Risk Measurement and Regulatory Arbitrage in the Basel Odyssey

Over time, the shaping of financial regulations and coordinated supervision of internationally active banks has appeared as a regulatory response to financial and economic shocks that have followed episodes of financial liberalisation. While the definition of regulatory capital has remained stable since the initial Basel I agreement, the measurement of risk has undergone radical changes. In particular, the key concept in international solvency regulations – the risk sensitivity – has been profoundly revised under the Basel II framework. By providing the financial institutions with the ability to assess the risks internally, by themselves, the regulator has unintendedly introduced adverse incentives and paved the way for regulatory arbitrage. This, in turn, has challenged the effectiveness of the solvency standards.