In attempting to promote international financial stability, the Basel Committee on Banking Supervision (2006) provided a framework that sought to control the amount of tail risk that large banks around the world would take in their trading books relative to their corresponding minimum capital requirements. However, many of these banks suffered significant trading losses during the recent financial crisis. Our paper examines whether the Basel framework allowed banks to take substantive tail risk in their trading books without a capital requirement penalty. We find that it allowed banks to do so and that its minimum capital requirements can be notably procyclical. Hence, focusing on the way the Basel framework sought to control the amount of tail risk in trading books relative to their corresponding minimum capital requirements, our paper supports the view that it was not properly designed to promote financial stability. We also discuss alternative regulatory frameworks that would potentially be more effective than the Basel framework in preventing banks from taking substantive tail risk in their trading books without a capital requirement penalty.
Bibliographical noteFunding Information:
This paper has benefited from the valuable comments of an anonymous referee, Peter Christoffersen, Klaus Duellmann, Paul Embrechts, René Garcia, Edward Kane, seminar participants at SUNY Buffalo, College of William & Mary, National University of Singapore, and MIT, and session participants at the Ukrainian Academy of Banking of the National Bank of Ukraine Conference in Sumy, Deutsche Bundesbank Conference in Eltville, Northern Finance Association Meeting in Winnipeg, Multinational Finance Society Meeting in Barcelona, Downside Risk Measures Workshop at the University of Minho, China International Conference in Finance in Guangzhou, AFA Annual Meeting in San Francisco, FMA Annual Meeting in Grapevine, INFORMS Annual Meeting in Washington, DC, FMA European Conference in Prague, and European Financial Management Symposium on Risk and Asset Management in Nice. We thank Hadi Mohammadi and Piotr Zielinski for assistance in collecting data. Baptista gratefully acknowledges research support from the School of Business at The George Washington University.
Copyright 2014 Elsevier B.V., All rights reserved.
- Bank regulation
- Basel framework
- Financial crisis
- Financial stability
- Tail risk