According to a senior UNCTAD economist, the Basle Committee's proposed new framework for capital adequacy for banks could have negative implications for developing countries and transition economies.

by Chakravarthi Raghavan

Geneva, 31 Aug 2000 -- The proposed New Capital Adequacy Framework for Banks and their credit risks, and specially its reliance on ratings by credit-rating agencies for setting risk weights may have negative implications for developing countries and transition economies, in terms of costs and availability of external financing, according to Mr. Andrew Cornford, a senior economist and specialist on finance issues at the UN Conference on Trade and Development (UNCTAD).

Analysing the proposed New Framework and commenting on some of its features, Cornford says that the proposed reliance on ratings by the credit-rating agencies in setting risk weights for banks and their capital adequacy could have negative implications both on the cost of credit for borrowers, and the possibility that fluctuations of conditions in credit markets and thus financial crises could be exacerbated.

Cornford’s views and analysis are in UNCTAD’s G-24 Discussion Paper Series (No. 3 May 2000) -- “The Basle Committee’s Proposals for Revised Capital Standards: Rationale, Design and Possible Incidence”.

The Basle Committee (representing the central banks of the G-10 countries) has published its draft proposals for the revision of the 1988 Basle Capital Accord, and in the light of comments and views it is expected to finalise the New Framework and publish them sometime next year.

Starting out as an initiative to develop more internationally uniform prudential standards for capital required for banks’ credit risks, strengthening the international banking system and promoting convergence of national capital standards, thus removing competitive inequalities among banks (of the G-10 countries), the impact of the 1988 Basle Agreement is now felt more widely and by 1999 is part of the regime of prudential regulations not only for international but also strictly domestic banks in more than 100 countries.

The original accord, not a legal document though, was designed to apply to internationally active banks of member countries of the Basle Committee on Banking Supervision, and the form of its implementation was left to national discretion. The continuing work of the Committee on various banking risks, and the main practical outcome was the amendment adopted in 1996 to cover market risk.

Though the 1988 accord, and further changes, were aimed at supervision of international banks in the G-10 countries, the Basle accord and its standards have been widely incorporated into the regimes of banking regulations of non-OECD countries, partly the result of emulation and the efforts of the Basle Committee to promote wider use of its standards. But the growing internationalization of banking and the grant of market access to foreign banks also led to the insistence of host countries on the observance of satisfactory regulatory standards in the parent or home countries.

From inception, Cornford points out, the 1988 accord was the subject of criticism over its features such as failure to make adequate allowance for the degree of reduction in risk exposure achievable through diversification, at the possibility that it would lead banks to restrict their lending, and at its arbitrary and undiscriminating calibration of certain credit risks.

In the aftermath of the East Asian crisis, other issues of special interest to developing countries also became a focus of attention— the effectiveness of the Accord in contributing to financial stability in developing countries and the incentives which the Accord was capable of providing to short-term inter-bank lending - a significant element of the volatile capital movements perceived as having contributed to the crisis.

In an eventual response, the Basle Committee proposed in June 1999 a New Framework for Capital Adequacy - incorporating three main pillars: minimum capital rules based on weights intended to be more closely connected to economic risk (than those of the 1988 Accord), supervisory review of capital adequacy in accordance with specified qualitative principles, and market discipline based on the provision of reliable and timely information.

However, says Cornford, the rules of the 1988 Accord may have a continuing practical relevance since a version modified in certain ways, such as the inclusion of more stringent criteria for short-term inter-bank loans qualifying for a low risk weight, may be included in the Basle Committee’s revised proposals - owing to disagreements expressed during the consultation process over the proposals concerning numerical standards for capital adequacy in the new Framework.

At the time of the 1988 Capital Accord, the concerns of developing countries focused more on the differences in risk weights for OECD and non-OECD countries and on their implications for the cost of external sovereign borrowing, than on the way in which the Accord’s capital standards may be incorporated into their own systems of banking regulations. For, at first the Accord appeared to be an instrument for regulation of internationally active banks of the developed countries.  The spread of capital standards based on the Accord to developing countries took some time to gather momentum.

But as the adoption of these standards have become more common, and as their purview in many countries extended beyond internationally active banks to much or all of the banking sectors, broader questions began to be raised.

One of these concerned the appropriateness of the Accord’s standards to countries with less developed banking sectors. And in the aftermath of the East Asian financial crisis, voices were also raised that the capital standards for banks might be used to raise the costs of some categories of their lending in such a way as to restrain volatile international capital movements as their source.

