A Comparison of Capital Standards and Proprietary Surveillance as Mechanisms for Regulating Financial Market Risk in the EU

The EC's Capital Adequacy Directive (CAD) and the 1995 Basle Committee (BC) proposals are analysed as approaches to regulating market risk. We derive conditions under which the BC's proposal, namely supplementing a CAD-type standardized risk measurement framework with proprietary procedures subject to market surveillence, enhance regulatory efficiency. We demonstrate that the BC's approach enhances efficiency, unless asset deficiencies imply an institution has insufficient incentives to effectively implement proprietary procedures. Moreover, the CAD's dual objective, namely ensuring the prudential safety of, and promoting competitive equality in, the financial services market cannot be reconciled without imposing restrictive assumptions on the regulator's information set. (C) 1998 John Wiley & Sons, Ltd.