Friends, 

Fascinating post-Davos chat with a major U.S. regulator: Central bankers and regulators who enforce global capital standards are concerned that they have imposed risk caputal standards on Financial Instutions that are "formalist in nature" and "do little to affect tactical management." That is fascinating language. Here is what we discussed and what I think is the intended meaning. 

Requirements for regulatory capital calculations are more specific than they were in the past. There is now an accumulated body of guidance both written and oral as to how to calculate VaR. The same process of definition is well underway for stress tests, spurred by Dodd Frank compliance. As the Federal Reserve, the OCC, the BIS, and increasingly FINRA issue guidance and directives, the requirements become increasingly specific. There is much that is good about this. Institutions and the service providers that assist them are much clearer on what the regulators require, even as many are still unable to comply. The more specific the requirements, though, the more likely that they become formalistic, i.e., legal requirements that are to be fulfilled to the letter rather than living and breathing regulation that stimulates management and affects tactical decisions. 

This is a dilemma for regulators. Their ultimate hope is that banks and non-banks manage themselves better. That's the whole point. As the requirements become more specific, though, they can constrain past the point of utility. 

Given my academic interest in legal theory, I very much appreciate the formulation. I do note happily the implication for the business of risk advisory. Institutions will need to demonstrate how they interpret the numbers they are required to submit. A new set of guidelines will emerge on how banks can demonstrate the active management of business lines and balance sheet on the basis of the regulatory requirements imposed on them. My counterpart noted my Tweet on a shift from VaR to Expected Shortfall, commenting that it is itself intended to focus requirements on metrics that are more easily interpreted and hence more likely to affect tactics. The money quote: "There are too many physicists in the risk business and not enough bankers."

A second topic of discussion was the shift toward more retail-oriented regulation. I will likely share a note on that topic early next week.

Best to all.

Tony