And as the increasingly global impact of the Basle Committee’s prudential standards have become more evident, there has been greater attention to the issue of desirability of wider participation in the formulation of these standards than one limited to the Committee’s member countries.

In the assignment of country credit risks, initially the Basle Committee had proposed a neutral approach. But in the light of comments from banks and banking associations of G-10 countries, membership of the OECD or fulfilment of certain other restrictive criteria were selected as the basis for differentiation.

Some developing countries, including some oil exporters, raised objections at that time to such differentiation. The Basle Committee itself has implicitly acknowledged that the relative ratings among countries were not always justifiable.

As the reform of banking regulation became an important item on the policy agenda of developing and transition economies in the 1990s, the appropriateness of the Basle standards to such economies has become the subject of debate. Inter alia the question has been raised whether a more stringent capital standard than the 8% ratio (of bank’s risk weighted assets) was not justified for economies more vulnerable to macroeconomic shocks and with more fragile financial sectors.

A more significant set of problems relate to the application of the Accord to developing and transition economies concerned its effectiveness in countries where financial reporting and banking supervision fell short of standards attained in the more developed countries.

Recent initiatives of the Basle Committee, including the proposed revisions of the 1988 accord, are seeking to address these. The standards for capital adequacy are an integral part of the Core Principles for Effective Banking Supervision. Supervisory review of capital adequacy in accordance with specific qualitative criteria is the ‘second pillar’ of the proposed New Framework.

There is a widely observed tendency for countries experiencing currency crises to manifest a high level of dependence on short-term borrowing, but the autonomous contribution of such borrowing to the crises is difficult to identify, says Cornford. Nevertheless, short-term borrowing sometimes becomes a major part of countries’ capital inflows well in advance of an eventual currency crisis. In the case of several East Asian countries such dependence was also accompanied by high levels of dependence on inter-bank lending. In order to restrain the destabilizing potential of such capital flows, the attribution of a risk weight to short-term interbank lending better consonant with its real risks has been part of the Basle Committee agenda for development of new proposals on capital adequacy.

“But the new proposals,” says Cornford, “do not contain other provisions specifically directed at restraining the more volatile categories of capital flow at their source”, although one of the objectives of the Basle standards for capital adequacy has been to contribute to financial stability through the standards’ effect of achieving better pricing and control of international lending by banks.

The draft New Framework proposals of the Basle Committee, have a certain tentative quality.

The proposed numerical standards for capital adequacy involve two basic approaches - one a so-called standardized approach and the second based on the banks’ own internal ratings. Under the first, two alternative options are possible for setting the capital requirements for banks’ exposures to other banks. There are also indications that difficulties over the application of the two basic approaches, raised in the consultation process, may lead to the consideration and adoption in the final proposals of a third approach - the 1988 Accord revised only in fairly minor respects.

The focus of the New Framework is credit risk, and the Basle Committee’s objective of developing explicit capital charges for other banking risks, such as operational risk and interest rate risk.

The definitions of capital in the New Framework remain unchanged from those of the original accord, as amended and clarified since 1988.

The New Framework devotes more attention than the 1988 accord to qualitative pre-requisites of banks’ capital adequacy. The supervisory review of capital adequacy and market discipline, the second and third pillars of the New Framework, fall under this heading.

The Basle Committee views the three pillars of the framework as complementary parts of a general attempt to enhance international capital adequacy framework and improve its overall effectiveness and operation.

Nevertheless, in the context of current initiatives to reform the international financial system, the lesson of much recent experience in countries with state-of-the-art bank supervision that such requirements did not provide fail-safe protection against outbreaks of instability in the banking sector.

The second pillar of the New Framework indicates that supervisory skills similar to those required for effective auditing will also be needed for implementation of other proposals of the New Framework, and such skills will have to be continuously upgraded to enable supervisors to handle changes in banks’ operations and products.

The potential of market discipline to reinforce capital regulation, depends on disclosure of reliable and timely information enabling banks’ counterparties to make well-founded risk assessments.

The introduction of more uniform regulatory standards for capital adequacy in a large number of countries is believed to have been due in part to an improvement in the market’s ability to exert pressure in this area. But the effects have varied among countries, to a significant extent owing to differences in standards of disclosure linked to both accounting and auditing practices and other dimensions of transparency.

While the apparently uncontroversial nature of the third “pillar” attracted relatively little attention at the time of the publication of the proposed New Framework, its implementation may pose particularly awkward problems in several developing countries and transition economies, and may thus prove to be a major source of difficulties during compliance assessment.

