New Basel Capital Accord draft faces continuing concerns

by Chakravarthi Raghavan

Geneva, 28 June 2001 - - The proposals for a New Basel Capital Accord, issued in a draft form (for comments) by the Basel Committee on Banking Supervision (BCBS), but whose finalisation has now been postponed (at the instance of many leading banking establishments), continues to raise several concerns, not all of which would be easy to address within the present framework of the proposals, according to Mr. Andrew Cornford, an UNCTAD senior economist and expert following these issues.

One set of concerns, Cornford says (in a forthcoming publication), relate to the New Accord’s impact on supervisory divergences among countries, cross-border competition between banks and cooperation between national supervisors. Another, and a potential source of problems for global financial governance, is the relationship of the New Accord to ongoing exercises involving codes and standards. A third set of issues involve the possible effects of the New Accord on banking operations, in particular on regulatory arbitrage, and on economic activity and international capital flows.

The BCBS had issued the new proposals - a 9-part, 500-page consultative document on capital standards - and had invited comments, in the light of which it had planned to finalise the document. The Committee announced last week that it was modifying the original time-tables for completion of its work and implementation of the new accord - with complete and fully specified proposals to be issued in early 2002 and to be finalised during 2002, and for the new accord to be made effective in 2005.

While the ostensible reason for extending the time-table has been the large number of comments, and very detailed ones, some of the complexities and the concerns of several banking institutions that it may require quick injections of new capital to cover risks is also viewed as an element.

In comments on the draft proposals finalised before the extension of the deadline, Mr. Cornford notes that the scale and duration of the process of consultations on the document reflect partly the increasing complexity of banking operations but also the role of the BCBS as the institution responsible for globally applicable standards for banking regulation and supervision.

When the original Basel accord was issued in 1988, no such role was assumed: the Accord was directed at the internationally active banks of the BCBS member countries. But during the decade since issuing the original accord, its application has been extended much more widely to other jurisdictions and banks - partly due to the closely parallel regulatory activities of the EEC/EU, and the BCBS’s own proselytizing of other supervisory groups and the internationalization of banking itself, since the granting of market access to foreign banks has become widely conditional on the standards of the regulatory regimes in their home countries - standards for which the rules enunciated by the BCBS are accepted as a model.

Even among developed countries, the range of sophistication of banking firms is wide and this applies a fortiori to the international economy as a whole. The number of issues that the BCBS has to confront has thus become correspondingly greater, and the consultation process more inclusive and lengthy.

The 1988 accord, whose basic objectives were strengthening the international banking system and promote convergence of national capital standards, thus removing competitive inequalities among banks resulting from differences on this front. The key features of the 1988 accord were a common measure of qualifying capital, a common framework for valuation of bank assets in accordance with associated credit risks, and a minimum level of capital determined by a ratio of 8% of qualifying capital to aggregate risk-weighted assets.

Subsequently, a series of amendments and interpretations were issued to various parts of the Accord ; and in 1996, the BCBS adopted an amendment covering market risk. However, the 1988 Accord lacked explicit provisions for capital to cover banks’ interest rate risks not included under the heading market risk and their operational risks.

>From inception, the Accord was subject to criticism that increased over time.  Three points were particularly prominent in the criticisms: the failure to make adequate allowance for the degree of reduction in risk exposure achievable by diversification; the possibility that the Accord would lead banks to restrict their lending, particularly if new capital requirements are introduced in deflationary conditions and downward pressure on their profits; and the arbitrary and undiscriminating calibration of credit risks.

This last led to regulatory arbitrage resulting from misalignments between regulatory rules and economic incentives - with banks tempted to take advantage of the opportunities and increase holdings of higher-yielding but also higher-risk assets for a given level of regulatory capital. Other features of the Accord, exploited for regulatory arbitrage, were the possibilities that the Accord offered for reducing regulatory capital through rolling over loans to banks in non-OECD countries to avoid maturities exceeding one year.

The financial crises of the 1990s drew attention to the ineffectiveness of the 1988 Basel Accord on its own as an instrument for achieving banking stability and the incentives it provided to categories of lending generally believed to have contribute to the financial vulnerability of the countries - issues where the concerns regarding, and concerns of developing countries received much greater prominence.

The different elements of regulatory frameworks for banking depended on quality of supervisory implementation and the extent to which the standards of the framework were incorporated into the norms of the operations and management of the banking sector. These were crucially linked to financial reporting and accounting practices (items classified under ‘transparency’) on which supervisors, lenders and investors rely. But the financial crises of the 1990s in the emerging markets underlined the importance of these factors with a vengeance. In some of the countries affected, for example, capital standards based on the model of the 1988 Basel Accord had been or were being introduced, but provided little protection to the banking systems owing to poor accounting standards and weak supervision.

