A Non-Cyclical Capital Adequacy Rule and the Aversion of Systemic Risk

We present in this note a method for computing the regulatory capital of financial institutions, along with the Basel Committee requirements, which avoids the pitfalls of the Value-at-Risk and, in particular, the fact that – as observed during 2008 crisis – it aggravates systemic risk rather than preventing it. The computation is based on stress testing, with the following principles: (i) market scenarios are defined by the regulator; (ii) sensitivities are estimated by each institution, as well as the impact of scenarios defined by the regulator and reported to it; (iii) the regulator not only counts the number of violations of the risk reporting but also their size; (iv) the regulatory capital is a multiple of the worst stress test, where the multiplier depends on the size and the frequency of the violations. By letting the institutions estimate their sensitivities to extreme market shifts, the regulator not only avoids a costly burden, but also keeps institutions responsible for their reporting. On the other hand, by keeping control on the list of stress tests involved in the computation of the capital, the regulator offers itself a very strong lever to prevent speculative bubbles, by making them costly in terms of capital requirements