New Basel Accord draft raises concerns over unfair competition

Developing countries have expressed concern that proposals being mooted for a new Basel Capital Accord on banking supervision would, if implemented, pose substantial new complications for national supervisory regimes besides allowing large foreign banks to undercut their domestic competitors in the developing world.

by Chakravathi Raghavan

GENEVA: Proposals from the Basel Committee for a new Basel Capital Accord on banking supervision, when implemented, would impose substantial additional costs in developing countries, while the multi-track approach envisaged of some banks adopting the internal-ratings based (IRB) approach and others the current standard approach may result in unfair competition between the big foreign banks and domestic ones in developing countries.

The major international banks, based in the G-10 countries, which will be able to use the IRB approach will need a lower level of minimum capital requirement than under the standard approach that requires 8% of qualifying capital to aggregate risk-weighted assets.

This would mean that for banks following the standard approach, the cost of capital for doing business would be higher than that of the foreign banks, which are basically supervised for their global operations by the home countries but which would be able to operate in the host countries at a lower cost and greater profit and undercut their domestic competitors.

The effects of the takeover or dominance of the banking and financial services sector by foreign banks (whether they come in as a result of commitments undertaken by countries under the WTO’s General Agreement on Trade in Services or via other routes, such as foreign direct investment), and their tendency to neglect domestic small and medium enterprises and concentrate on big enterprises, more so foreign enterprises, have been brought home by the Argentine crisis.

The other aspects of banking and financial services supervision, the removal of the old ‘firewalls’ separating banking and non-banking activities, and the use by banks of derivatives and other instruments for non-banking activities (and ‘shielding’ them), have been brought home even more vividly in the burgeoning Enron scandals, where some leading Wall Street banks have found themselves involved in deals and counter-party trade deals where there have been conflicts of interest and even, in effect, one side of the enterprise suing another!


The concerns in developing countries over both the costs of implementation of the new Basel Accord and the prospects of unfair competition have emerged in comments received by the Basel Committee from developing countries, including market participants.

This unprecedented level of open consultations is unlike the practices of the Bretton Woods institutions but is one that the latter, in particular the IMF, could do well to emulate in line with the principles of Good Governance which they promote everywhere excepting within themselves.

The Basel Committee of BIS-area central banks, which started the consultation process for revising the original Accord, has enabled participants to post their views and comments on the BIS (Bank for International Settlements) website for others to take note of and comment in turn. This is enabling not only BIS-area participants, but also those from developing countries and others, to offer their own comments and views to influence the outcome.

The Committee in December announced that it was delaying the completion of the consultation process, and had decided to undertake an additional review process and not to set or announce at this time any revised schedule for completion or implementation of the new Accord. Initially, the finalization of the new Accord had been set for 2002, with the member countries of the BIS to implement the new Accord in 2005.

The Basel Committee’s proposals for revision were published in June 1999, followed (in the light of views) by the second consultative document, a 9-part, 500-page document issued in January 2001.

According to Andrew Cornford, a senior economist at the United Nations Conference on Trade and Development (UNCTAD) who tracks these issues, the comments come not only from the banks and market participants in the BIS area; a large number of comments have come from developing countries - raising various issues including the burden of implementation and the need for a longer phase-in, as well as the prospect of unfair competition that may arise with foreign entities in these countries following the IRB approach and the others following a standardized approach.

The very extensive comments both from developing and developed countries, and market participants have led the Committee to undertake an additional review to assess the overall impact of the new Accord on banks and the banking system before releasing its next consultative paper.

The Committee now plans to specify a complete version of its proposals in draft form, including on aspects like asset securitization and specialized lending where there is now an ongoing dialogue with market participants. After preparing a complete version, the Committee is to undertake a full impact assessment and incorporate these results. It will then release the draft proposals for a formal consultation period, inviting all interested parties to comment on the proposals. The new Accord is to be finalized thereafter. The Committee still hopes to do this in 2002, and give time to governments to implement it in 2005.

