The Future Financial System

For a variety of reasons, including deposit insurance and limited liability (to which I will return in a moment), banks can hold too little capital. Capital regulation is the response to this. But as the regulatory framework has evolved, we have moved to more and more complex structures. In particular, we have moved to risk weighting. That is, we ask a bank to hold more capital to support riskier assets or activities. In its internal risk management process, a bank’s capital is allocated to different activities based on models calibrated from historical data. These models are then used to generate probability estimates of losses of particular size. Or, at least, that’s my understanding.