Academic

I've already said that the answer to that question is no.  Steve Randy Waldman (on how bank capital is impossible to measure) and Noah Millman (on how Basel III won't work) have manfully made the argument that the answer is yes, and they are worth a read.  But, of course, we hedge against imperfectly understood risks all the time.  Doctors do it.  Entrepreneurs do it.  And any lawyer who tells you he can value you case down to the dollar is takings risks with the truth.

Still, Basel III depends on risk.  That is, the common equity banks must hold - 7% - is seven percent of a number, and to Basel that number is the amount of the bank's risk weighted assets.  Banks that hold cash can weight that risk, under Basel's rules, at 0% - they don't need to hold any capital against it.  But if the bank's assets are tied up in corporate bonds or housing related assets, then the risk weight increases, to 50% or 100%. You get the idea.  There's the assets that the bank might list on a balance sheet: a billion dollars in CDOs, a $300 million skyscraper, deposits, and so on.  But that isn't the number they report to Basel.  They report those assets multiplied by their committee-set discount rates.  And so regulatory capital depends a little on the regulators making those risk weightings accurate.  In Basel II, the regulators deferred to the banks' own models in risk weighting assets, at least to oversimplify a bit, while still leaving some minimum weights in place.

Here's Millman on what is wrong with this:

the regulatory framework recommended by Basel II assumes that banks are in the best position to measure their own risks, and that a regulatory framework that aligns regulatory capital requirements with the risk being taken is to be desired. In other words, the regulatory framework was pushing banks hard in the direction they were already going: towards avoiding measurable risks and hence (since you still have to make money) into risks you can?t easily measure (or don?t know exist).

Basel III retains this basic framework, but increases (somewhat) the amount of capital that banks need to hold generally. Therefore, it should further increase the incentive to avoid measurable risks and to hold positions whose risks are not well-measured.

HT: Felix Salmon