Perhaps, the most contentious proposal of the New Framework is for the use of the ratings of credit-rating agencies to set risk weights under the standardized approach, notes Cornford.

There is a widespread view that the agencies’ track record, especially with respect to identifying the probability of serious threats to the debt service capacity of, or defaults by, sovereign borrowers is not good enough to justify such reliance. While most of the expansion in the number of sovereign ratings since the Second World War has taken place since 1970s, such ratings were common in the inter-war period.  And a majority of the countries that defaulted between 1929 and 1935 had investment-grade weightings from Moody’s in 1929. The performance of the rating agencies during the Asian debt crisis shows that there was a large and swift downgrading of some of the countries affected - Thailand’s, Indonesia’s and South Korea’s - but after the crisis.

The two major concerns about the use of the agencies’ ratings are the effect such a shift would have on borrowers cost of credit at the time of adoption and the possibility that if credit rating agencies’ announcements simply parallel changes in market sentiment or, worse still, actually follow such changes, then they are capable of exacerbating fluctuations of conditions in credit markets and thus financial crises.

While the statistical evidence concerning effects of agencies’ announcements concerning credit worthiness of countries’ borrowing costs shows a strong correlation between the announcements and yield spreads, such mere correlation does not settle questions regarding the nature of the agencies’ role during fluctuations in credit conditions, Cornford points out.

“Only if the announcements of credit agencies concerning changes in credit-worthiness preceded changes in market conditions, would it seem reasonable to credit them with an effective ex-ante capacity to rate credit risk. And the results of current research provide at most rather weak support for this proposition.”

The recourse to credit agencies in setting weights for credit risk, Cornford suggests on an analysis of the evidence, may actually exacerbate fluctuations in the cost and availability of external financing for developing countries.

“This would be an unfortunate outcome in the context of the New Framework’s potential contribution to greater international financial stability, since a major part of this contribution would be in the form of improved procedures for pricing and allocating bank loans which the framework is intended to foster.”

The Basle Committee’s progression from being a source of regulatory initiatives directed at internationally active banks of its member countries to its current role as a global standards setter has also raised questions concerning its representativeness, Cornford says.

These questions are particularly understandable in relation to rules regarding capital adequacy that are a linchpin of regimes for prudential supervision.

The Basle Committee’s membership is currently still limited to agencies (regulatory bodies, ministries of finance and central banks) from 12 countries. While there have been some weighty arguments in favour of its composition and working methods, and that the Committee devotes considerable efforts to its contacts with supervisory bodies throughout the world, nevertheless they do not preclude changes in the direction of broader participation in the Committee’s work, argues Cornford.

And the beneficial effects of broader participation in the Committee’s work would not be limited to satisfying demands which are a natural concomitant of its global impact. As those parts of the banking industry and the network of financial markets outside the main industrial countries grow increasingly important, the credibility of the work of global standards setter for banking regulations in the banking sector may actually be enhanced by greater participation in the preparation of the standards.

While the Basle Committee itself has taken some steps in preparing its core principles by associating a number of outside countries, there is need for developing appropriate modalities. And expanded participation that characterized the preparation of the Core Principles should be a more general characteristic of future work of the Basle Committee, suggests Cornford.

In looking at the future, Cornford not that the various implications of long-term trends in the control and regulation of banking risks are highlighted by the proposals of the New Framework. Changes in this area are taking place at different rates in different countries. This complicates the task of global standard setting, especially with regard to the objective of a reasonable degree of uniformity, and thus contributing to a level playing field.

The changes are also increasing the skills required for banking supervision, and are leading to the introduction of new activities and operations by banks for many of which supervisory capacity, especially in most developing countries, is not yet prepared.

Appropriate policy responses to some of these changes are fairly straightforward in principle, though not necessarily easy to implement in practice.

For example, suggests Cornford, countries can license banks to engage only in activities which they have the capacity to supervise, though this is not necessarily an easy counsel. To some extent supervisors can rely on their counterparts in the country of the bank’s parent institution, but there may be limits to the extent of such reliance.  Moreover, in situations of banking crisis where infusion of capital to local institutions from foreign banking groups is regarded as essential to restructuring, countries may be in a weak bargaining position regarding the licensing of the activities which new entrants are permitted to undertake.

While in time there may be convergence in banking practices and supervisory standards, and these may attenuate these difficulties, “it is foolhardy to expect the process to be other than gradual.-SUNS4731

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

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