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    BoE Paper on Risk Sensitivity and Risk Shifting in Banking Regulation

    July 04, 2018

    BoE published a paper that examines risk sensitivity and risk shifting in banking regulation. The paper provides evidence that the more risk‐sensitive Basel II framework may have reduced banks’ incentives to engage in higher‐risk mortgage lending in the UK. The analysis suggests the need for a robust regulatory framework with several complementary standards interacting and reinforcing each other, even if subjecting banks to a number of regulatory constraints adds to complexity.

    The paper reviews the history of risk sensitivity in capital standards and assesses whether a higher degree of risk sensitivity necessarily leads to a better measurement of risk. The paper provides a sketch of the history of risk‐weighted capital requirements, a history that reached its pinnacle with the introduction of the advanced internal ratings‐based approach of Basel II. The paper then reviews whether Basel II has improved the way risk is measured, in particular why ex‐ante risk sensitivity may not lead to greater ex‐post risk sensitivity. Finally, the paper assesses whether Basel II led to less regulatory arbitrage and less risk shifting, as was the intention, before offering a conclusion.

    The financial crisis exposed enormous failures of risk management by financial institutions and of the authorities’ regulation and supervision of these institutions. Reforms introduced as part of Basel III have tackled some of the most important fault‐lines. As the focus now shifts toward the implementation and evaluation of these reforms, it will be essential to assess where the balance has been struck between the robustness and the risk sensitivity of the capital framework. This paper contributes to this assessment by stepping back from the details of the recent reforms and instead taking a bird’s eye view on the fundamental trade‐offs that may exist between robustness, complexity, and risk sensitivity.

     

    Related Link: Financial Stability Paper No. 44

    Keywords: Europe, UK, Banking, Risk Sensitivity, Risk Shifting, Banking Regulation, Basel III, Basel II, BoE

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