The role of Risk Management and Compliance in Micro-Prudential Capital Regulation
Chapters 4 covers micro-prudential regulatory capital requirements. Micro-prudential regulation is concerned with the safety and soundness of individual banks. The chapter first explains the rudimentary concepts of leverage and economic and regulatory capital. Understanding management’s incentive to minimize equity on a balance sheet to maximize return on capital helps to explain banks’ motive for capital arbitrage, which involves the search for a portfolio of assets that minimizes capital requirements. The chapter then discusses loss-absorption and other rationales for capital regulation and describes the Basel III/Dodd-Frank risk-weighted assets methodology that underlies global bank capital regulation. Two versions of capital rules exist: a general ‘standardized’ approach and an ‘advanced’ approaches methodology for large banks. The latter banks, subject to approval, can determine their own risk weights through internal modeling and credit ratings. The chapter comprehensively describes the capital rules for credit, market, and operational risk and the associated risk management and compliance expectations. The market-risk rule seeks to reduce arbitrage by banks that reclassify positions to and from the ‘at cost’ banking book and ‘fair value’ trading book, a common practice before the financial crisis. Leverage ratio capital rules, a backstop to risk-based capital regulation, and portfolio diversity restrictions provide additional safety and soundness protection.