Here is a crude summary of some of the key points of Persaud's argument
1. Regulation should be counter-cyclical. Credit mistakes are made during the boom and exposed during the downturn. Regulation therefore needs to be stricter during the boom and relaxed during the downturn.
2. Basel 3 attempts to regulate risk in terms of risk sensitivity. This concept has several flaws.
- It focuses on the private risks to banks and their shareholders, rather than the public risks to system and society.
- It is based on the market price of risk, which is cyclical and therefore cannot support counter-cyclical regulation.
- It assumes that all risk is homogeneous.
- Credit risk denotes the risk that a given creditor will be unable to pay. This risk is mitigated by having a portfolio of uncorrelated creditors, and assuming that the failure of each creditor is a statistically independent event.
- Liquidity risk denotes the risk that a given asset cannot be sold at short notice for the desired amount. This risk is mitigated by a preparedness to hold assets for long periods.
- Market risk is a combination of credit risk and liquidity risk.
4. Sustainable long-term investment entails liquidity risk. A regulatory regime that supports credit risk and fails to support liquidity risk tends to militate against sustainable long-term investment. But this is exactly the outcome of the Basel 3 regulations, according to Persaud. Instead, he argues, we need a regulatory regime that encourages firms to take appropriate long-term risk, according to their risk absorptive capacity.
5. The Basel 3 regulations force risk to be misallocated, because of a failure to appreciate time and its effect on risk. The goal of regulation should not be on reducing risk sensitivity but on increasing risk absorptive capacity.
6. The Basel 3 regulations therefore represent a missed opportunity for financing sustainable activities and longterm finance.
Note: In our risk management work, we use the term Bearing Limit, which roughly corresponds to what Persaud calls Risk Absorptive Capacity.
Papers by Avinash Persaud:
- Liquidity Black Holes (pdf) April 2003
- Regulation, valuation and systemic liquidity (pdf) October 2008
- How risk sensitivity led to the greatest financial crisis of modern times. VOX, 7 October 2008.
- The Empire strikes back. VOX, 14 September 2010