basel capital accord and asian impact

8/8/2019 Basel Capital Accord and Asian Impact

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BASEL CAPITAL ACCORD AND ASIAN IMPACTBackgroundBASEL 2 was formulated by the Banking Committee on Bankingsupervision at The Bank for International Settlements (BIS) aninternational organization which was formed in 1930 to fosterinternational monetary and financial cooperation and serve as a bankfor central banks around the world. The BIS currently has 55 membercentral banks. The mandate of the BIS is

Act as a forum to promote discussion and facilitate decision-making process among the central banks and within theinternational financial community.

Act as center for monetary research. Act as a prime counter party for the central banks in their financial

decision. Act as an agent or trustee in connection with international

financial operations.

Banks are unlike most manufacturing and services organizations. Theyact as intermediaries between those who have money and those whoneed it. Most banks operate on operate on wafer thin margins as aresult banks typically operate with extremely high levels of leverage orfinancial gearing. So, banks are vulnerable to collapse if they are notmanaged prudently.The function of the banks capital is to provide a cushion againstdownturn and to ensure that shareholders of the bank have sufficient

funds at risk so that they are likely to take a casual attitude towarddepositors funds. In banks capital is not synonymous with shareholderequity as it is with most corporations.Before 1988, many central banks allowed different definitions of capitalin order to make their countrys bank appear as solid than theyactually were. As a result the definition of capital began to divergemore and more. In order to provide a level playing field the concept ofregulatory capital was standardized in the first BASEL CAPITALACCORD or BASEL 1. Along with definition of regulatory capital a basicformula for capital divided by assets was constructed and an arbitraryratio of 8% was chosen as minimum capital adequacy.

Capital was divided into two components Tier 1 and Tier 2 capital. Tier1 comprised of the shareholders equity and Tier 2 was mainlycomprised of subordinate debt. Similarly, the total assets were riskweighted. Certain assets such as loans to corporation were weighted at100 %, while others; for instance, short term loans to banks in certaindeveloping countries were weighted at 20%. These risk weighting weretotally arbitrary and no empirical correlation existed.


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However, there were drawbacks in the BASEL 1 as it did not did notdiscriminate between different level of risk. As a result a loan toReliance was deemed as risky to Haldirams to use an example. Also itassigned lower weight age to loans to banks as a


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result banks were often keen to lend to other banks for example ifEuropean banks were keen to lend to THAI financial institutions theywere able to do so without allocating too much capital and depressingtheir capital adequacy rations. It is one of the reasons why Europeanbanks suffered larges losses in the 1996-97 South East Asian crises.

BASEL 2BASEL 2 proposal have sought to rectify the defects of the old accord.To accomplish this BASEL 2 proposes getting rid of the old riskweighted categories that treated all corporate borrowers the samereplacing them with limited number of categories into which borrowerswould be assigned based on assigned credit system. While some bankshave been permitted to use the internal credit system. Most bankswould have to rely on external credit rating agencies such as Moodysand Standard & Poors. However, greater use of internal credit systemhas been allowed in standardized and advanced schemes, while theuse of external rating. The new proposals avoid sole reliance on the

capital adequacy benchmarks and explicitly recognize the importanceof supervisory review and market discipline in maintaining soundfinancial systems.

ASIAN IMPACTFirstly, the most obvious impact of BASEL 2 is the need for improvedrisk management and measurement. It aims to give impetus to the useof internal rating system by the international banks. More and morebanks will use internal model developed in house and their impact isuncertain.Secondly, in order to comply with the capital adequacy norms we will

see that the overall capital level of the banks will rise. Here there is aworrying aspect that some of the banks will not be able to put up theadditional capital to comply with the new regulation and they will beisolated from the global banking system.Thirdly, banks will have to be more conservative in their lendingactivities. As a result we will see that the large number of companieswill have to come out with fixed income securities, as there will be lesscredit available from the banking system. This is likely to grow thefixed income market and add more depth and breath to the market.Finally, a large number of Asian banks have significant proportion ofNPAs in their assets. Along with that a large proportion of loans of

banks in Thailand, Philippines and Indonesia are of poor quality. Thereis a danger that a large number of banks will not be able to restructureand survive in the new environment.One the face value the new norms seem to favor the largeinternational banks that have better risk management andmeasurement expertise. They also have better capital adequacy ratiosand geographically diversified portfolios. The small banks are alsolikely to be hurt by the rise in weight age of inter-bank loans that will


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effectively price them out of the market. Thus banks will have torestructure and adopt if they are to survive in the new environment.


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References:www.bis.orgwww.financeaisa.comwww.clarkewillmot.comPosition Paper on The New Basel Capital Accord Consultative

Document from The Basel Committee on Banking Supervision (2001)

1.1. BACKGROUNDThe international banking environment hasbecome more complex and potentially riskier since the early 1980sdue to combined effects of financial deregulations, innovations,technological advances and rapid integration of the world financialmarkets (Sahajwala and Van den Bergh, 2000:1). These factors havecontributed to changes in the way banks collect, measure and managetheir risks (Carauana, 2004:1). The fast track integration of global

markets has given the need to achieve financial stability through theadoption of common rules of regulating the global financial system. Inthe global banking sector, capital regulation can be used to achievethe stability. As central players in the global financial system, banksare subjected to regulatory capital requirements because this benefitsthe economy when they are sufficiently capitalised and properly-managed. Such banks are in a position to withstand unexpected lossesarising from market, credit and operational risk exposures; helpingthem to extend credit to their clients throughout the business cycle,adding to the efficiency and enhanced public confidence in the bankingsystem (BIS, 2004:1; Hassan Al-Tamimi, 2008:1). Satisfactory bank

capital levels serve as a base for bank growth, cushioning it againstunforeseen losses which can lead to bank failures (AccordImplementation Forum (AIF): Disclosure Subcommittee, 2004:7). It isimportant to monitor and evaluate business activities of the banksrelative to the capital necessary to cover the associated risks (Amidu,2007:67).Following the collapse ofBankhaus Herstattin Germany and FranklinNational Bankin the United States in 1974, the G10 central bankGovernors agreed to come up with the Basel Committee on BankSupervision (BCBS), commonly known as The Committee 2 (BIS,2008:1; Klaus, 2001:4). To foster stability in the global banking system

through the prevention of bank failures, the BCBS came up with the1988 capital accord (Basel I). Basel I introduced the first internationallyaccepted definition of, and a minimum requirement for capital ofbanks, and addressed the inconsistencies in bank capitalisation. Allbanks were2 The G-10 countries now includes eleven countries which cooperate on financial,monetary and financial matters and these include Belgium, Canada, France, Germany,

Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United


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States. The BCBS is concerned with the convergence in the guidelines for international

co-operation in bank supervision and this committee is a standard-setting body on all

aspects on bank supervision (BIS, 2008).required to implement the Basel I framework, with a minimum capitalstandard of 8% by the end of 19923 (AIF: Disclosure Subcommittee,

2004:10). This capital accord was aimed at improving the soundness ofthe international banking environment by increasing capital holdingsand reducing competitive inequalities between internationally activebanks (Cumming and Nel, 2005:641). It was intended to link regulatorycapital to the risk portfolios of different banks, creating incentives tolower the overall risk in the system. Banks would hold higher levels ofcapital and riskier banks would reduce their risk profiles in order toreach the minimum capital to risk-weighted assets ratio of 8% (BCBS,2001:1). After almost a decade later, the BCBS proposed thereplacement of the 1988 accord with the new risk-sensitive frameworkin June 1999. The effectiveness of Basel I was becoming less and less

due to the developments that had taken place in the financial systemsince it was adopted. A number of these developments that causedBasel I not to cope include among others; increased globalisation(supported by the increased cross-border trading, investment andfinance flows globally); technological advances and financialinnovations. Advances in managing risks, technology and bankingmarkets made the simple approaches of Basel I to become lessvaluable for a number of banking institutions for capital adequacyrequirements (AIF: Disclosure Subcommittee, 2004:10). For thisreason, there was need to move to a more complex and risk-sensitiveframework. Almost five years later, on 26 June 2004 the BCBS

authorized the publication of the International Convergence of CapitalMeasurement and Capital Standards: a Revised Framework, which isthe Basel II framework (BCBS, 2004:1). Its main objective is to bringstability and consistency in the regulation of the capital adequacy ofinternationally active banks (BCBS, 2004:1). Basel II outlines thedetails for implementing the risk-sensitive minimum capitalrequirements for banking institutions and reinforces them by statingthe principles for assessment by banks and supervisors for their capitaladequacy to cover their risks (BCBS, 2004:1).3 For illustrative purposes, this simply implies that if a bank lends R1000, it will be

expected to keep R80 as capital.

The Basel II framework builds a firm foundation for capitalregulation, supervision and market discipline to enhanceprudent risk management to achieve financial stability (BCBS,2006). It is based on the 1988 accords basic structure ofsetting capital requirements, and better reflects theunderlying risks that banks face and provides incentives forrisk management. This is accomplished partly by aligningcapital requirements with credit risk and establishing a capital


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charge for exposures to operational risk (BCBS, 2006; AIF:Disclosure Subcommittee, 2004). Basel II can be applied to allbanks in both G10 and non-G10 countries, because it providesa menu of approaches suitable for both sophisticated and leastsophisticated banks (Mboweni, 2004:6). Its underlying

principles facilitate the alignment of capital 4adequacy requirements to the key elements of banking risks, and alsoadvance risk measurement and management capabilities of the banks.In this way, Basel II attempts to cope with the new developments andinstruments in the financial system due to financial innovations(Mboweni, 2004:6). Basel II will considerably affect both the banks andsupervisors, in re-engineering their organizational structures and processesto comply with the requirements and standards of the new accord (Mboweni, 2004:7).

With proper implementation, the new capital accord has the potential of improving riskmanagement in banks and aligning economic capital more closely with regulatory capital

(AIF: Disclosure Subcommittee, 2004:7). For the successful implementation of Basel II,

total co-operation between banks and supervisors, between supervisors of differentcountries and between different banks is very important (Global Risk Regulator, 2005:1).

In conclusion, it seeks to ultimately promote sound bank capitalisation, encouraging

improvements in risk management to strengthen the stability of banking markets through

the application of the three reinforcing pillars.

2.4.1. The 1988 Capital Accord: Basel IUnderBasel I, the minimum total capital equal to 8% of its risk-adjustedassets was set and accepted by over 100 countries internationally(South Africa included) with its prescribed full implementation by theend of 1992. Basel I focused mainly on credit risk, with exposures

broadly classified, and hence reflecting similar types of borrowers andrisk. According to Klaus (2001:1), it became a globally acceptedstandard for credit risk measurement framework for banks. Since 1988,Basel I was progressively implemented not only in G10 membercountries, but also in all other countries with internationally activebanks. In this section, the strengths and weaknesses of Basel I arebriefly outlined in order to understand the reasons that necessitatedthe transition to Basel II. Following the implementation of this accord ina number of countries, the international banking system wasstrengthened by the provision of the standard for capital requirementsand measurements (Rime, 2001; Cumming and Nel, 2005). The playingfield for the banks was levelled by successfully raising internationalcapital levels and improving the competitiveness in the bankingenvironment. According to Dobson and Hufbauer (2001:123) the 1988Basel Accord drew the lesson from the financial crises of the mid-1970s that more adequate capital levels in international banks wouldhelp in reducing the systematic risk of bank failure. The minimumcapital adequacy requirements set were designed to ensure that


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individual banking institutions have the ability to absorb losses,particularly credit losses (Dobson and Hufbauer, 2001:123). 2.4.2.From Basel I to Basel II: What Prompted the Change?Basel I did provide much stability among internationally active banksby improving the international financial systems capital base.

