Is the New Basel Accord Incentive Compatible?

1. Is the New Basel Accord Incentive Compatible? Comments by Klaas Knot

2. Outline • Value added of the paper • Four main comments: • NBA versus PONBA • Perfect competition / fair pricing • Risk sensitive deposit insurance premiums • Incentives: entity versus agent

3. Value added of the paper (1) • “While BCBS consultative documents fully embrace the goal of harmonizing capital regulation with bank internal processes, it is troubling that the BCBS fail to discuss the nature of the externalities that mandate capital regulation or provide any analysis that supports the claim that banks’ internal processes can be harnessed to control the underlying market failure(s).” (p.3)

4. Value added of the paper (2) • “While the BCBS has been studying the potential regulatory capital implications of the NBA by having cooperating banks estimate their potential capital requirements under the proposed IRB approaches, these estimates are based on banks current portfolio compositions. Given incentives created under the NBA, it is likely that the composition of banks’ credit portfolios will change…” (p.16)

5. NBA versus PONBA (1) • Main criticism of the paper: New Basel Accord is not only about minimum requirements! => This challenges its two main assertions:

6. NBA versus PONBA (2) • Paper: Since Pillar One of NBA does not include any economic incentive to switch to IRB, there would be no reason to expect banks to voluntarily evolve toward IRB • Response: PILLAR 3! Market discipline will force systemically relevant banks onto IRB.

7. NBA versus PONBA (3) • Paper: From the incentives created by NBA natural banking clienteles will emerge within which poor quality credits will be concentrated in SA banks • Response: PILLAR 2! • Concentration risk => no sensible supervisor would allow small standardized approach banks to operate at 8 percent • Hence, equations 6-8 are no equalities

8. Perfect competition / fair pricing • Deposit insurance value is only source of profits in the model => Rather extreme assumption! • Relaxing this assumption would lead to other sources of profits not always maximized by stripping the deposit insurance scheme • imperfect competition, franchise values • asymmetric info and adverse selection • securitization: cost-of-capital argument

9. Deposit insurance premiums • Deposit insurance premiums are assumed lump sum (and therefore normalized at zero) • But what about risk sensitive deposit insurance premiums, as proposed a.o. by Baltensperger and Dermine, Economic Policy 1987, and Garcia, IMF Occasional Paper 2000?

10. Incentives • Paper maintains neoclassical view of banks as holistic entities • What if more behavioral aspects would be taken into account? • decentralized decision making: principal versus agents • RAROC type incentive schemes

11. Conclusion • Attention for interaction between deposit insurance and minimum capital requirements is well deserved, but … • … strong results and concomitant assertions are strongly conditional upon equally strong assumptions, and • … resolution may well have to be found in deposit insurance scheme rather than NBA