BIS study confirms some perceptions of Basle accord

by Chakravarthi Raghavan

Geneva, 28 May -- The pressures on banks to increase their capital to meet the minimum capital requirements under the Basle accord may have resulted in banks cutting their bank lending in cases where it would be too costly to raise new capital, according to a working paper of the Basle Committee on Banking Supervision.

The paper, 'Capital Requirements and Bank Behaviour: The Impact of the Basle Accord," has been prepared by a working group of the Basle Committee whose secretariat is at the Basle Bank of International Settlements, and in general appears to bear out some of the perceptions of analysts about the outcome of the Basle Committee requirements in the financial crisis.

The working group considered two major questions:

* firstly, whether the adoption of fixed minimum capital requirements led some banks to maintain higher capital ratios than would otherwise have been the case and whether any increase in ratios was achieved by increasing capital or reducing lending;

* secondly, whether the fixed capital requirements have in fact been successful in limiting risk-taking by the banks relative to capital as intended, or whether banks have been able to take actions to reduce their effectiveness either by shifting to riskier assets within the same weighting band or through capital arbitrage.

The 1988 Basle Accord for common capital requirements has been adopted by the G-10 countries, and is now being implemented in some 100 countries around the world.

More recently, in the wake of the nearly 24-month old crisis in financial markets, the adoption and implementation of the Basle accord by developing countries is being promoted (by institutions other than the BIS itself) as a panacea for the problems faced by liberalization of financial services and markets.

In formulating the Basle standards, and promoting its adoption in not only G-10 countries, but in the developing and transition economies, the Basle Committee thought that the framework would help to strengthen the soundness and stability of the international banking system by encouraging international banking organisations to boost their capital positions. The Committee also believed that a standard approach applied to internationally active banks in different countries would reduce competitive inequalities.

The framework, Importantly, the framework established a structure that was intended to make regulatory capital more sensitive to differences in risk profiles among banking organisations; take off-balance-sheet exposures explicitly into account in assessing capital adequacy; and lower the disincentives to holding liquid, low risk assets.

Have these objectives been achieved?

As a preliminary to amending the Basle accord itself, a Working Party on Bank and Behaviour was set up to examine the empirical evidence suggests that the outcome is mixed.

The Working Party also considered whether the introduction of fixed minimum capital requirements had unintended side effects, apart from encouraging capital arbitrage activity.

Some have suggested that in some periods, banks may be constrained by the capital requirements from increasing lending or may have to reduce lending, thereby causing a credit crunch and affecting the real economy. Another potential side effect is that the introduction of capital requirements for banks may have reduced their competitiveness in relation to other forms of intermediation.

According to the working paper, the overall message from the empirical literature and the data is that, at least initially, the introduction of formal minimum capital requirements across the G-10 appears to have induced relatively weakly capitalised institutions to maintain higher capital ratios. However, there is also some evidence that bank capital pressures during recent cyclical downturns in the U.S. and Japan may have limited bank lending in those periods and contributed to economic weakness in some macroeconomic sectors.

But these effects may have reflected both regulatory and market pressure on banks to maintain ratios at least as high as the minimum.

A common structure of formal regulatory capital requirements across countries may have enabled financial markets to exert greater market discipline on under-capitalised banks than would otherwise have been the case. However, over time the banks have learnt how to exploit the broad brush nature of the requirements - in particular the limited relationship between actual risk and the regulatory capital charge.

For some banks, this has probably started to undermine the meaningfulness of the requirements, the working paper says.

Data on the capital ratios of G-10 banks indicate that the introduction of the Basle Accord was followed by an increase in risk-weighted capital ratios in a number of countries.

The average ratio of capital to risk-weighted assets of major banks in the G-10 rose from 9.3% in 1988 to 11.2% in 1996. But it is hard to say whether these increases reflected the direct effects of the Basle Accord, as opposed to increased market discipline, since the introduction of consistent standards for bank capital probably worked to increase transparency and improves the market's ability to exert pressure.

But several studies of the experience in the US and elsewhere, both pre- and post-Accord, suggest that firmly applied capital standards induce weakly capitalised banks to rebuild their capital ratios in various ways more rapidly than otherwise.

As for the reactions of the banks to the regulatory constraints on their capital ratios, the working paper says that the research is consistent with the view that banks respond to capital ratio pressures in the manner they believe to be most cost effective. Raising new capital or boosting retained earnings may be easier in booms whereas cutting back loan books may be more cost effective in economic troughs.