However, in spite of its success in enhancing global banking sectorcapital and risk measurement, the accord had a number of flaws thatled to the public outcry for the need for fundamental reforms (Ong,2004). Evidently there have been developments in the financial systemsince the Basel I was introduced and implemented in a number ofcountries. In particular, the banking business, risk managementpractices, supervisory approaches, and financial markets havechanged making Basel I unable to cope with these developments(BCBS, 2001:1).Ong (2004) adds that in the past decade there have been remarkabledistortions of credit risk in banking because of financial innovations

which opened regulatory capital arbitrage opportunities through assetsecuritization vehicles. Financial engineering has brought thedevelopment of complex financial products. According to Hai et al.(2007:3) innovations such as financial derivatives and securitization8largely contributed to the decline of traditional banking. As a resultBasel I was no longer sufficient enough to be the benchmark formeasurement of capital adequacy and the actual risks that banks facedue to innovations supported by new technologies9. All thesedevelopments precipitated the need to move to a more appropriateaccord, Basel II which could capture the inherent risks in the globalfinancial system.

8 These are new ways to un-bundle and transfer risks. 9 This also implies that there are agrowing number of methodologies for managing and measuring risks. Technological

advances imply that there is an improvement in data collection and analysis. 10 Banksended up holding lower quality (high risk) assets on their balance sheets and off-loaded

their high quality (less risky) assets (Hai et al., 2007:3). Banks will start to hold low risk

assets that attract lower capital charges and reduce high quality assets which attract highcapital charges under Basel II (IMF, 2005). 11 Cumming and Nel (2005) argue that Basel

I was not comprehensive in its coverage because it only concentrated on credit risk,

though market risk was added in 1996.According to Ong (2004) the failure of Basel Is one size fits allapproach to risk management is considered to be one of the crucial

reasons for the need to replace it. There were no incentives for thebanks to improve their risk management systems because the samecriterion was applied to all banks in determining the minimum capitalrequirements. Hai et al. (2007:3) adds that Basel I was risk insensitive,because it failed to make a distinction between credit risk and othertypes of risk and was prone to regulatory arbitrage10. It was notsophisticated in its approach and it did not assess all the true riskprofiles of banks11. Basel I is also largely criticized because its risk


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categories were only weakly correlated with the actual banking risks,for instance all corporate exposures were given a risk weighting of100% regardless of their credit rating (Cumming and Nel, 2005:641).Given the broad risk categories, it can be argued that the 1988 accordactually increased the overall systematic risk because it allowed

regulatory capital arbitrage. In this respect, it did not adequately takeinto account the hedging strategies available to banks. According toCumming and Nel (2005:641) banks engaged incherry-picking,which involved shifting the composition of a portfolio towards higher-risk assets within a particular risk category. This gave the chance forbanks to arbitrage their regulatory capital requirements. 12


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Globalization of the financial markets is also regarded among thefactors that contributed to the replacement of Basel I. Withglobalization, integration and expansion of the global financial marketscoupled with the introduction and exposure to new financial products,banks have continually become more exposed to diversified structure

of risks (Hai et al., 2007:3). The increased integration of global marketshas seen the growth of cross-border trading, finance and investment.However, this implies that there are sophisticated risks that need to beaccounted for, with a more risk sensitive framework. In conclusion, therecognition of these important developments highlights the factorsthat necessitated the introduction of Basel II which is a more risk-sensitive framework (Pagia and Phlegar, 2002). The hallmark of Basel IIis ultimately combining effective bank-level management andsupervision with market discipline to restore safety and soundness ofthe ever-changing and complex financial system


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The New Capital Accord: Basel IIAccording to BIS (2007:1) Basel II intends to bring improvements in theway regulatory capital requirements mirror the underlying risks,considering the financial innovations such as asset securitizationstructures that has occurred in recent years. As mentioned above, it

does not only focus on capital, but also on maintaining a level playingfield and strengthening incentives to foster sound systematic riskmanagement through the three mutually reinforcing pillars12(Caruana, 2003:1). Pillar 1 strengthens the minimum capitalrequirements set out in the 1988 accord, while pillars 2 and 3represent the innovative additions to capital supervision (BCBS,2001:7). The new accord aims at raising the capital that banks musthold to cushion against credit risk losses resulting from the internalfactors such as bad lending decisions and external factors for example,economic downturns and crisis contagion (Dobson and Hufbauer,2001:133). This ensures that banks that engage in risky transactions

will have to set aside more capital than those that do not. The Basel IIframework seeks to enhance capital supervision that is governed by aforward-looking approach and help banks to identify the risks (forexample credit, market and operational13) they may face, presentlyand in future and thereby developing and improving their ability tomanage those risks (BCBS, 2006:12-14).12 Minimum capital requirements (pillar 1), the supervisory reviewprocess (pillar 2) and market discipline (pillar 3). 13 Credit riskis the risk ofloss that is incurred when a creditor defaults. Market riskrefers to the risk of losses

resulting from fluctuations in prices in the financial markets (Dupuis, 2006:5).Operational riskrefers to the risk of direct or indirect losses that result from inadequate

or failed internal processes, people and systems, or external events (BCBS, 2001:10). 13


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The overarching objective of Basel II is to promote stability of thefinancial system by ensuring that banks are adequately capitalized andhave improved risk management techniques in place. Pillar 1,minimum capital requirements maintains the definition of capital,setting the minimum capital requirement at 8% of capital to risk-

weighted assets, with the guidelines closely aligned to each banks

actual risk of economic loss14 (BCBS, 2001:3). This improves riskmeasurement, i.e. the calculation of the denominator of the capitalratio15 which comprises of the credit, market and operational risk. Theobjective of pillar 1 is to clearly align the level of the regulatory capitalmore closely with risk (Bailey, 2005:5). It achieves this by linking risk-weights to credit ratings, meaning that a loan to a corporate willattract a risk-weight that reflects the individual credit-worthiness of thecounterparty, rather than one that simply acknowledges thecounterparty as a corporate (Bailey, 2005:5). In this way, there isbetter alignment of capital with the underlying risks and this helps to

