“Confidence Levels”

In “An Explanatory Note on the Basel II IRB Risk Weight Functions” published by the Basel Committee on Banking Supervision in July 2005, we read in 5:1:

"The confidence level is fixed at 99.9%, i.e. an institution is expected to suffer losses that exceed its level of tier 1 and tier 2 capital on average once in a thousand years. This confidence level might seem rather high. However, Tier 2 does not have the loss absorbing capacity of Tier 1. The high confidence level was also chosen to protect against estimation errors, that might inevitably occur from banks’ internal PD (Probability of Default), LGD (Loss Given Default) and EAD (Exposure at Default) estimation, as well as other model uncertainties. The confidence level is included into the Basel risk weight formulas used to provide the appropriately conservative value of the single risk factor.”

Three things come to mind: First, of course, how little resilient those confidence levels turned out to be… in just about the first 3 years of those thousand years… not only a couple banks went down.

The second, much more important… Who authorized these regulators to set a confidence level for our banks at 99.9%? ... Are our banks not supposed to take more risks than that in order to help the society to move forward? Where would we be had that sort of confidence levels been applied?

And last, what kind of confidence level should we have in that these regulators, locked in their little incestuous mutual admiration club, really know what they are up to?