Higher bank capital requirements on the way

A new capital adequacy framework for banks is in the pipeline which seeks to better align capital charges to the lending institutions' underlying risk profile. The proposed new requirements are being drawn up in the wake of the recent turmoil in financial markets that brought to light the inadequacies of the existing Basle standards.

by Chakravarthi Raghavan

GENEVA: A consultative document on a new capital adequacy framework for banks, made public on 3 June by the Basle Committee on Banking Supervision, suggests that when it is finalized and made effective, banks would face an increase in their capital adequacy requirements in relation to sovereign risk loans and collaterals.

The Committee has sought comments from all interested parties by 31 March 2000. In the light of these, the proposals will be finalized and a decision taken as to when the framework should be made effective.

While the Basle Committee's jurisdiction is over the G-10 banks, the standards are now being applied in over 100 countries.

While a critical assessment of the proposals requires study of the detailed document (only a press release was available at time of writing) and comparison with the existing Basle standards, the press release issued by the Bank for International Settlements suggests that the supervisors have resisted demands from the private sector for loosening some requirements, such as lowering the weighting on mortgage loans to commercial real estate, and plan to tighten others.

One area of some controversy among the G-10 countries not touched in the proposals relates to the idea aired publicly by the US Federal Reserve Chairman, Alan Greenspan, for higher capital ratios for inter-bank lending.

Three essential pillars

The chairman of the Basle Committee, New York Federal Reserve President and Chief Executive Officer William McDonough, who introduced the new paper, said the three elements of the proposed new capital framework are:

  • minimum capital requirements - which seek to develop and expand on the standardized rules set in the 1988 Basle Accord;

  • supervisory review of an institution's capital adequacy and internal assessment process, and

  • effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices.

Taken together, McDonough said, these three elements are essential pillars of an effective capital framework.

The Basle standards have been the cornerstone of the international financial architecture, but the recent crisis on the financial markets has shown up their inadequacies in the face of the ability of the private-sector banks to get around rules through use of the vast array of new financial instruments .

In the proposals for minimum capital requirements, the Basle Committee wants to revise the current approach so as to align capital charges better to underlying risks.

For sovereign risks (loans to governments of countries), the Committee proposes to replace the existing approach with a system that would use external credit assessments for determining risk weights.

Such an approach is intended also to apply, either directly or indirectly and to varying degrees, to the risk weighting of exposure to banks, securities firms and corporate loans.

The Committee says this will result in reducing risk weights for high- quality corporate credits and introduce higher-than-100% risk weights for certain low-quality exposures.

A new risk-weighting scheme to address asset securitization is also proposed, as is the application of a 20% credit conversion factor for certain types of short-term commitments.

In regard to mortgages on commercial real estate, the Committee has decided that in principle such loans do not justify other than a 100% weighting of the loans secured.

The appropriate capital treatment of various types of assets, including those secured by commercial real estate, will continue to be reviewed by the Committee during the consultative period and after it has received comments.

The BIS press release says the Committee recognized that for some types of transactions, the 1988 Accord does not provide proper incentives for credit risk mitigation techniques.

For example, there is only minimal capital relief for collateral, and in some cases, the Accord's structure may not have favoured the development of specific forms of credit risk mitigation by placing restrictions on both the types of hedges acceptable for achieving capital reduction and the amount of capital relief.

The Committee is seeking to devise a more sound and consistent approach for capital treatment of credit risk mitigation techniques, including proposals for expanding the scope for eligible collateral guarantees and on-balance-sheet netting.

The Committee's proposals are intended to provide a basis for a standardized approach to set capital charges at the majority of banks. The Committee recognizes that for some banks, internal credit ratings could become a viable basis for regulatory capital requirements, subject to supervisory approval and adherence to quantitative and qualitative standards. The Committee also plans to develop an approach to regulatory capital based on the internal ratings of banks.

As for use of portfolio credit risk models to set regulatory capital requirements, the Basle Committee has suggested continued development of such models and their use.

Expanding coverage of risk

The Committee is also planning expanded coverage of the Accord to incorporate other major categories of risk - such as market risk, interest rate risk and other risks such as operational risk. The original Accord focused mainly on credit risk, but the growing significance of these other risks has led the Committee to conclude that they are too important not to be treated separately within the capital framework.

The Committee plans to develop a new capital charge for interest rate risk in the banking book for banks where the interest rate risk is significantly above average. It also proposes to develop an explicit capital charge for other risks, principally operational risk, and the practical ways this could be done.

It is also planned to extend the proposal to holding companies that are parents of banking groups.

As for supervisory review of capital adequacy, it is proposed that such review would seek to ensure that a bank's capital position and strategy is consistent with its overall risk profile and strategy, and encourage early supervisory intervention if the capital does not provide a sufficient buffer against risk.

The report notes that supervisors should have the ability to require banks to hold capital in excess of minimum regulatory capital ratios. This point has been underscored in the Committee's discussions with supervisors from emerging markets.

The new framework also stresses the importance of bank managements developing an internal capital assessment process and setting targets for capital that are commensurate with the bank's specific risk profile and control environment, with this process being then subjected to supervisory review and intervention where appropriate.

Supervisors, says the Committee, have a strong interest in facilitating effective market discipline as a lever to strengthen the safety and soundness of the banking system.

Effective market discipline requires reliable and timely information that enables market participants to make well- founded risk assessments.

Market operators want supervisors to publish all the details and reports arising out of their supervision, but there is some understandable resistance from supervisors to publish their own "assessments" which, by their very nature, are "subjective".

The Committee plans to issue more detailed guidance on the disclosure of capital structure, risk exposures and capital adequacy later this year. (Third World Economics No. 212, 1-15 July 1999)

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

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