maintain the required level of capitalisation of banks. There are twooptions for measuring credit risk, i.e. the standardized approach andthe internal rating based (IRB) approach. According to BCBS (2001:4),the standardized approach allows a bank to assign risk-weights to itsbalance and off-balance sheet assets to derive the total risk-weightedassets. This implies that if a risk-weight of 100% is assigned, it meansthat the full value of an exposure is included in the calculation of therisk-weighted assets and this translates into a capital charge equal to8%. In the 1988 Accord, individual risk-weights depended on the broadcategories of borrowers (i.e. sovereigns, banks or corporates). UnderBasel II, risk-weights are refined by reference to a rating provided by

external credit rating agency under the standardized approach. Therisk-weights are determined by the supervisor depending on the natureand characteristics of the exposure. There are five risk-weightingsavailable, 0%, 20%, 50% 100% and 150% under Basel II (BCBS,2006:15-19; Cumming and Nel, 2005:643). For corporate lending,Basel I provided only one risk category of 100% but Basel II providesfour risk categories (20%, 50%, 100% and 150%) (BCBS, 2006:19).14 Basel II improves credit risk sensitivity by requiring higher capital levels forborrowers who are likely to present higher levels of credit risk. 15 Total capital = Thebanks capital ratio (minimum 8%). Credit risk + Market risk + Operational Risk.The internal ratings based approach (IRB) allows the use of the banks

estimates of the creditworthiness of each borrower to approximate thepossible future losses, and this forms a basis of minimum capitalrequirements under stringent methodological and disclosurerequirements (BCBS, 2006:12). Unique analytical frameworks areavailable for loan exposures of different types, with varying losscharacteristics. Under the IRB approach, banks are required tocategorise the banking-book exposures into broad asset


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classes with different underlying risk characteristics. The five classes ofassets include: corporate, sovereign, bank, retail and equity16 (BCBS,2006:48). Since the IRB approach can be categorized into thefoundation and advancedmethodologies for corporate, sovereign andbank exposures, it gives a diverse range of risk-weights than those

under the standardized approach and hence the greater sensitivity torisks (BCBS, 2006:12). The Foundation IRB (FIRB) approach and theAdvancedIRB (AIRB) approach only differ in the sophistication appliedin the quantification methodology. When using the FIRB methodology,banks come up with estimates of the probability of default (PD) ofspecific borrowers and the supervisors contribute other inputs. Whenusing theAIRB methodology, a bank that has an advanced internalcapital allocation process is allowed to contribute other inputs as well(BIS, 2001:4). The probability of default (PD), loss given default (LGD),exposure at default (EAD), and maturity (M) are the four parametersthat are used to determine the estimated credit risk when the IRB

approaches are applied17(BCBS, 2006:48). The new accord also setsout that banks should come up with a suitable capital charge foroperational riskwhich was not included in the previous accord. Thismakes a greater improvement in the new accord because banks needto quantify the risk of losses from failure of internal processes andsystems versus damages from external disruptions. There are threespecific approaches that will help to capture operational risk i.e. thebasic indicator, standardized and internal measurement. Pillar 2,Supervisory review process, emphasises the need for conductingsupervisory reviews of banks internal assessments of their overallrisks to ensure that adequate measures are available for such risks

(BCBS, 2006:204). Supervisors must ensure that every bank hasinternal processes available for its capital adequacy assessment(BCBS, 2001:4). Basel II emphasizes the development of a banksinternal assessment processes and determination of targets for capitalin line with its risk profile and control environment (BCBS, 2001:4).After evaluation of the banks activities and risk profiles, supervisorsare mandated to decide if the banks must hold higher capital levelsabove the 8% level set in Pillar 1. These internal processes are subjectto supervisory review and intervention when deemed necessary (BCBS,2001:5).16 According to BCBS (2006:48) within the corporate asset class, there are five sub-

classes of specialised lending that are separately identified. In the retail asset class, threesubclasses are identified. Within the corporate and retail asset classes, purchased

receivables may be treated accordingly depending on certain conditions being met. 17

These are the four risk factors. The probability of Default (PD) is obtained from theexamination of the default history of a specific type of exposure. The loss to the bank

given counterparty default (LGD) calculates the loss, less the collateral if the loan is

secured. According to Cumming and Nel (2005:644), LGD allows for greater discretion

in the assessment of the value of credit risk mitigants and their contribution towards


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diminishing the capital charge. Exposure at Default (EAD) and Maturity of the loan (M)

are self explanatory parameters. 15Pillar 3, market discipline, reflects how bank management can beimproved through transparency in public reporting. It points out thedisclosures that banks must report for the public to have better insight

into their capital adequacy (BCBS, 2006:226). Market participants canonly understand the risk profiles and capital adequacy of the banksthrough the disclosure which enhances market discipline (BCBS,2001:5). By understanding the banks activities and its ability tomanage its exposures, consumers will be in a position to reward banksthat prudently manage their risks and punish those that do not.Although Basel II was initially designed for internationally active banks,its underlying principles can also be applied to other banks withdifferent levels of complexity (BCBS, 2001:2). It provides a menu ofapproaches per risk and given the existence of a supervisory review, itis more flexible in risk and capital management and measurement.

This ensures that there is improved corporate governance andtransparency. More importantly, there are improved regulatoryframeworks and supervisory policies, practices and processes. Thebenefits of adopting Basel II can be summarised in terms of the loan,portfolio and organizational levels (Skosana Risk ManagementCompany, 2006). At loan level, Basel II help in differentiating betweenrisky borrowers (given the probability of default, PD), differentiatingthe risk of the facility (LGD), improving provisioning and pricing of thefinancial products. At theportfolio level, Basel II help in recognizing thepower of diversification, understanding the impact of concentrations,and extending limits and capital. Lastly, at organizational level, Basel II

helps in justifying large investments, enhancing thinking like fundmanagers, rewarding smart risk taking, and hence adhering totransparency and good corporate governance (Skosana RiskManagement Company, 2006). It is often argued that Basel I wascentred on the banks total capital with the aim of reducing chances ofbank insolvencies that would negatively affect depositors (BIS,2001:1). Basel II improves safety and soundness in the financialsystem by emphasizing the application of the three pillars consistently(BCBS, 2001:2; Bauerle, 2001). Although Basel II maintains the overalllevel of regulatory capital, it provides comprehensive and sensitiveapproaches to risks as compared to Basel I (BCBS, 2001:2). The new

accord can be seen not only as a major change in how the minimumcapital requirements are calculated, but also in the responsibilities ofbanks and regulators within the prudential regime (Bailey, 2005:3;Caruana, 2004). A summary of the main differences between Basel Iand Basel II are shown in Table 2.1 below.

