Not About Capital
The reality is that regulatory capital requirements, no matter how much we try to refine them, will always be a blunt tool. Certainly they should not create the wrong incentives, but we cannot micromanage firm behavior through regulatory capital requirements. There are diminishing returns to pursuing precision in regulatory capital requirements.
Terri Vaughan, NAIC
These remarks were made in Europe recently by the lead US regulator of the insurance industry. In Europe, there has never been a regulatory capital requirement that was risk related. But the Europeans have been making the discussion all about capital for about 10 years now in anticipation of their first risk based capital regime, Solvency II.
The European assumption is that if they follow as closely as possible the regulatory regime that has failed so spectacularly to control the banking system, Basel II, then everything will be under control.
The idea seems to be that if you concentrate, really concentrate, on measuring risk, then insurance company management will really take seriously the idea of managing risk. Of course, that conclusion is also based upon the assumption that if you really, really concentrate on measuring risk that you will get it right.
But the Law of Risk and Light tells us that our risk taking systems will lead us to avoid the risk in the light and to load up on the risk in the dark.
That means the risks that are properly measured by the risk based capital regulatory system will be managed.
But whatever risks that are not properly measured will come to predominate the system. The companies that take those risks will grow their business and their profits faster than the companies that do not take those poorly measured risks.
And if everyone is required to use the same expensive risk measurement system, very, very few will invest the additional money to create alternate measures that will see the flaws in the regulatory regime.
The banking system had a flaw. And many banks concentrated on risks that looked good in the flawed system but that were actually rotten.
What is needed instead is a system that concentrates on risk controlling. A firm first needs a risk appetite and second needs a system that makes sure that their risks stay within their appetite.
Under a regulatory risk capital system, the most common risk appetite is that a firm will maintain capital above the regulatory requirement. This represents a transfer of the duty of management and the board onto the regulator. They never need to say how much risk that they are willing to take. They say instead that they are in business to satisfy the regulator with regard to their risk taking.
The capital held by the firm should depend upon the firm’s risk appetite. The capital held should support the risk limits allowed by the board.
And the heart of the risk control system should be the processes that ensure that the risk stays within the limits.
And finally, the limits should not be a part of a game that managers try to beat. The limits need to be an extremely clear expression of the fundamental way that the firm wants to conduct business. So any manager that acts in a way that is contrary to the fundamental goals of the firm should not continue to have authority to direct the activities of the firm.