New proposals for bank capital adequacy standards unveiled

by Chakravarthi Raghavan

Geneva, 16 Jan 2001 --    The Basel Committee on Banking Supervision has issued proposals for a New Basel Capital Accord which when finalised and implemented will replace the current 1988 accord.

The Committee has invited comments on the proposals - through national supervisory authorities, central banks or directly -  to be sent by 31 May this year. The draft rules are expected to be finalised in the light of the comments by end 2001 and is to be implemented in 2004.

The Basel Committee on Banking Supervision, located in Basel with the Bank of International Settlements providing the locale and secretariat support, consists of bank supervisors and regulators from the major industrialized countries, but the capital accord rules and standards set by it are said to be adopted and followed by more than 100 countries.

In announcing the draft proposals for the new accord, the Chairman of the Basel Committee, William J.McDonough (who is the president and chief executive officer of the New York Federal Reserve Bank) said the new proposals are aimed at aligning regulatory capital requirements more closely with underlying risks, and provide banks and their supervisors with several options for the assessment of capital adequacy.

In formulating the proposals, the Basel Committee has consulted the supervisors worldwide, said the chairman of the Basel Committee Task Force on Future of Credit Regulation, Mr. Claes Norgren, Sweden’s Director-General at Finansinspektionen.

Thus, while the central banks of the developing countries - with whom the BIS and the Basel Committee have established a dialogue - have been consulted, and will have an opportunity to present their views, the decision-making continues to be in the hands of the major industrial countries and their interests.

The draft is a revised, and nuanced version of the conceptual proposals mooted by the Committee in June 1999.

The new accord is based on what the Basel Committee calls the “three pillars” of minimum capital requirements, supervisory review of an institution’s capital adequacy and internal assessment process, and market discipline through effective disclosure to encourage safe and sound banking practices.

The new accord will “on average” neither raise nor lower regulatory capital for banks (which under the 1988 capital adequacy standards of capital to risk-weighted assets stood at 8%), the Committee claimed in a press release issued from Basel. However, it conceded, the capital requirements may increase or decrease for an individual bank depending on its risk profile.

But other experts said that while an assessment must await a detailed study of the bulky and detailed proposals, it is reasonably clear that the emphasis is on the use of the words “on average” in the Committee’s press release.

The very big international banks, who are the global players, will probably be able to have less capital locked up to satisfy the capital adequacy ratios, while the smaller banks including those in the developing world whose central banks and governments apply the Basel Rules (which are instituted and finalized by the Banking supervisors of the major industrial countries), will probably be forced to maintain or even increase the minimum adequacy capital needs.

The new rules, when made effective, will clearly strengthen the competitive position of these big banks, and the major global corporations,  while the small businesses and corporations of the developing countries may well find themselves having to pay a higher price for banking and financial services.

And to the extent of the liberalization and deregulation of banking and financial services - and these and other supervisory rules increase on the one hand the level of competition among a dozen or more of the banking oligopolies (in the lending and securitisation business) and ‘price’ their services to different clients (depending on the level of competition) - the retail clientele of banks (individuals, small businesses etc) will continue to be exposed to ever-increasing charges and costs by the banks.

This last raises a whole range of public policy questions. Banks, in a market society, perform a basic function  of intermediation and facilitation over a range of economic activities. It is in recognition of this role, and the intermediation they do in taking in deposits of individuals and customers and lending them out on a longer time-span, and the risks that are posed to the system (if all depositors were to simultaneously seek their money back) that a whole range of guarantees and facilities by the central banks (and ultimately by the tax-payer) are provided.

If this primary function is not being done, or done at a relatively higher cost (relative to the costs and prices charged on their big customers), and the banks engage in financial trading, speculation and other activities to make profits, why exactly is ultimately the public tax-payer underwriting and guaranteeing the banking system and its facilities, the elaborate supervisory systems and expenses?

Has the time come to have a new look at the issues of ‘narrow banking’ and using it as a centrepiece in any exercise of designing or reforming a financial system, as suggested in a book review article in the Journal of Economic Issues in 1994 by Andrew Cornford, the UNCTAD senior economist and expert following banking and financial market issues?

The 1988 Banking Capital Adequacy standard set an overall minimum requirement of  8% of total capital, taking account of all three kinds of risks in a banking operation: credit risk, market risk and operational risk.