Table 2.1.Basel I versus

BASEL I BASEL II


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Basel II.FOCUSRisk measure Single. Broad.Risk

Sensitivity

Broad brush

approach.

Enhanced risk-

sensitive.Credit RiskMitigation

Limitedrecognition.

Comprehensiverecognition.

OperationalRisk

Excluded. Included.

Flexibility One size fits all. Menuapproaches.

Supervisory

Review

Implicit. Explicit.

MarketDiscipline

Not addressed. Addressed.

Incentives Not Addressed. Explicit andwell defined.

EconomicCapital

Divergence. Convergence.

Source: Oothuzien (2005:24).

An analysis of Table 2.1 combined with the discussion above, makes itclear as to why there was a transition from Basel I to Basel II. The nextsection focuses on the literature survey on Basel II, discussing thegeneral implementation issues.

2.5. THE IMPLEMENTATION OF BASEL II:GENERAL ISSUESThe new capital accord has received diverse commentary sinceits first proposal in June 1999 with regard to itsimplementation and effects on the whole banking system. Inthis section, the common concerns around the implementationof Basel II are discussed to gather insights into the

implementation issues. The BCBS and a number ofcommentators concur that Basel II will bring financial stabilityin the financial system, because it provides sophisticated risk-sensitive methodologies (BIS, 1999; BCBS, 2004; Cumming andNel, 2005; van Rixtel, Alexopoulou and Harada, 2003;Jacobsohn, 2004). However, Basel II is also entangled withsome criticism and scepticism with regards to the promotion of


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sounder banking environment, volatility and consequences fordeveloping and emerging market countries (Griffith-Jones andSpratt, 2001). These concerns are worth noting because theyhelp to form the basis for comparison of the implementation ofthe new accord in the countries covered in this study

2.5.1. Basel II and Developing CountriesAn ongoing debate about Basel II has been on its impact on developingcountries. It is often claimed that the adoption of Basel II, particularlythe IRB approach will lead to a significant reduction of bank lending tothe developing countries and/ or a sharp increase in the cost ofinternational lending to the developing countries (Griffith-Jones andSpratt, 2001:14). Additionally, there is a common view that Basel II willresult in an increase in the cost and volatility of bank lending todeveloping countries. Furthermore, developing countries will need toimplement Basel II at a considerable cost to their regulators andbanking sectors (Bailey, 2005:4).

Bailey (2005:4) argues that the returns to such an investment will belower because the accord was not designed for, nor is it appropriate fordeveloping countries because the original idea came from the G10countries which are predominantly developed countries. Given thesecases, local banks may find themselves increasingly capitalconstrained, making them more vulnerable to acquisition by advancedinternational banks which are able to offer huge injections of capitaland expertise required by the regulators (Bailey, 2005:4). Dupuis(2006:8) adds that Basel II tends to unfairly favour larger bankinginstitutions because they have abundant resources and capacity toenforce the capital requirements. In the long-run, internationally active

banks will completely dominate the domestic banking sector, posing athreat to the domestic supervisors and regulators. Anotherconsequence for developing countries is that they may fail to attractinternational banks18 in the event that they fail to adopt this newaccord (Bailey, 2005:4).As regulatory capital becomes aligned with risk, there will be anincrease in capital requirements for loans to developing countrieswhich tend to be less creditworthy (Griffith-Jones and Spratt, 2001). Inso doing, borrowing costs will increase as banks seek to cover theirhigher capital charges (Bailey, 2005:6). However, contrary to the viewsof Griffith-Jones and Spratt (2001), Bailey (2005) concludes that Basel

II implementation in developed countries holds no serious implicationsfor developing country lending because costs will not be affected asinternational banks price using economic capital, not regulatorycapital19. Additionally, Basel II will not exacerbate the business cyclesof recipient developing countries because Pillars 2 and 3 will preventinternational banks from behaving procyclically. Pillar 2 will increasethe scope for regulatory forbearance and corruption, andunderdeveloped capital markets mean that Pillar 3 is likely to be


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ineffective, and Pillar 1 is unable to offer any significant improvementsover Basel I due to poor data environments (Bailey, 2005:40).

Sharing the same view, the IMF (2005) points out that the risksensitivity of Basel II will likely lead to higher capital charges on loans

to the developing and emerging market economies because of theirrelatively higher credit and operational risks. Consequently, thisincreases the costs of borrowing and reduces capital inflows to theseso-called high-risk destinations (IMF, 2005). A similar concern is thatmost banks in developing countries lack the necessary resources forthe implementation of Basel II. It is therefore argued that the new rulesmay constrain accessibility to credit for a number of developingcountries (Dupuis, 2006:8).2.5.2. Basel II and ProcyclicalityIt is often argued that Basel II may destabilize the financial systembecause of procyclicality since capital charges are positively

dependent on the probability of default (PD) (Cumming and Nel,2005:644). For instance, in the event of a downturn, the capital chargewill rise in all exposures and banks will be less willing to extend creditto corporates20; making it difficult to secure loans when they are mostneeded, causing firms to fail and ultimately exacerbating the effects ofthe recession (Cumming and Nel, 2005:644). Credit charges tend to fallduring an upswing, giving an incentive for firms to expand. Similarly,banks are likely to attach risk-weights that are higher during aneconomic slowdown, raising the banks cost of extending credit, whichmight in turn restricts bank lending (IMF, 2005). IMF (2005) believesthat this is a reality in risk-based capital management and therefore

Basel II potentially leads to relatively accurate pricing of risk althoughbusiness cycles can be aggravated by procyclicality. It can beconcluded that Basel II capital requirements tend to becountercyclical , increasing during recessions, inducing procyclicallending behaviour on the banks side and hence financial instability inthe financial system.According to Heid (2007:3886)21 some sceptics fear that Basel II willunduly increase the volatility of regulatory capital. By limiting thebanks ability to lend, capital requirements may exacerbate aneconomic downturn22. Arguably Basel II makes the required minimumcapital more cyclical because it increases the sensitivity to credit risk.