The 1997 Core Principles for Effective Banking Supervision were intended to be a remedy for such supervisory weaknesses, but there is a widespread belief that supervisory prerequisites for effective capital regulation should be an explicit part of international initiatives, as also of the need for more explicit recognition of the role of ‘transparency’.

The crises in emerging markets is often related to the tendency of countries to have a high level of dependence on short-term borrowing. Sometimes, short-term borrowing became a major part of the capital inflows of countries, well in advance of an eventual crisis. In several Asian countries such dependence was accompanied by high levels of dependence on interbank lending.

It is generally assumed that short-term and interbank borrowing are connected, much of it driven by interest rate arbitrage. Thus, attribution of a risk weight to short-term international interbank lending better consonant with its real risks have become part of the agenda of reform of the 1988 Basel accord in order to restrain the destabilizing potentials of such lending - as well as reduce opportunities for regulatory arbitrage through manipulation of its maturity classification.

There is a widespread view among developing countries, notes Cornford, that the regulatory regime for capital of banks should be capable of making a contribution to the stability of capital flows which goes beyond improved risk weights for international interbank lending. One of the major proposals along these lines is that supervisors in major countries should vary the capital requirements on banks’ international lending in response to changes in the risk of different borrowers. Much of the BCBS’s document, “A New Capital Adequacy Framework” was drafted with a broad brush. Many of its proposals are clearly tentative. Where more concrete or precise, it did not generally depart from the approach of the 1988 Accord, though its amendments are extensive and many new options have been broached. The objectives of the old Accord have been restated, but the proposed New Framework has accepted that while its focus should be internationally active banks, its underlying principles should be suitable for application to banks of varying levels of complexity and sophistication.

This explicitly acknowledges the BCBS’s expanded role as a global standard setter.

The scope of application of the proposed new Framework is to be extended, from banks on a consolidated basis including subsidiaries to holding companies that are parents of banking groups. And the revised accord will be applied on a sub-consolidated basis to all internationally active banks below the top level of the banking group; and supervisors are to ensure that each bank within the group is adequately capitalized.

The definition of capital remains unchanged in the proposed New Framework. The objectives of the revised accord include that it should at least maintain the current overall level of capital in the system. This implies that new and more explicit capital charges for operational risk and interest rate risk should on average be expected to offset any reductions due to changes in credit risk requirements.

On the treatment of different categories of exposure, the proposed New Framework envisages two approaches: a standardised and an internal ratings-based (IRB) approach. The first is intended for use by less sophisticated banks, an amended approach to that used in the 1988 Accord. The second reflects an acknowledgement of the innovations by banks in their measurement and control of credit risk since 1988, but falls short of allowing banks to deploy their own internal methods of risk to set their capital changes.

Much of the banking industry would clearly like to move in the direction of setting capital charges for credit risk based on the banks’ own internal models.  But the BCBS is unwilling to accept such an approach. The proposed New Framework has come out in favour of an internal ratings-based (IRB) approach involving ‘risk buckets’ - with particular categories of exposure assigned a risk weight, as in the 1988 accord, but through a mapping from exposures to risk weights based wholly or partly on banks’ own estimates of risk.

By far the most controversial idea in the proposed New Framework is the recourse to external credit assessment institutions (ECAIs). One common reaction among those attempting to predict the impact on developing countries, has been to identify likely beneficiaries and losers among countries as a result of risk weights based on ratings of agencies about sovereign risk. A second criticism on recourse to ECAI ratings is the pro-cyclicality of ratings of major agencies.

A widespread concern among developing countries is that if the announcements of agencies simply parallel changes in market sentiment or, worse, follow such changes, recourse to ratings for setting risk weights for capital standards might exacerbate the instability of bank lending.

Another point of major concern to developing countries is over the coverage of major agencies’ ratings. In India, for example, in early 1999, out of 9640 borrowers enjoying fund-based working capital facilities from banks only 300 had been rated by any of the major agencies. This has led to calls for more attention to the possibility of recourse to ratings of domestic agencies.

The basic structure of the 2001 consultative document for the proposed New Framework follows that of the June 1999 proposals. However, despite the details, the proposed New Framework still contains many loose ends on which further work is projected for final revision.

The proposed framework is based on three pillars: numerical standards with a number of alternative options; treatment of supervisory review based on four principles, with a check-list of policies and actions required for their fulfilment; and a wide ranging list of subjects to be covered by the disclosure requirements - including a bank’s capital, accounting policies, risk exposures and risk management.

In its background remarks, the BCBS has referred to problems related to transparency and effectiveness - and one of these concerns proprietary information which, if disclosed might reduce the value of banks’ investments in certain areas or undermine its competitive position. The BCBS itself has noted that during the consultation process, respondents pointed out that release of too much information could blur the key signals in the market. And the recent financial history of developed countries, points out Cornford, provides many examples of limits of transparency in preventing financial instability.

