Counterparty Risk, Regulation and Basel II

“Hell, there are no rules here—we’re trying to accomplish something.”

Thomas A. Edison (1847–1931)


In most developed countries, banks are regulated by the government. A critical form of regulation is determining the minimum amount of capital that a given bank must hold. Capital acts as a buffer to absorb losses during turbulent periods and therefore partially defines the credit-wo rthiness of a bank. Ultimately, regulatory capital requirements partially determine the leverage that a bank can operate under. Since banks have historically sought to have strong credit ratings, regulatory capital requirements should be significant and easily cover losses in any plausibly bad financial scenario. On the other hand, banks have continual ly strived for ever-greater profits to be shared by employees (via bonuses) and shareholders (via dividend payments and capital gains). Banks will therefore naturally wish to hold the minimum amount of capital possible in order to maximise the amount of business they can do and risk they are able to take.

There is clearly a balance in defining the capital requirements for a bank; it must be high enough to contribute to a very low possibility of failure and yet not so severe as to unfairly penalise the bank (at least in comparison with competitors that operate under a different regulator y regime). The danger of overly optimistic capital requirements has been highlighted during the recent ...

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