In an assessment of the earlier versions of the paper (issued as UNCTAD Discussion Paper No. 156 in September 2001), Cornford had raised several issues of concern, particularly for developing countries. These related to the new Accord’s impact on supervisory divergence among countries, cross-border competition between banks and cooperation between national supervisors. While crafted to accommodate banks at different levels of sophistication, Cornford had pointed out, it may compromise the basic objective of enhancing competitive equality by actually creating regulatory divergences in some areas of banking practice, both within and across countries. This might well increase difficulties of achieving effective cross-border cooperation among supervisors.

Also of concern was the relationship of the new Accord with the ongoing exercise of evolving codes and standards, with the new Accord representing a quantum increase in the complexity of supervisors’ responsibilities in most countries. The administrative burden will be aggravated by the incorporation of assessment exercises regarding compliance with key standards, and the prospect that this may become a part of the IMF’s Art. IV surveillance and a conditionality.

Another set of issues related to the possible effects on regulatory arbitrage.

Developing-country reactions

In a new note analyzing the reactions of developing countries to the proposals and focussing on the substance of the comments (rather than the source), Cornford points out that a recurring theme in comments from developing countries has been the likely impact on supervisory regimes for banks and on banks’ management and internal controls. Related to these have been comments on the extent to which the new Accord would achieve the objective of a more internationally uniform supervisory regime - a “level playing field.”

Another set of reactions relates to how the standardized and IRB approaches would be applied to developing countries, the treatment of expected and unexpected losses, and the possible alternatives.

Many comments from developing countries suggest that the new Accord would increase considerably the complexity of responsibilities for both supervisors and banks, involving additional costs, and there is hence a need for a more gradual phasing-in of implementation than currently envisaged.

The implementation of the IRB approach, in particular, is likely to create special problems, more so for banks not considered as belonging among the “internationally active” banks. These may lack the historical data needed for an IRB approach, a problem much greater and more widespread in the developing than in the developed world. The regulatory discretion provided for in the new Accord may also result in national divergences in supervisory implementation.

This may lead to problems to supervisors in host countries where most domestic banks will be using the standardized approach to credit risk but foreign entities the IRB approach. This will complicate not only domestic supervision but also cross-border supervisory cooperation.

Where foreign banks use the IRB approach and the domestic banks the standardized approach, there could be significant cost advantage to the foreign banks, owing to their lower capital charges. This will lead to charges from domestic banks of unfair competition from foreign banks.

Several other comments, Cornford says, relate to more general issues raised by the new Accord, though some of these are linked to more specific features such as the recourse to the ratings of credit rating agencies under the standardized approach to credit risk and the lack of necessary historical data for the IRB approach.

There is widespread recognition of the advantages to banks of the IRB approach but this is combined with the belief that its introduction would generally be more difficult in developing than in developed countries owing to weaker managerial and supervisory capacity and lesser availability of necessary historical data in the former.

This has given rise to the suggestion that there should be a relaxation of the requirement that a banking group using the “foundation” IRB approach for some exposures must adopt it across all exposure classes and across all significant business units (groups, subsidiaries and branches) within a reasonably short period. Instead, it is proposed, national supervisors should be allowed to approve a more selective application of the “foundation” IRB approach, segments not covered being subject to the standardized approach.

Many comments are critical of the aggregation in the new Accord of expected and unexpected losses as well as of the way in which part, but typically not all, of loan-loss provisions are included in regulatory capital. This reflects a preference for treating expected losses as a cost of doing business to be covered by provisions, while requiring capital for unexpected losses.

However, it is pointed out that the eligibility of only part of provisions for inclusion in regulatory capital could act as a disincentive to banks to carry adequate provisions; and the lack of guidelines in the new Accord on provisioning could blur the process of attributing provisions to prospective future loan losses, with the result that some of banks’ credit risks may be covered both by regulatory capital and by provisions not recognized as being part of such capital (so-called “double counting”).

Concerns about the treatment of expected and unexpected losses are accompanied by requests not only for clearer guidelines on this subject but also for national supervisory discretion regarding their application, as well as by some more specific suggestions concerning ways to give greater recognition to provisions for loan losses.

