Central bankers from the United States, England, and Japan jointly sponsored a recent conference to take stock of the 10 years since capital standards were first tied to asset risk. Advances in technology and bank operations make changes in the 1988 Basel accord inevitable, they agreed.
"The question is not whether the Basel standard will be changed, but how and why each new round of change will occur, and to which market segment it will apply," Federal Reserve Board Chairman Alan Greenspan said in a speech during the two-day conference.
Nearly 20 papers were presented at "Financial Services at the Crossroads: Capital Regulation in the 21st Century." Copies of the papers are available from the Federal Reserve Bank of New York by calling (212) 720-6130 or may be viewed on its Web site: www.ny.frb.org.
The broad case for reform of current capital rules is made in a 37-page paper by Federal Reserve Board researchers David Jones and John Mingo.
The authors point out that securitization and other financial innovations let banks evade capital rules. At the same time, the largest banks have developed sophisticated risk analysis to determine how much capital is needed to back specific assets.
Though a bank's internal credit risk modeling will not replace formal capital standards in the near term, regulators must begin to heed the work banks are doing, according to the authors.
"The current one-size-fits-all system of risk-based capital requirements increasingly is inadequate to the task of measuring large-bank soundness," Mr. Jones and Mr. Mingo write. "Despite difficulties with an internal- models approach to bank capital, no alternative long-term solutions have yet emerged."
In "Industry Practices in Credit Risk Modeling and Internal Capital Allocations: Implications for a Models-Based Regulatory Capital Standard," the authors suggest an incremental approach, possibly using bank internal models to set capital standards for certain assets.
Arturo Estrella, a New York Fed researcher, makes the case for smarter regulators versus more sophisticated capital requirements in a 16-page paper titled "Formulas or Supervision? Remarks on the Future of Regulatory Capital."
"Scarce public resources are better employed to enhance supervision than to develop new formulas whose payoff may be largely illusory," he writes.
As the business of banking becomes more dynamic and complex, mechanical formulas seem "grossly inadequate," he concludes. Regulators need to rely more on informed supervision of compliance with sound practices. Mr. Estrella's paper addresses the pros and cons of the so-called precommitment approach, which would let banks set capital levels for market risk but would penalize them for underestimating losses.
Tim Shepheard-Walwyn at Swiss Bank Corp. and Robert Litterman at Goldman, Sachs & Co. outline a potential alternative to risk-based capital in "Building a Coherent Risk Measurement and Capital Optimization Model for Financial Firms."
The authors argue for something they call "base-plus," which draws on the advantages of both the precommitment and internal models approaches.