This potentially poses severe capital management problems becausecapital charges are likely to increase in an economic downturn at thetime when banks are confronted with theerosion of their equity capital as a result of write-offs in their loanportfolios. Such instabilities in the financial sector can then betransferred into the real sector (Jacobsohn, 2004:82; Heid, 2003:1). Asthe banks are forced to hold more capital during a downturn, they shiftthe incidence to borrowers. Without other sources of finance,


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companies will reduce spending for investment purposes, therebyaggravating the economic meltdown. The impact on themacroeconomy may be even more severe if the capital strained banksare forced to reduce their lending (Heid, 2007:3886). Therefore, thecapital buffer that banks hold on top of the required minimum capital

plays a significant role in mitigating the impact of the volatility ofcapital requirements. Likewise, Jacobsohn (2004:82) points out thatdue to increased risk sensitivity of capital charges, continuousprocyclical effects may arise when the quality of the banks assets isattached to the business cycle movements. Consequently, this distortsthe central objective of capital regulation to foster stability in thewhole financial system (Heid, 2003). Procyclicality also affectsdeveloping countries in the sense that capital allocations will becomeentangled with the economic cycle of the recipient country,exacerbating its booms and busts (Griffith-Jones and Spratt, 2001;Reisen, 2001; Ward, 2002).

2.5.3. Basel II: Needs in terms of Bank Resources Basel IIrequires very complex systems for risk measurement andmanagement and this is a challenge to banks because they need toimprove their internal systems, processes and staffing (Dupuis,2006:8). Banks must have compatible infrastructural systems for datareporting, verification and validation in place for the successfulimplementation of the advanced methodologies (IMF, 2005). In somecases, the implementation process may be delayed because financialinstitutions, particularly in developing and emerging countries putgreat efforts to improve their systems, practices and procedures(Dupuis, 2006:8). Experts in risk-based supervision are needed and this

poses a challenge to supervisors in finding the qualified staff (IMF,2005). The pace of implementation of Basel II is largely influenced byplanning and resource constraint of the national supervisors and banks(Cornford, 2005:16). This shows that the banks need to plan carefullyand set aside resources for the implementation process to besuccessful.Basel II: Requirements For and Choice of ApproachesBasel II adoption in any country demands that banks must meet theminimum supervisory requirements, internal controls and riskmanagement, although the selection of the advanced approaches and

other options largely depend on its ability to fulfil all the expectedrequirements (Cornford, 2005:19). For instance, for a bank to use theIRB approaches, it must meet stringent eligibility criteria which mainlydepend on its management and internal controls (Cornford, 2005:17).In some instances, different rules may be applied to a bank by the home and hostsupervisors. It might be the case that the home supervisor might require the bank to use

the IRB approach, and the host supervisor prescribes the standardized approach for the

same bank because of limitations on its supervisory capacity. In some instances, host


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supervisors may be reluctant to let a foreign bank to use, for example, IRB approach

because of lower costs and capital requirements which gives it competitive advantages

over the domestic banks (Cornford, 2005:18). Such differences between supervisors canpotentially complicate Basel II implementation processes globally.

2.5.5. Basel II and the Development of Rating Agencies This is one of the implications

of Basel II that is not considered by many. Rating agencies help in coming up with therisk-weights of the assets that are used in the standardized approach of Pillar 1. In this

way, countries have incentives to develop credit rating agencies to improve credit

management (IMF, 2005)2.6. SUMMARY This chapter has analysed the Basel Accords and highlighted their

strengths and weaknesses. It can be observed that the failure of Basel I to cope with the

ongoing developments in the financial system led to the need for its revision and ultimate

replacement with a more risk-sensitive approach (Basel II). However, Basel II is alsoentangled with a number of concerns which mainly relate to the developing countries,

procyclicality, choice of the appropriate methods, resources necessary for implementation

and the development of rating agents. Therefore, there is need to proceed to the next

chapter that explores the implementation issues for all the countries in the study. Itattempts to explain how these countries have approached these issues which mainly relate

to planning and resources, timetables and extents of implementation, as well as the trendsin banking sector variables. This is done in light of the implementation issues raised in

this chapter.

2. The new Basel proposalsBasel Accords 1988 and 2003

The 1988 Basel Capital Accord (Basel Committee, 1988) is a commitment by financialauthorities within the G-103 countries to apply a minimum capital requirement to

internationally-active banks in the G-10.4 It defines a measure ofcapitaland a measureofrisk, the latter measure known as risk-weighted assets. The rule is that a bankscapital must be no less than 8% of its risk-weighted assets.

The Accord is an example of soft law (Alexander, 2000). Its signatories do not legally

bind their nations. Although they are expected to fulfil their promises, there is no explicitsanction for violation.

The problem with rules is that the world is complex, and it changes (Hart, 1961). And so

it is for the 1988 Accord. The calculation of risk-weighted assets is crude. For example,OECD governments5 are held to be much less risky debtors than non-OECD

governments, which is true on average but not in all cases. Some collateral is recognised,

while other collateral of equivalent quality is not. Banks have incentives to collect risks

that they consider underpriced by the Basel regime, and to repackage and sell risks thatare they consider overpriced. Junk debt might be in the former category, lending to

bluechips in the latter. Incentives to do so are stronger, the more the regulatory measure

of risk differs from the bankers assessment of risk.The designers of the Accord knew that the rules were crude, but they were the best

technology available. At the time, banks were ill-equipped to respond to marginal

incentives. Since then, however, risk management and product innovations have reducedthe cost of reacting to marginal incentives, and competition has sharpened banks


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incentives to do so. Innovations have created products, such as credit derivatives, for

which the 1988 Accord has no answer. Many new products are created precisely because

the Accord requires them to be treated in ways that do not reflect the economic risk.

