Moral Hazard and Basel II

One of the fundamental precepts of Basel II was simple and yet inspired. It argued that as banks adopt more sophisticated (and probably superior) approaches to measuring risk, their regulatory capital charges should decrease. So for market risk, capital charges for standardized approaches were greater than those for internal models approaches. For credit risk, internal ratings based approaches required less capital than standardized approaches, and for operational risk, AMA and standardized approaches requre less capital than Basic Indicator approaches. But enter crisis driven regulatory changes. Suddenly capital requirements for market risk within a trading book for internal models approaches are likely to more than triple, as modifications to the basic IMA approach such as stress var, removal of tier 3 capital, and the potential introduction of Incremental Risk Capital dramatically increase the capital required. This breaks the fundamental incentive for institutions to move towards more sophisticated (presumably better) risk models. Of course there's the rub, the regulators no longer trust the models. After the crisis is the reaction against quantification of risk and the mathematical finance that underpins it.