infonet-economy

Over the past decade, European banking and insurance regulation has been subject to significant reforms. One of the declared goals of the authorities was the enhancement of market stability through adequate and consistent capital standards. This paper provides a critical analysis of the Basel II, III, and Solvency II capital standards for asset risks in light of these regulatory objectives. Our discussion begins with a detailed overview of the current standard approaches for market and credit risk. Based on a theoretical analysis and a numerical comparison of the capital charges our contribution is twofold: we reveal an inaccurate treatment of risk categories and severe inconsistencies between the capital standards for banks and insurers. Regarding the former, we are able to show that the models’ inaccurate parameter settings do not reflect the specific risk-return characteristics of asset classes and unduly promote government bond holdings. This might lead to severe distortions to the financial institutions’ investment decisions. With respect to the latter, the numerical part of our paper displays considerable differences in required capital for the same type and amount of asset risk, burdening insurers with almost twice as high capital requirements than banks. This not only contradicts the authorities’ goal, but gives also rise to regulatory arbitrage opportunities across financial sectors.