Sophisticated banks can now use them to manipulate the ratios (an act known as

regulatory arbitrage) to achieve virtually any solvency ratio of their choosing. Forsophisticated banks the Accord is a minor irritant, not an effective constraint.

Consequently the Basel Committee is changing the rules. It is engaged in a lengthy,

iterative process of designing and consulting on new proposals. The Committee plans topublish the final rules at the end of 2003 and to implement them simultaneously in

member countries at the end of 2006. Since the Committee does not have the power to

make rules in member states, this timetable is a statement of intent rather than a

commitment. The new framework (Basel Committee 1999b, 2001a, 2001c) updates thecapital adequacy rules to address product innovations such as credit derivatives. It also

aims to reduce regulatory arbitrage by reducing the gains from it. As a result, regulatory

risk

weights are to be moved towards bankers risk estimates, to become more risksensitive.But Basel 2 is no mere second edition. It represents a change of approach to regulation.

Banks can, and do, change their risk profiles very rapidly. Periodic examination ofprudential returns has become less useful, and some banks routinely window-dress at

reporting dates. Regulators, like auditors, have for some time been shifting their attention

away from box-ticking rule enforcement towards a subjective assessment of the risks in a

bank and of the degree to which they are managed, or supervision. (In most BaselCommittee countries, this is actually a return to tradition.) Rules are seen to be

inflexible, inappropriate in a fast-changing world. In addition, regulation not just

financial regulation - has moved away from simple quantitative limits towards moreprice-based, incentive-compatible systems. Regulators have come to believe

increasingly in the benefits of assisting markets in their quasi-regulatory job. In the

context of bank regulation, the idea is that markets, if given sufficient information, willincreasing funding premia, thus disciplining banks that take on more risk and reducing

their risk appetite.6

Reflecting these changes, the Basel 2 proposals are based on three pillars. The first iscapital adequacy (or solvency) regulation; the second is the supervisory review

process; and the third is disclosure requirements as an aid to market discipline.

Pillar 1 now sets capital requirements against three risk classes: credit risk (introduced in

1988); market risk (1996), and operational risk. Each of the risk classes will offer a menuof approaches varying from the crude but penal to the sophisticated and more generous.7

The simpler approaches are based on rules automatically relating an observable and

verifiable figure to a capital requirement. The more sophisticated approaches do not setcapital requirements directly. Instead, they specify conditions under which banks

determine their own capital requirements. Banks estimate inputs into a risk weight

function set by regulators;8 what is verified by supervisors is not the input, but theprocess by which the input is estimated.

For banks, credit risk is the most important risk category. The simplest approach to

credit risk is now called the standardised approach. Instead of basing the risk weight on

the category of borrower (bank, sovereign, public sector entity, none of the above), the


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risk weight is now based on the borrowers rating. There are rules determining what kind

of rating agencys ratings can be used. The more sophisticated, internal ratings based, or

IRB approach, relies on banks estimates of key determinants of credit risk. It comes intwo flavours. The foundation approach uses banks estimates of a borrowers probability

of default (PD), while other inputs are set by the regulator. In the advanced approach, the

bank may estimate other inputs, such as loss given default (LGD), but the mapping frominput to risk weight is still set by the Basel Committee.9 There are also to be three

approaches to operational risk: the Basic Indicator Approach, the Standardised

Approach, and the Advanced Measurement Approaches. The definition of capitalremains the same.

Banks may only use the sophisticated methods for regulatory capital purposes if

supervisors are satisfied, both at the outset and thenceforth, that they meet certain

minimum standards. These standards are rules, in that they bind behaviour. Unlikeformulaic rules, however, standards do not have content until they are enforced (Kaplow,

1992). Third parties courts, other regulators, market participants cannot observe or

verify whether standards have been enforced, only (at best) the processes used by the

enforcers. Standards therefore delegate discretion to supervisors in a way that simplerules do not. The more sophisticated approaches require supervisors to make skilled

judgements, and so contain a large element of discretion. While the addition of twopillars appears to be a more revolutionary architectural redesign, the change of rule type

within Pillar 1 is in fact more radical.

However, the 1988 Accord is by no means free of discretion. The calculation of capital

requirements is based on inevitably artificial delineations, whose boundaries are vagueand require interpretation. Two boundaries are particularly difficult: judging whether a

securitisation has truly transferred risk outside the bank; and judging whether a

transaction should go into the banking book or the trading book. Defining and defendingthese boundaries takes up a great deal of regulatory time.10 Banks, too, employ people to

invent products that reap the regulatory rewards of one category with an economic

structure that belongs to another. Securitisations are designed so that the loans are legallytransferred from the balance sheet; in reality a bank intending to fund its activities in the

future by securitisation will find any way it can to compensate investors for any losses.

Therefore, while investors may have no legal recourse, they often have moral recourse.A third definition, that of capital, is also extremely problematic. Banks maximising

shareholder value should use a simple definition of capital: equity. So do those who

make lending decisions, such as bank lending officers and credit analysts. The

Committee, however, recognised two tiers of capital, and added a third in 1996. Tier 1is supposed to be equity and Tier 2 is mainly subordinated debt,11 although some kinds

of

subordinated debt are now treated as Tier 1 capital for no good reason.12 Tier 2 alsoincludes general provisions, up to a maximum of 1.25% of risk-weighted assets (ie 16%

of minimum capital). The boundary need not coincide with that drawn by tax authorities.

So banks subordinated liabilities are designed to possess just enough payment flexibilityto persuade the banking supervisors to treat them as core capital and just enough payment

obligation to persuade the tax authorities to treat them as debt. The effective result is to

replace equity with debt, increasing the probability of insolvency.