Similarly capital structure decisions by banks may well be sensitive to the higher cost of Tier 1 capital (mainly equity) relative to Tier 2 capital (mainly debt instruments of a long- term character and with ranking in bankruptcy proceedings).

When the cost of raising Tier 1 capital is prohibitive, banks may attempt to meet capital requirements, where possible, through issuance of Tier 2 capital. Nonetheless in some countries banks have a richer mix of equity relative to Tier 2 than the capital regulations would require, probably because of market pressure.

Available research suggests that, in order to meet minimum capital requirements, banks are likely to cut back tending when it would be too costly to raise new capital.

There have been suggestions that capital requirements applied uniformly across a broad class of assets may induce banks to substitute towards the riskier assets in the class, leading in some cases to an overall rise in the riskiness of the bank's portfolio.

The report of the working group says that the broad nature of the Basle Accord risk classes does give considerable scope for substitution between more and less risky assets. But because of the difficulties in measuring bank risk-taking with available data, the very limited academic literature in this area is inconclusive.

There have also been criticism that banks have artificially boosted their capital ratios by engaging in capital arbitrage.

The working paper says that the broad risk asset classes in the Basle Accord have undoubtedly created a gap between the economic capital which banks feel they should be holding to back some loans and the regulatory capital they have to hold.

Increasingly, innovations in the market have enabled banks from a variety of countries to make use of techniques to effectively arbitrage between these two amounts -- increasing bank risk relative to minimum capital levels. One technique used is securitisation, though other factors too may be involved in use of this instrument.

The volume of securitisation is substantial. At March 1998, outstanding non-mortgage securitisations by the ten largest US bank holding companies amounted to around $200 billion (more than 25%, on average, of the risk-weighted loans of the banks). European banks have also been using the US markets for securitisations and there is also evidence that securitisations performed outside the US have been growing exponentially.

New structured finance in Europe (bank and nonbank) is estimated to have increased from $8.5 billion in 1995 to more than $41 billion in 1997. Overall, with increasing sophistication of the banks and the development of new innovative techniques in the market, the largest banks have started to find ways of avoiding the limitation which fixed capital requirements place on their risk-taking relative to their capital. "For certain banks, this is undoubtedly starting to undermine the comparability and even the meaningfulness of the capital ratios maintained."

And available evidence suggests that the volume of regulatory capital arbitrage is large and growing rapidly, especially among the largest banks. Securitisation is motive by a number of factors, including taking advantage of increased economies of scale, reduced costs of debt financing, and better diversification of funding sources.

"But there are also indications that in many cases the effect is to increase a bank's apparent capital ratio relative to the riskiness of its actual book - making the ratios more difficult to interpret and in some cases less meaningful."

Are the fixed minimum capital requirements creating credit crunches affecting the real economy?

It is likely to be the case, says the paper, that in some periods banks in a particular country may find it difficult to maintain the fixed minimum capital requirements and therefore may be forced to cut back lending. It would in fact be strange if fixed minimum capital requirements did not bite in some periods, thereby constraining the banks, given that the purpose of bank requirements is to limit the amount of risk that can be taken relative to capital. However, for this to have an effect on output, it would have to be true that any shortfall in bank lending was not fully made up through lending by other intermediaries or by access to securities markets.

There is evidence that banks play a special role in financial markets, particularly in their lending to smaller companies, and that it may be difficult for such borrowers to find alternative sources of funding .

For the US, there is some indication that particular sectors such as real estate or small companies, may have been affected by pressure on bank capital in the early 1990s. Currently, the weakness of the Japanese banks may be contributing to the weakness of the economy but more evidence is needed to assess this effect.

On the question whether the Basle accord has levelled the playing field between banks internationally, the working paper notes that differences between capital ratios of internationally active banks across different countries may reflect competitive issues such as the perceived magnitude of the safety net or other issues such as nature of the activity carried out by banks in a particular country.

No firm conclusions could be drawn from the studies. Empirical studies have tried to test this directly by looking at the stock market reaction to announcements of the introduction of requirements. This evidence is generally mixed and does not indicate an overwhelming reaction one way or other regarding the expected effect on profitability.

Also, other important differences need to be borne in mind such as the cost of capital and the perceived magnitude of the safety net, the working paper adds. (SUNS4444)

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

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