This is an important time in the development of issues surrounding bank capital and risk. Quantitative risk measurement methodologies have moved from the technical fringe to the center point of capital and risk management for most major international financial firms. Market, credit and liquidity exposures have been the source of important market-based disruptions from the Asian crisis, to the severe degradation of Japanese bank balance sheets, to the LTCM/fixed income crisis of Fall 1998. In addition, the June 1999 Basel Committee standards for international banks remains open for comments for a brief remaining period, stimulating a window of intense commentary and reflection.

The last decade has witnessed a very swift transformation in financial institutions that continues today. Banks and other financial institutions that formerly existed to warehouse risk began to shed and hedge many forms of risk from their balance sheets and off-balance sheets. They aggressively diversified into fee and service businesses and concentrated more on the origination and distribution aspects of many financial services. The implications of this sea change are profound, especially for regulators and for the Basel Committee’s new risk capital standards.

To keep pace with such change, it is important that we refine concepts of economic and regulatory capital to ensure that they suit well the financial institutions of today and the future, rather than those of the past. If the standards are too thin, we risk accumulating systemic and liquidity risks to a new degree. If they are too harsh, then regulatory arbitrage will ensure that the problems go elsewhere, with the regulators eventually in tow.

This paper takes the view that the ongoing evolution of financial-firm activities constitutes the single most important set of changes to challenge effective management and bank regulation. Much needs to be done to bring Basel’s new standards in line with these changes. In what follows I explore these changes and their implications for the definition of bank capital, the measurement of risk, and the pricing and allocation of internal bank capital.

As is well known, the Basel standards represent a shift in regulation away from deposit insurance and toward the regulation of capital. The hope all along has been that adequate regulation of capital will reduce the costs of deposit insurance. The approach of the 1988 standards and those proposed in 1999 is focused on defined “risk buckets” which group assets with ostensibly similar risk, and on a risk-based weighting system to aggregate the values for these assets. The recent proposals do provide for a substantial movement towards market-based risk evaluations, primarily through permitting banks to employ their own internal risk-rating systems in determining capital and in discussion with their own national regulators. Even so, the Committee continues to rely on a definition of capital that relies substantially on book value and on definitions of risk that emanate from balance sheets, rather than from total business risk.