP Morgan Chase & Co.
matter of some concern. More generally, the financial
strength of banks, and banking systems, is a somewhat
complex combination of both capital ratios and interest
rate spreads and profit margins. Focussing solely on one of
these two legs is likely to lead to a somewhat unbalanced
position.
3. Should we abandon risk-related capital
adequacy ratios?
Indeed for these and other related reasons, I have come at
long last to the reluctant conclusion that the concept of
relating officially set and required capital ratios (CARs) to
the relative riskiness of a bank’s portfolio of assets has
been, in practice, a wrong turn.
The idea that officially set and required CARs should be
risk-related appears intuitively natural, even obvious.
Surely a bank with a portfolio full of risky loans to property
speculators is more likely to go bust than a bank holding
government Treasury bills, and should therefore be required
to have a larger capital buffer. Most commentators have
strongly supported the idea of such risk-related CARs, and
indeed I did so myself until quite recently.
Let me start by recalling the several drawbacks of riskrelated CARs. First, in a sophisticated and fast-changing
market, it will be well-nigh impossible for officials,
however able and devoted, to get the assessment of relative
risks correct, and, if accurate now, innovation will soon
make them outdated and erroneous. Even after all the huge
effort that has been put into the Basel II process, there are
still likely to be several major deficiencies in relative risk
assessment. For example, as already noted, the basic
structure of the credit risk approach adopted effectively
rests on the premise of a single systematic risk factor
(Gordy, 2003; Repullo and Suarez, 2004), which is in most
cases presumably the domestic economy. If there are – as is
surely the case – numerous other systemic risk factors, then
the Basel II approach probably gives insufficient weight to
the risk mitigation inherent in diversification across
countries and across industries. Be that as it may, even with
much improved risk assessment, officials will, indeed can,
never get it exactly right. There will always remain gaps,
lacunae and errors that can be exploited for regulatory
arbitrage and by ‘gaming’, and these will only increase
over time.
Second, the attempt to achieve ever more accurate risk
measurement inevitably increases the complexity of the
whole exercise. A comparison of Basel II and Basel I makes
the point. Moreover, any attempt to fill some of the
remaining gaps in Basel II would just make this whole
problem worse.
Third, despite the reliance on banks’ internal risk-based
assessments, in the Foundation and Advanced IRB versions,
Basel II appears, at least to this observer, to provide a
rather pervasive model for how a commercial bank’s own
risk analysis should be undertaken. Many argue that this
will bring major benefits. They claim that the application
of Basel II will encourage many, perhaps most, banks to
bring their own internal risk-assessment models up to
speed. Indeed, one of the main benefits of Basel II is seen
to lie in its impetus to improving the education of many
commercial bankers on the basis of proper risk
assessment.
No doubt there is truth in this, but is there not also a danger
that as prescriptive an approach as Basel II could lead to an
excessive focus on one single methodology, in a context
where uncertainty and innovation suggest the advantage of
encouraging multiple competing models of risk
assessment? And could that focus also enhance ‘herd
behaviour’, whereby all banks tend to respond similarly
and simultaneously to common stimuli? This can increase
the riskiness of the system as a whole, even if each
individual bank appears to be behaving exactly according
to the new, ‘improved’, rules. This interactive effect has
been termed ‘endogenous risk’ by my colleagues
Danielsson, Shin and Zigrand (2004). Blum and Hellwig
(1995) have also emphasised that the macro effect of a
(regulatory) measure cannot necessarily, or simply, be
ascertained just by considering the individual micro effects,
also see Summer (2003).
GOODHART FINANCIAL REGULATION, CREDIT RISK AND FINANCIAL STABILITY 123
The important result to observe is the much greater
variance of the simulated outcomes for the IRB than for the
standardised or ICRM approaches. During periods of
strong growth, high profits and low non-performing loans
(USA in the mid-1990s and Norway in 1997), the IRB has a
lower CAR than the standardised approach in all our
developed countries; whereas in recessions (e.g. USA in
ICRM
9.60
8.94
8.93
9.13
9.46
9.46
9.46
9.56
9.56
9.99
9.69
9.29
8.90
8.51
8.25
8.29
8.31
8.40
8.41
8.53
8.31
8.11
8.96
0.34
8.59
7.19
7.62
8.02
9.99
9.82
8.66
10.80
11.68
11.43
8.06
6.47
5.40
5.56
5.65
5.94
6.51
7.81
8.13
8.25
8.18
6.60
8.02
3.39
8.07
6.80
7.031
7.26
8.74
8.55
6.99
6.49
7.60
7.54
6.47
4.67
3.78
4.09
4.32
4.84
5.83
6.70
7.16
7.24
6.78
6.26
6.51
1.95
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Average
Variance
Chart 3. CARs for the USA
14
12
10
8
6
4
2
Standardised
IRB F
2002
2000
1998
1996
1994
1992
1990
0
1988
Anyhow, we have simulated the time paths of CARs under
each of our three approaches, standardised, IRB
Foundation (IRB F) and ICRM, for our various countries,
and the results are set out in tables 1 to 3 and charts
3 to 5.
