Capital Adequacy, Pro-cyclicality and Systemic Risk

VaR-based capital adequacy as specified by Basel II accords is subject to procyclical effects, potentially aggravating systemic risk, when it is supposed to mitigate it, as observed during 2008 crisis. Supposed improvements in Basel III, not only don’t resolve the problem, but introduce new sources of systemic risk. The method proposed here for computing the regulatory capital of financial institutions avoids the pitfalls of the Value-at-Risk. The computation is based on a generalized stress testing method, with the following principles: (i) market scenarios are defined by the regulator; (ii) institutions compute the impact of scenarios defined by the regulator and report them; (iii) the regulator not only counts the number of violations of the risk reporting but also their size; (iv) the regulatory capital is a multiple of the worst stress test, where the multiplier depends on the size and the frequency of the violations. By letting the institutions estimate their sensitivities to extreme market shifts, the regulator not only avoids a costly burden, but also keeps institutions responsible for their reporting. On the other hand, by keeping control on the list of stress tests involved in the computation of the capital, the regulator offers itself a very strong lever to prevent speculative bubbles, by making them costly in terms of capital requirements.