Calibrating Capital to Risk Management rather than to History

The way that we calculate capital requirements is one of those embedded assumptions that has existed for so long that we fail to think about whether it really makes any sense or not.  And if you do stop and take a step back, you will realize that it actually does not necessarily make much sense. 

We calculate capital requirements looking backwards, when the thing that we will need capital for is in the future.  That backwards capital requirement is only broadly close to being correct for firms that always do tomorrow what they did yesterday. 

So what will we do tomorrow?  Not entirely sure, especially regarding risk.  Especially if you do not have a risk management program. 

Oh, but you say that you do have a risk management program.  Well that changes every thing.  Because one of the most important features of a risk management program is that you have made plans to enforce boundaries on your future risk taking.  So at the extreme, you will need capital for the amount of risk you would have at those boundaries. 

It sounds very different from what we have been doing.  It is a quite troubling idea for firms whose limits are sky high, or who do not have a history of actually enforcing their limits. 

But aren't those the firms that need more capital? 

Read more.

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Comment by Riskviews on May 11, 2014 at 1:29pm

Required capital can be seen as a product of two factors.  One is the amount of potentially risky activity, which is what is addressed here.  The other element is the rate of riskiness, which you address.  Banking practices for determining the rate of riskiness of their activities had exactly the problem that you mention.  They did look back, but not very far back with the VaR calculation.  The newer Stressed VaR is an attempt to get past that problem.  

Comment by Per Kurowski on May 11, 2014 at 11:50am

If bank regulators had calibrated risk to history, then they would have seen that all bank crises ever, no exceptions, have resulted from excessive exposures to what was ex ante perceived as “absolutely safe”, and never because of excessive exposures to what was perceived as “risky”.

And then they would have set the capital requirements for banks 180 degrees in the opposite direction. Higher for what is perceived as “safe” and lower for what is perceived as “risky”… and we would not have suffered the AAA rated mortgage backed securities mess, nor over-lending to Greece and to real estate, nor under-lending to small businesses and entrepreneurs.

So please, do not write of history!

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