Some countries have also made the point that inadequate provisioning by banks could contribute to pro-cyclicality in their lending since the substantially increased provisions which can result from deteriorations in loan quality in cyclical downturns can lead to greater restrictiveness regarding new lending.

Setting risk weights

Another important potential source of more pro-cyclical bank lending which might result from the new Accord is the reliance on the ratings of credit rating agencies in setting risk weights under the standardized approach to credit risk.

This is one of a number of reservations expressed about reliance on credit rating agencies. Others concern the limited coverage of the ratings of existing agencies, the difficulty of establishing guidelines that would assure the high quality of agencies and thus the closely related incentives provided by the new Accord for the emergence of new, less reliable agencies, and the likelihood of use of unsolicited credit ratings (whose value is questioned by several developing countries).

Such reservations have led some countries to suggest that a different way of setting risk weights under the standardized approach to credit risk is needed since dependence on credit rating agencies would otherwise be an unsatisfactory feature of the approach likely to be widely adopted in developing countries.

India has made a detailed suggestion as to what this alternative might involve: under its proposed simplified standardized approach for banks “not internationally active”, risk weights in the range of 20% to 150% would be attributed to different exposures on the basis of banks’ internal ratings, which would be derived from a mapping of such ratings to benchmark probabilities of default estimated by supervisors on the basis of pooled data for selected banks.

The Indian proposal combines elements of the standardized and IRB approaches to credit risk. Its thrust seems similar to that of a proposal of some Latin American countries for the development of a “standard IRB” which would adapt the theoretical framework of the new Accord’s IRB approach to data available in a particular jurisdiction, using methodology and parameters provided by local supervisors.

Several of the comments concern the risk weights under the standardized and IRB approaches. In terms of the standardized approach, attention is drawn to what continues to be perceived as its failure to take adequate account of the effect of diversification in reducing banks’ credit risks. There is also criticism of the calibration of the risk weights of the standardized approach as being insufficiently discriminating and as being asymmetric in part of its range.

Most of the more specific suggestions refer to ratings below that of BBB+ (in the illustrative notation of Standard and Poor’s). In the case of loans to sovereign borrowers, for example, there is a suggestion for an intermediate risk weight between 50% and 100% for borrowers rated between BB+ and BB-. In the case of loans to corporations, the attribution of a single risk weight of 100% for those rated between BBB+ and BB- is viewed in some comments as insufficiently discriminating between the categories of “investment” and “non-investment” grade and as thus requiring adjustment.

Several comments also draw attention to the perverse incentives under the standardized approach for borrowers to avoid being rated since the risk weight for unrated entities is less than for entities with low credit ratings.

A number of comments on the standardized approach are directed at the preferential risk weight for claims on banks with an original maturity of three months or less. This, it is argued, would act as an incentive to increased lending on inappropriately short terms. Alternatives proposed include a preferential risk weight of 20% for credit lines of up to six months in countries where the government has established specific policies for the management of the liquidity risks of such lines (such as explicit requirements as to liquidity, taxes on capital inflows, etc.), extension to six months of the original maturity of exposures benefiting from the preferential risk weight, and elimination of the special consideration given to short-term claims as part of a rule nonetheless providing greater discretion to national supervisors to set lower risk weights for banks.

As for the IRB approach, comments have drawn attention to the sharp rise in risk weights for borrowers with probabilities of defaults above a certain threshold - a rise which is capable of leading to levels of capital for exposures to borrowers of below investment-grade substantially higher than under the standardized approach. This is regarded as counter-productive with regard to the new Accord’s objective of promoting adoption by banks of the IRB approach: on the one hand, banks with large concentrations of low-rated borrowers would have an incentive to use the standardized approach to keep down capital requirements; and, on the other hand, low-rated borrowers would have an incentive to become clients of banks using the standardized (as opposed to the IRB) approach.

This inconsistency between the risk weights of the two approaches is one of several opportunities for regulatory arbitrage which would result from the new Accord, and is widely regarded as likely to be especially important in the many developing countries where most borrowers have relatively high probabilities of default and low ratings.

