Until the fog around banks’ capital adequacy is reduced, including regulatory-induced fog, banks’ cost of capital may remain high. Where next? Taken together, it is difficult to escape the conclusion that the current regulatory system, however well-intentioned, needs root-and-branch repair. The good news is that regulators internationally are increasingly coming to recognise that fact and have slowly begun the process of repair. In the past year, the Basel Committee has begun work to improve the “Simplicity and Comparability” of the regulatory framework. And earlier this year, the G20 Finance Ministers and Central Bank Governors committed the regulatory authorities to improve comparability of regulatory standards. The practical question is what might be done to improve the credibility of the framework? In the spirit of moving forward the debate, some possible practical ingredients include: (a) Greater transparency One simple way of alleviating some of the uncertainty around the existing regulatory framework would be through improved transparency, in particular around models and risk weights. Some encouraging progress has been made on this front recently. In 2012, the Enhanced Disclosure Task Force (EDTF) of the Financial Stability Board produced a set of recommendations for improved bank transparency. This included greater disclosure around the models used to calculate risk weights. At present, banks are at various stages of progress in implementing these EDTF recommendations. For example, a number of UK banks made good progress towards compliance in their end-2012 accounts. A firm future commitment by global banks to meet  3  8  With thanks to Jason Kravitt.

At the same time, regulators have continued to bulk-up their own resources in the face of a rising tide of regulatory rules. Ultimately, these costs are borne not by regulators or regulated firms, but by general taxpayers and bank customers. These come in the form of higher taxes, lower savings rates and higher lending rates. If system stability can be achieved in simpler ways, these are deadweight costs to society. (b) The unlevel playing field A second unintended consequence of the move to a model-based regulatory framework is that it has tended to work in quasi-discriminatory ways. In particular, it has tended to discriminate both between small and large banks and between new entrants and existing incumbents in the amounts of capital they are required to hold even against identical exposures. The reason for this is that small or new entrant banks will generally adhere to Basel I or simple standardised approaches for measuring risk. In general, they will have neither the data nor the technology to support internal model approaches. But simpler, standardised approaches tend to require much higher amounts of capital than internal model approaches. Indeed, this was a design feature of Basel II. Chart 8 demonstrates those differences among the major UK banks for a selection of portfolios. For an identical corporate exposure, a small bank on Basel I or a standardised Basel II approach holds, on average, twice as much capital as a large bank using models. For retail mortgages, these differences are larger still.