Model-Based Capital Regulation: Where Do We Stand and Where Should We Go from Here?

This article examines the evolution and challenges of model-based capital regulation in banking, discussing its impact on banking system resilience and financial stability. Introduced with Basel II, model-based regulation sought to link capital requirements to asset risk but encountered practical issues like discretion in banks’ risk reporting, complexity, and procyclicality, weakening its effectiveness. Large banks often exploited modeling discretion to reduce capital requirements, lowering equity levels and amplifying systemic risk, as evidenced in the global financial crisis of 2008. While greater distance between banks and supervisors limits discretion, the findings underscore the advantages of simpler frameworks, such as leverage ratios, for enhancing transparency and stability. Political economy considerations, however, complicate international regulatory alignment, as national regulators balance stability objectives with considerations about domestic competitiveness. The article concludes that streamlined regulation paired with strong and robust equity standards would bolster financial stability and calls for further research on regulatory frameworks and systemic risk.