Many comments feel that the rules in the new Accord for the recognition and valuation of collateral in the form of commercial real property would be too restrictive. Several countries draw attention to the fact that commercial real estate tends to be a more important source of collateral in developing than in developed countries owing to the more underdeveloped state of financial markets in the former and thus the lesser availability of financial instruments suitable for this purpose. Therefore, it is proposed, subject to appropriate haircuts to allow for the volatility of the value of such property, commercial real estate should be recognized as allowable collateral alongside of eligible financial instruments under the standardized approach.

Moreover, several countries object to the attribution of a risk weight of 150% to the unsecured position of loans overdue for more than 90 days (net of specific provisions). This set of comments prefers a less severe approach, in their view better reflecting such exposures’ real risk, which would impose an exceptionally high risk weight only on loans overdue for a significantly longer period.

Some also express the view that for loss given default (LGD) for loans collateralized with real estate under the “foundation” version of the IRB approach, the percentages of the values of exposures proposed as part of supervisory rules may often be considerably higher than levels for this variable actually observed, and thus require further thought.

A number of comments are directed at the estimation of capital requirements for equity exposures. In the context of the restructuring of banks’ balance sheets after financial crises, Thailand has drawn attention to possible consequences of the rule that minority-owned, non-controlling equity investments should be deducted from capital (or in certain cases be subject to consolidation on a pro rata basis). Such equity investments in countries which have recently experienced financial crises may constitute exceptionally high proportions of banks’ exposures owing to recourse to debt-for-equity swaps as part of debt restructurings, but are not intended to be long-term holdings. Since the rule in the new Accord may lead to exacerbation of the depletion of banks’ already low capital, the suggestion is made that such equity exposures be attributed lower risk weights through recourse to those of the counterparties in question under the standardized or IRB approach.

Operational risk

There have been a large number of comments on the proposed approach to capital requirements for operational risk. Their major focus is the basic indicator approach regarded as that likely to be most widely used in developing countries. The capital charges which would result from application of this approach are criticized as being too high and as not properly reflecting the lesser complexity of banking operations (and thus lower operational risks) in developing countries. The point is also made that gross income to which the capital charge would be proportional under the basic indicator approach is frequently not closely correlated with operational risk in a simple way (if at all). There is also criticism of the proposed floor for the capital charge in the most sophisticated approach to operational risk, the internal measurement approach: this, it is argued, would be a disincentive to its adoption and more generally to improved risk management in this area.

Other points made concerning operational risk are the need to allow for insurance cover as well as possible recourse to an alternative approach which would put greater reliance on enhanced supervision and on locally set rules for capital charges owing to the difficulty of making generally applicable measurements  of  operational risk and to the close links between the problems of controlling operational and other banking risks.

Problems of disclosure and definition

The proposals for disclosure and selected definitional issues have attracted comments from developing countries. The reservations as to enhanced disclosure (a subject covered not only under Pillar 3 of the new Accord but also under some other subject headings such as operational risk) focus on two issues: firstly, the way in which financial markets in developing countries would absorb and respond to greater disclosure and, secondly, competitive effects.

On the first, skepticism is expressed in several comments as to market participants’ capacity to interpret the increased information resulting from enhanced disclosure, some even going so far as to suggest that such disclosure could be a source of financial instability. On the second issue, there is concern as to the likelihood of pressures associated with the rules of the new Accord for disclosure of proprietary information of a kind capable of unfavourably affecting a bank’s competitive position.

Many comments are directed at terminology used in the new Accord. For example, increased clarity is requested concerning the definition of “internationally active” in the classification of banks. If in several countries the application of the new Accord were to differ in significant respects between “internationally active” banks and those not belonging to this category, lack of a reasonably clear definition could be a source of divergences between national supervisory regimes and thus of attendant competitive inequalities among banks.

The fleshed-out definition of “default” in the new Accord is still felt by some countries to lack clarity in that it leaves some latitude of interpretation in assessment of the likelihood that an entity will meet its debt obligations. (SUNS5042)