IRB F
1986
The results of this exercise for the three countries examined
are stark. We compared the implied capital requirements
for our ‘typical’ bank under three regulatory regimes; first
the standardised approach in Basel II (which is close to that
applied in Basel I); second, the Foundation Internal Ratings
Based (IRB) approach (i.e. assuming a constant Loss Given
Default, since we have no good time series in any country
for average LGD); and third, an Improved Credit Risk
Method (ICRM). This latter uses a Merton approach to
model credit quality changes and an indirect approach to
model correlations amongst the individual credits in the
overall portfolio. The construction of an ICRM is,
however, quite complex, and interested readers should
consult our companion paper, Goodhart and Segoviano
(2004).
Standardised
1984
My colleagues and I have done some work on this subject
(Goodhart, Hofmann and Segoviano, 2004). Very briefly
we reconstructed a typical bank portfolio as follows. We
assumed that each portfolio consisted of 1000 loans, each
one with equal exposure. From each specific country data
sources, we obtained the through time proportion of assets
(bonds for the USA or corporate loans for Mexico and
Norway) that were classified under each of the reported
ratings for a given country. With this information we
constructed the benchmark portfolio that we used to
compute capital requirements at each point in time.
Period
1982
4. Is procyclicality a serious worry?
Table 1. CARs for the USA
Percentage
That consideration leads on to the fourth problem of
relating capital requirements to a common measure of
relative risk, which is, of course, that it is likely to engender
procyclicality. This is now widely understood, and so much
has been said on the general point that it is unnecessary to
add more. The issue has moved from that of general theory
to a question of specific empirical quantification. Is it likely
to be a serious problem in practice, or not?
ICRM
1990/1, Mexico mid 1995/6 and Norway in 1994/5), the
CAR is markedly higher for the IRB than in the other two
approaches. In Mexico, an emerging market economy, the
average quality of loan is lower throughout than in
developed countries, so the IRB gives a higher CAR in all
years but, as in developed countries, the variance of the
CAR (up in recessions as in 1995/6, and lower during the
better years) is greater for the IRB than in the other two
approaches.
124
NATIONAL INSTITUTE ECONOMIC REVIEW No. 192 APRIL 2005
Table 2. CARs for Norway
Period
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Average
Variance
Table 3. CARs for Mexico
Standardised
IRB F
ICRM
Period
9.99
10.27
10.47
10.37
10.27
10.94
11.32
10.67
10.27
10.27
10.27
10.27
10.36
10.46
10.44
0.11
8.31
9.28
9.78
9.93
9.52
13.24
14.07
12.14
8.86
9.00
9.219
9.49
9.65
9.76
10.16
2.94
7.58
8.13
8.68
9.03
9.19
9.82
11.08
9.72
7.32
7.42
7.53
7.93
8.33
8.34
8.58
1.19
March 1995
June 1995
Sept. 1995
Dec. 1995
March 1996
June 1996
Sept. 1996
Dec. 1996
March 1997
June 1997
Sept. 1997
Dec. 1997
March 1998
June 1998
Sept. 1998
Dec. 1998
March 1999
June 1999
Sept. 1999
Dec. 1999
Average
Variance
Chart 4. CARs for Norway
16
Standardised
IRB F
ICRM
8.77
9.22
9.30
9.49
9.25
9.49
9.56
10.30
9.43
9.27
9.40
8.93
8.81
8.85
9.06
9.04
9.05
8.98
9.14
8.97
9.22
0.12
13.86
16.65
17.10
18.15
17.07
18.45
19.42
24.23
19.09
17.50
18.25
15.19
14.40
14.43
15.55
15.46
15.52
15.30
15.98
15.35
16.85
5.64
10.46
12.29
12.71
12.82
12.59
13.25
14.89
17.65
15.15
13.90
14.34
14.80
13.67
12.26
11.62
11.80
12.00
12.25
12.73
12.10
13.16
2.59
14
Chart 5. CARs for Mexico
10
30
8
6
25
4
20
The implication of this is that procyclicality may well still
be a serious problem with Basel II, even after the smoothing
of the risk curves that were introduced between CP2 and
CP3 to mitigate this problem.