The new proposed standard refines the measurement frameworks set in the 1988 accord, and sets out in some detail approaches to measure credit risk, market risk and operational risk. The approach to measuring the market risk in the 1988 accord,   using a standardised approach or an internal (to the bank) models approach, has been left unchanged, but changes are envisaged in the other two.

In relation to the measurement of credit risk and the menu of approaches (to be adopted by banking regulators), a modified version of the existing standardised approach has been set. In relation to ‘operational risks’ - the risk of direct or indirect loss resulting from inadequate or failed internal processes, peoples and systems or external events (it could range from a computer system failure to a market crash or even a natural disaster like an earthquake or other prolonged disasters in one or more major financial centres)  - the menu of approaches provide for a so-called basic indicator approach, standardised approach or an internal measurement approach.

While somewhat apparently more nuanced, the standardised approach of credit risk still calls for recourse to the ratings of external credit agencies in setting weights for credit risk.

As Cornford commented in a G-24 research paper (on the 1999 Basel Committee’s initial drafts for discussion), the track of the credit agencies, especially with regard to identifying the probability of serious threats to the debt-service capacity or defaults by sovereign borrowers has not been good enough.  They have also acted cyclically, coming up with large and swift downgrading after a crisis has broken, thus accentuating the crisis and the problems of the borrowers (as demonstrated most recently in the Asian crisis). Cornford further commented that if the announcements of credit rating agencies “simply parallel changes in market sentiment or, still worse, follow such changes, then they are capable of exacerbating fluctuations of conditions in credit market and their financial crises.”

There is also an imprecise correspondence between the minimum risk weights of a standardised approach and the allocation by banks of capital to their exposure to different borrowers and the pricing of their lending.

The new draft of the Basel Committee claims that under its proposal, some of the corporations in the developing world may get a higher rating than their governments (as sovereign borrowers).

Previously, the credit rating of any private borrower in an emerging market could not be higher than that of the country concerned.

The new draft proposals say that the standardised approach could be used by, and is available for less complex banks.

But banks with more advanced risk management capabilities, and which can meet rigorous supervisory standards, can make use of an internal-ratings-based approach. Under this, some of the key elements of credit risk, such as the probability of default of the borrower, will be estimated internally by a bank. The Committee also proposes an explicit capital charge for operational risk.

Use of a bank’s own internal risk ratings approach involves use of the ‘value at risk’ methods of assessing market risks. They may be useful and reliable in good times, but their fault lines in bad times were shown in the case of the Long-Term Capital Management (LTCM) hedge-fund (to which several leading banks had  lent heavily, and ultimately took heavy losses, which they recouped by increasing the price for their other borrowers).

The detailed consultative package sets out a number of possible options, but outside experts say that they need careful scrutiny before a judgement can be made on whether it is an improvement and what effect it will have on developing countries.

The new draft accord proposes procedures through which supervisors can ensure that each bank has sound internal processes in place to assess the adequacy of its capital and set targets for capital that are commensurate with the bank’s specific risk profile and control environment.

The overall effect of the new proposals would be that big banks, with sophisticated risk management systems, will be able to hold less capital, and thus their competitive position in the market will be strengthened  - a case of rules set to help the ‘globalization/oligopolization’ process.

Other banks, both in the industrial world and in those emerging markets where central banks follow these guidelines, would need to hold more capital.

Previously the weightage on all borrowers in emerging markets were 100%. Now, while some companies and banks in some emerging markets could get a better rating than their governments, others will find their weightage increased to 150%.

Enforcing the new rules will require more, and better trained staff for regulators.

One effect of the rules would be that in good times, banks, particularly those using their own internal credit assessment systems, would be willing to lend more. But just at the time when the markets take a downturn, and their borrowers need more consideration, the banks may tend to pull back (since otherwise their capital ratios would have to increase).

Some of the big-name private corporations in the US who only last year had very high ratings have found themselves with their credit ratings reduced.

And with a bank’s capital adequacy and credit risk based on the rating of the borrower, and the extent of a bank’s exposure to a single borrower, the pressure on a bank to cut back would increase.

Thus the banking system will act cyclically, adding to the problems and downturns of a business cycle. It will also have the effect of increasing the volatility in the financial markets (exchange, stock and bond markets) and one more element for recurring financial crises, now apparently endemic to liberalized financial  markets and systems.

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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