Cornford says that the documents set out in the proposed New Basel Accord are impressive in scope of coverage, despite the still provisional or unfinished character of parts of the blueprint. Yet the proposals also raise several concerns, not all of which will be easy to address within the present framework of the proposals.

One set of concerns relate to the proposed New Accord’s impact on supervisory divergences among countries, cross-border competition among banks and cooperation between national supervisors. Another potential source of problems for global financial governance is the relation of the New Accord to ongoing exercises involving codes and standards. And a further set of issues involve the possible effects of the New Accord on banking operations, in particular on regulatory arbitrage, and on economic activity and international capital flows.

The BCBS now finds itself in the role of global standard setter for banks. The proposals for the New Accord have been crafted to accommodate banks of very different levels of sophistication.

“Yet the effort to achieve this aim may compromise in ways difficult to predict the New Accord’s basic objective of enhancing competitive equality by actually creating regulatory divergences in some areas of banking practice and both within and between different countries.

“To the extent that the outcome is a multi-track regime for prudential capital internationally, characterized by significant differences among countries in the sophistication of supervision, the difficulties of achieving effective cross-border cooperation amongst supervisors are likely to increase.

“These difficulties are capable of spilling over into areas of supervisory cooperation other than prudential capital requirements such as information sharing and mutual recognition of regulatory standards.”

The proposed New Accord poses new problems in the context of implementation of key standards for financial systems. In practice, the proposed New Accord is likely to provide the framework for setting levels of capital adequacy for all banks, and in this role have an integral connection to key standards for the financial systems. This may result in administrative burdens for developing countries: not only will supervisors in these countries face a substantial increase in the complexity of their primary responsibilities as a result of the proposed New Accord, but they will also have to cope with the additional administrative burden due to its incorporation in assessment exercises regarding compliance with key standards.

The link between the proposed New Accord and key standards for financial systems also implies that implementation will become a subject of IMF Article IV surveillance, and part of the conditionality associated with the IMF’s Contingency Credit Line (CCL) facility.

A major objective of the proposed New Accord is the reduction of regulatory arbitrage due to the banks’ pursuit of economic incentives within a framework of regulatory rules, leading to outcomes at variance with the objectives of the framework.

“However, the very comprehensiveness and detailed character of the rules of the New Accord will almost inevitably be a source of new opportunities for regulatory arbitrage. It is difficult to visualise how this could be avoided, but regulatory arbitrage is likely in future to be a source of continuing pressures for further amendments to the proposed New Accord.”

The proposed risks weights of the IRB approach are capable of leading to substantial rises in interest rates for lending to borrowers with low credit ratings, both within countries and internationally - an issue of concern to several developing countries.

While the effects may not be as drastic as in hypothetical examples (for those with ratings below investment grade), they could impose what may be regarded as excessively restrictive limits on the access to international borrowing of certain countries. As a result, consideration may need to be given to ceilings for risk weights even under the IRB approach, suggests Cornford.

More generally, the risk weights proposed in the proposed New Accord are capable of contributing to the procyclical character of bank lending, both within countries and across borders. Lending cycles connected to pro- cyclical credit risk are a long standing feature of business cycles and of economic instability.

And the danger on the regulatory front comes from prudential rules which translate higher credit risks in more difficult times into increased capital requirements, and thus more restrictive lending policies. Prudential rules to minimise such dangers can be sketched, says Cornford, but would nonetheless be difficult to incorporate in the actual design of regulatory systems.

An approach to this problem could be based on the principle of setting aside reserves in goods times to meet exigencies of harder ones. In practice, this might involve various alternatives.

One would be for supervisors to prescribe average levels of capital for banks significantly in excess of minimum levels - insisting on higher levels during periods of buoyant economic activity and bank profits, and permitting lower levels in recession. Another would be to establish guidelines for appropriate levels of general provisions of banks, to include provisions designed to cushion the impact of macro-economic fluctuations.

It is possible to visualise supervisory guidelines to achieve in a rough-and-ready way objectives of the first alternative, though it would have to confront the difficulty that the duration and intensity of economic fluctuations are hard to forecast. Hence, setting of appropriate variable levels of capital would only be approximate.

The second alternative too would face the same problems, but has the potential to provoke a more fundamental rethinking of the rationale and design of prudential capital requirements in this area by reopening questions about the appropriate relations between capital and provisioning, on the one hand, and expected and unexpected loan losses, on the other.

The approach of the BCBS has been to aggregate expected and unexpected losses, under the headings of credit and operational risks for the purpose of setting capital requirements.

Eventual modification of this can be envisaged in principle, and one reason might be an eventually perceived need to mitigate the procyclical effects of variations in capital requirements of banks, adds Cornford. – SUNS4927

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

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