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OpRisk Capital Chess: Banks Lose First Match article by Peter Hughes

When the Basel Committee on Banking Supervision first mooted the setting aside of protective capital for operational risks in the late 1990s, large international banks lobbied for their in-house models to provide the basis for calculating the new regulatory capital charge. The Basel Committee acquiesced and, in so doing, handed the initiative for their development to the elite banks.

Basel II attached an Advanced Measurement Approach (AMA) tag to the in-house models. A thin principles-based framework was also offered in the expectation that a robust AMA framework, with comparable bank-to-bank outputs, would emerge over time. But that never happened. Once each bank had control of the method of its own regulatory capital calculation, it held onto it. Like the queen on the chessboard, banks could move the calculation around to achieve the best positional advantage.

The banks’ slickness in taking control of the regulatory capital agenda was not replicated in the operating space, where events exposed their susceptibility to carelessness on a grand scale. From the mid-1990s, the banking sector suffered a series of costly scandals that included the misguided or fraudulent activities of rogue traders, payment protection insurance (PPI) in the U.K., and the subprime fiasco that became the backdrop to the global financial crisis of 2007-’08.

Read more on GARP’s website

How This Happened?

Playing the white pieces, the banks led with the regulatory capture opening. In a sequence of expertly coordinated moves, they progressively took control of the chessboard. That should have led to an easy win, but a few careless moves handed positional advantage to the regulators’ black pieces. With their position weakened, the banks subsequently lost their queen. The regulators continued to press their positional and material advantage until checkmate was inevitable.

As defined in Mattli and Woods’ The Politics of Global Regulation, regulatory capture is the “de facto control of the state and its regulatory agencies by the ‘regulated’ interests, enabling these interests to transfer wealth to themselves at the expense of society.”

Playing the regulatory capture opening isn’t without its risks; it is prone to creating short-term advantages that are rarely sustainable over the long term.