Basel II will, however, be a regime change, and one of the
purposes of this is to make bankers more conscious of risk
assessment and risk management. It has already succeeded
in this. One hope is that it will induce bankers to be more
Standardised
IRB F
Sep-99
Mar-99
Sep-98
Mar-98
Sep-97
0
Mar-97
It follows that the percentage change in the required CAR
under the IRB as a country moves from boom to recession
(up) and back to boom again (down) is likely to be much
more extreme under the IRB than under the other two
approaches. This is shown in table 4.
5
Sep-96
ICRM
10
Mar-96
2001
1999
1997
IRB F
15
Sep-95
Standardised
1995
1993
1991
1989
0
Mar-95
2
Percentage
Percentage
12
ICRM
prudent during booms despite declines in CARs. An
implication of a move from the standardised to an IRB
approach is that the individual bank making this
transition will be encouraged to shift its portfolio to
higher-quality, higher rated credits, because it then
benefits from a lower CAR. This is good of itself, but the
higher the quality of the credit, the steeper is the risk
curve (relating required risk ratio to the quality of the
loan); so the procyclicality is likely to be enhanced, even
if average quality improves.
GOODHART FINANCIAL REGULATION, CREDIT RISK AND FINANCIAL STABILITY 125
Table 4. Maximum percentage change in CARs
Upwards
2 consecutive periods
1 Period
Date
A. IRB
USA
NORWAY
MEXICO
0.25
0.39
0.25
1989
1994
Dec 96
B. ICRM
USA
NORWAY
MEXICO
0.21
0.13
0.18
C. Standardised
USA
NORWAY
MEXICO
0.04
0.07
0.08
Downwards
Date
2 consecutive periods
Dates
1 Period
0.33
0.45
0.30
1989/0
1994/5
Sep/Dec 96
–0.29
–0.27
–0.21
1992
1997
Mar 97
–0.49
–0.41
–0.30
1992/3
1996/7
Mar/Jun 97
1998
1995
Dec-96
0.33
0.20
0.30
1998/9
1994/5
Sep/Dec 96
–0.28
–0.25
–0.14
1993
1997
Mar-97
–0.47
–0.37
–0.22
1993/4
1996/8
Mar/Jun 97
Jun-05
Jun-05
Dec-96
0.06
0.10
0.08
1985/6
1994/5
Sep/Dec 96
–0.07
–0.06
–0.08
1983
1997
Mar-97
–0.09
–0.10
–0.10
1994/5
1996/7
Mar/Jun 97
When a regime change is introduced, no one in truth can
predict its ramifications, certainly not me. Nevertheless
these simulations suggest that procyclicality could remain
a serious concern. It is even possible that with the advent of
a serious downturn, if one was to occur, the impact of
abiding by the IRB would be too severe for the authorities
in some countries to countenance. Perhaps, like the
Stability and Growth Pact, it would only be observed in the
breach when it began to bite hard. Possibly an even greater
worry might be that the adoption of Basel II, while not
being so adverse as to force reconsideration, might yet
exacerbate future economic fluctuations.
Certainly there remains a tension between relating CARs
more closely to underlying risks in individual banks, and in
trying for macroeconomic purposes to encourage
contracyclical variations in bank lending in aggregate.
How to square this circle is the subject of the following
section.
5. A second instrument?
However desirable on other grounds the recent changes to
the accounting and regulatory regimes, with the shift to fair
(market) values under the International Accounting
Standards (IAS) and the adoption of Basel II, they will do
nothing to check such bank lending/asset price cyclical
volatility. Indeed, if some of the more pessimistic
prognostications about procyclicality turn out to be
justified, such volatility may be considerably exacerbated.
In the meantime the sole instrument that central banks
currently wield, their command over short-term interest
Dates
rates, is predicated to the maintenance of stability in the
consumer price index, and rightly so. Despite proposals to
shade interest rate decisions to offset asset price volatility
(e.g. Cecchetti et al., 2000), the difficulties of doing so (see
Greenspan, 2002, Bernanke and Gertler, 1999) are
considerable. Rather than distort the use of the interest rate
instrument to try to achieve a second objective, what is
needed is a second instrument. The purpose of this second
instrument would be to maintain systemic financial
stability. This latter objective remains a core purpose of
central banks, whether or not they also supervise the
individual banks, and is complementary to their primary
role in achieving price stability, but – at present at least –
this is a field where central banks have few, if any,
stabilising instruments at hand, apart from emergency
liquidity assistance to help mop up after something goes
wrong in the financial system.
