Complex, self-regulation has added speed to the race to the bottom and incline to the international playing field. (b) Complexity and risk-sensitivity One of the conceptual lynchpins of the model-based, self-regulatory approach was the desire for risk-sensitivity. As a matter of principle, it is difficult to question risk-based regulation. The practical question is whether that has been achieved. On the face of it, the very act of risk-weighting assets would appear to guarantee a greater degree of risk-sensitivity than, say, using a risk un-weighted leverage ratio. Yet this intuition is wrong on two counts. Wrong empirically because it ignores the risks which come from modelling. And wrong theoretically because risk across banks’ whole portfolio may bear little relationship to the aggregated risk of each of its parts. Take model risk. This pollutes the signals from a risk-based capital ratio. In work at the Bank, we have explored this trade-off between model risk and risk-sensitivity. If model risk is sufficiently large, a risk-based capital ratio may in fact perform worse in predicting bank default than a leverage ratio. That is because the noise associated with imprecise risk weights can drown out the signal. A leverage ratio, unpolluted by model risk, may provide clearer risk signals. While slightly counter-intuitive, this result is well-understood in many fields outside of finance (Gigerenzer (2007)). It is why complex, risk-weighted algorithms have been found to perform poorly out-of-sample when predicting everything from sports events to medical diagnoses, from shopping habits to portfolio choices (Haldane and Madouros (2012)).

Even with the benefit of hindsight, these steps seem like sensible ones. In particular, there appear to have been three key objectives behind the evolution of international bank regulation over the period. •  First, to level the international playing field and prevent a race to the bottom in capital adequacy standards, in particular under Basel I. •  Second, to align regulatory capital with risk by improving the risk-sensitivity of capital standards, in particular under Basel II and III. •  And third, to reduce incentives to engage in regulatory arbitrage and create incentives to upgrade risk management, in particular under Basel II and III. All of these responses were understandable and, in concept, laudable. The question is whether, with the benefit of hindsight, they have been successful. Unfulfilled ambitions (a) Levelling the Playing Field The rationale for the original Basel Accord is that it would effectively defuse an international race to the bottom by setting a common, internationally-set capital standard. But the use of risk weights, in particular those based on internal models, in calculating banks’ capital ratios has provided an alternative avenue through which this race can be run. And empirical evidence suggests this race may have continued apace. Chart 1 plots the average risk weight applied to the assets of 17 major international banks over the period 1993 to 2011, together with a trend line. The trend is steeply and strikingly downward-sloped, falling on average by 2 percentage points each year.