Done.
Here is what I wrote-ed:
Few, if any, would argue that continuous improvement in the areas of risk measurement and risk management provide value to both society and the shareholders. Society benefits through increased credibility and stability in financial sector, whereas shareholders benefit from the increased returns realized by more accurately pricing risk. Furthermore, intuitively a streamlined process for this mechanism to operate across financial institutions would provide a consistent framework for both regulators and industry analyst.
Despite the merits of such a capital structure, IMF authors Kwast and De Nicolo opine about some hidden dangers caused by such a ubiquitous process. Essentially, if all financial institutions begin to measure and manage risk the same way, systemic credit risk enters the system. They implicitly argue that while such regulations lower the individual firm’s riskiness, it is at the cost of the entire industry. When regulators create rules that increase the similarity of the firms for the sake of transparency, they make their returns and response to economic shocks highly correlated. While such rules allow banks and analysts to gain greater insight into the systemic risk of the banking system, A black swan, such as a mortgage crisis has the capacity to bring down all ships.
Rule makers may be cognizant of the increased similarity between financial institutions caused by new capital regulations. It is possible that they believe strong standards and tightened capital regulations will be more beneficial to society, primarily through the intuitive idea of increased reserves promote financial stability. For example, if the financial institution is required to take a higher capital charge for offering loans to subprime lenders, they may reconsider such plans as the capital charge will be too high and they can create higher returns by loaning money to different clientele. The additional information gained by improved risk measurement and management practices may allow banks to actually charge a lower rate to some customers as they realize these customers are not as risky. A moral hazard often caused by regulations that increase capital requirements is avoided with such an industry wide change; that is the concept that manager’s will take on increasingly risky projects, as they are “forced to do more with less.” The challenge of a strong management record in the face of industry wide changes push managers to take on more and more risk. Risk-based measurement and management practices such as RAROC reduce this tendency, as riskier clientele require more capital.
Another flaw that comes with new capital regulations is the inclination of the firms to push the edge of the rules or attempt to get around the rules altogether. This is known as the regulatory dialectic. Once the new rules are established, companies try to circumvent them to increase profit or maintain a standard. For example, when the Obama administration sought to place a ceiling on CEO pay in exchange for accepting TARP funds, institutions immediately went to work to devise strategies that skirted such policies. Regulators the revise the previous rules in an attempt to close the loopholes that existed within the previous rules. Once again, the company seeks ways around the newly minted rules. Such a “cat and mouse” game continues to be played between the two parties. Eventually, a synthesis occurs and obsolete rules are eliminated. The removal of certain parts of the Glass-Stegall Act is an example.
Using metrics such as VAR and RAROC do provide stakeholders with a clear, transparent, and consistent mechanism for evaluating systemic risk within the financial system. However, the implementation must be done with respect to the firm, not industry-wide as such over-arching regulation actually introduces systemic risk to the banking system