The need is to introduce an instrument that will have
countercyclical characteristics, which could serve to check
bank lending during asset price hikes, and vice versa.
The BIS have been advocating such general measures for
some time (Borio and White, 2003). In the Conclusions to
their 74th Annual Report (2004), the BIS wrote (p. 143),
“Fortunately, the global economy now appears to be
on an upward path, and there is less call for macroeconomic stimulus. We should use this opportunity to
reflect on the processes that allowed our armoury of
macroeconomic instruments to become so depleted.
An obvious point, but not without objections, is that
this situation should be addressed directly through
126
NATIONAL INSTITUTE ECONOMIC REVIEW No. 192 APRIL 2005
more aggressive tightening in good times. In addition,
policies to strengthen the financial system, and to
encourage more prudent lending behaviour in upturns,
might help to mitigate the damage in downturns and
reduce the need to resort to aggressive policy easing
in the future.”
The next question is how do you do this? In an earlier paper
(Goodhart and Hofmann, 2001), I had suggested that,
analogously to the method of measuring the output gap, we
could use deviations of asset prices from a smoothed
(Hodrick-Prescott filter) trend to assess the gap between the
current asset price and its ‘fundamental’ value. But that got
roundly criticised on the grounds of inconsistency with
efficient market hypotheses. Borio and Lowe (2002), also
see Borio, Furfine and Lowe (2001) and Borio (2005, this
volume), suggest that the rate of growth of bank lending
itself is the key determinant of future asset price
movements, but the lags are long and the relationship
subject to structural changes in financial intermediation,
etc.
My own view now is that a better (perhaps best) approach
would be to relate the capital requirement on bank lending
to the rate of change of asset prices in the relevant sector.
Thus the capital adequacy requirement (CAR) on mortgage
lending could be related to the rise in housing prices
(relative to HICP inflation), and lending to construction
and property companies to the rise in property prices. For
manufacturing and services more broadly, the CAR could
be related to the rise in equity prices, up when equity prices
were appreciating, and vice versa. Similarly, required
solvency ratios for life insurance companies would be
adjusted counter-cyclically in response to shifts in
equities, bond and property prices.
The purpose of the exercise would be both to build up
reserves and to restrain bank lending during asset price
booms, so as to release them during asset price
depressions. In this respect it has much in common with
the current Spanish pre-provisioning policy proposals.
The flip-side, however, is that it relaxes prudential
requirements most during bad recessions, just when
individual banks and other financial intermediaries are
individually at their most fragile. But when the concern
of the central bank is for the aggregate, systemic state of
the system, surely this is the right course.
There are numerous practical problems, notably the
possibility of disintermediation abroad in a world
without exchange controls where a global financial
system exists. My belief is that such problems, though
real and serious, can be overcome, and I have started to
do some work on this subject (see Goodhart and Hofmann,
2004).
6. Conclusions
One of the reasons why I came to enjoy economics as an
undergraduate was that it was such an immature subject.
Unlike much of my prior studies at school, there was no
necessarily correct answer to the various questions being
asked. As can be seen here, this certainly remains the case
in the field of financial regulation.
The current adoption of Basel II, and the new accounting
standard, IAS39, do represent improve-ments on what had
gone before, but clearly Basel II has deficiencies and
problems. It is, perhaps, best seen as a stage in a continuing
process of refining and reforming our regulatory system. At
present neither theory nor practice seems firmly anchored.
It will be for the next generation to make progress.
NOTES
1
2
3
It is possible to measure and to model the risk of a single
asset quite accurately. It is somewhat more difficult, but
possible, to model the risk of portfolios of assets, e.g. because
of non-linear dependence, time-varying correlations. It
becomes even harder to model the risk of a banking institution
incorporating asset portfolios and operational functions. It is
hardest of all to measure the risk of a system of banks, though
in work done with P. Sunirand and D. Tsomocos, I have
recently been trying to do just that, see Goodhart, Sunirand
and Tsomocos, (2003, 2004 and 2005). In effect, the greater
the degree of aggregation, the more difficult financial risk
assessment becomes. I am grateful to Jon Danielsson for this
latter thought.
Instead, as Instefjord, et al. (1998) have argued, a better
approach is to apply incentives/penalties to managers who
unearth and prevent such frauds, also see Goodhart (2001).
The short-term effect is less, about 50%. Also, the adjustment
appears to be asymmetric, in that banks experiencing a decrease
in their requirement only adjust their actual capital by about
20% of that.
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