But by far the most important source of subjectivity in the Accord is the same as that in


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banks accounts: valuation. Being the differences between assets and other liabilities,

capital is sensitive to the valuation of assets and liabilities. Banks traditional assets are

loans, and the great majority of loans do not have a market price. (This helps to explainboth the existence of banks and their vulnerability to runs.) The accounting and

regulatory solution has been, broadly, to record loans on the balance sheet at the lower of

cost and net realisable value. Where a loan is considered to be impaired, the netrealisable value is reduced by taking a provision. Changes in net realisable value should

also flow through the income statement.

However, there is no common regulatory approach to loan classification or provisioning.Many bank regulators do not have the power to prescribe accounting standards for banks.

Nor do International Accounting Standards prescribe, although the G-7 finance ministers

and the IMF have called for this gap to be filled.13 The multitude of different approaches

has considerably complicated the design of the credit risk component of the new Accord(do provisions appear in the income statement? Do they appear as a liability or as a

reduction in assets? Do they constitute part of capital? Are they supposed to constitute

an estimate of existing impairment, including known but latent losses, or should they also

look forward to expected or even unexpected loss? See BCBS, 1998b for some answers).As in the other companies, it is primarily the responsibility of bank managers to produce

accounts, and to value their assets. Bank managers decide the level of provisions,following accounting precepts. Since there is no market price with which to verify the

provision, auditors examine the process by which provisions have been decided more

than the level of provisions itself. Supervisors, a second line of defence, do likewise.

And both sources of protection can suffer from private incentives that cause them tocollude with bank managers to inflate the reported solvency of the bank. If this

governance fails, bank managers can effectively decide both the value of the bank and its

reported income for the year, a temptation hard to resist.14So the story that the Basel 2 rules have become outdated is correct, but incomplete.

Banks have concentrated their attacks on those areas in which the rules were missing in

the first place, where supervisors were forced to use their discretion to fill in the gaps. Itis not so much that the rule has failed, but that there has failed to be a rule. Basel 2 does

not correct all these problems; for example, the definition of capital is off limits.The weaknesses of Basel 2

Unfortunately, the new framework has several fundamental weaknesses.15 First, it relies

on banks own risk estimates. This is not incentive-compatible. The review was

prompted largely by the observation that banks in large financial centres were

increasingly circumventing the rules by regulatory arbitrage. The conclusion that theCommittee came to at the very beginning of the process was that differences between

regulatory and economic capital caused regulatory arbitrage, and the way to eliminate

regulatory arbitrage was to make the regulatory rules converge on economic capital, thatis, to make the rules risk-sensitive. The Committee expects that the New Accord will

enhance the soundness of the financial system by aligning regulatory capital requirements

to the underlying risks in the banking business and by encouraging better riskmanagement by banks and enhanced market discipline, said the BCBS Secretariat

(2001).

13

Given the flood of regulatory arbitrage, this was the obvious conclusion to draw, but it


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was wrong, and the review has run into severe difficulties as a result. Because they have

limited liability, banks shift risk to others but keep the rewards, and so benefit too much

from risk. They also suffer from internal agency problems that induce their traders andcredit officers to seek risk. Banks may manage their risks perfectly for shareholders but

pose too much risk to others. A set of rules designed to eliminate private incentives for

regulatory arbitrage will not reflect the social risks. Thereshouldbe incentives forregulatory arbitrage. Risk-sensitivity, if it means sensitivity to private risks, is therefore

the wrong goal. Instead, capital requirements should be related to social risk.

At the very least, banks private risk measures need to be adjusted to measure social risk.The value at risk rules, for example, multiply banks risk estimates by a factor of at

least three. This can help correct failure externalities, albeit only under the strong

assumption that all bank failures pose the same risk to the system. However, when their

own estimates are used to set capital, banks have an incentive to manipulate them. Thereare two protections against this distortion: ex postpunishment for bad model

performance and minimum standards judged by supervisors ex ante. Inherent data

problems rule out the possibility of an automatic penalty function,16,17 and so the

regimerelies entirely on an increasingly baroque set of supervisory standards. Supervisory

judgement is prone to failure. These protections will therefore be insufficient.Even if the incentives to manipulate the estimates can be corrected, there is a further

problem. What protects the individual bank may not protect the system. Important

properties such as risk, correlations, liquidity - of the very system that the Basel

Committee is trying to protect are not exogenous but defined by the collective behaviourof banks and other financial institutions. If banks manage risk in the same way, shocks,

news and changes of opinion have greater effect.

Danelsson, Shin and Zigrand (2002) show that adding a value at risk constraint affectsthe demand for assets, and hence prices and price distributions. Their simulations

suggest that general use of VaR lowers asset prices, increases their volatility, and

increases the amplitude and duration of asset price response to large shocks. The sameauthors compare the fallacy of using for policy purposes models that assume exogeneity

of risk to the Lucas Critique: the risks derive from banks behaviour and are not invariant

to changes of regime.Regulators have not explained or tested the claim that using sophisticated quantitative

models represents better risk management from the point of view of anyone but bank

shareholders. Yet so confident is the Committee that models are better that the new

framework contains a capital incentive to move to the more sophisticated approaches.18As an example, regulatory capital on a given portfolio will rise during downturns and fall

during upswings, and this may increase the amplitude of economic cycles. This is

because banks prefer to estimate risk over short horizons. Minimum data requirementsdo not cover a full cycle, nor does the forecast horizon. Risk-sensitive rules will reward

short-term lending, reducing the extent to which bank systems provide liquidity insurance

to customers.The new framework, in which several approaches to credit and operational risk are

available, replaces one form of regulatory arbitrage with another. The IRB approach

generates higher capital requirements than the standardised approach on lower-quality

assets, but lower requirements on higher-quality assets. Banks on the IRB approach will


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tend to acquire all the high-quality assets and banks on the standardised approach all the

low-quality assets the assets for which the standardised approach undercharges.

Banking groups will be tempted to cherry-pick between the two regimes, but even ifthey do not, the banking system will do it automatically. Banks on the IRB approach

may branch into jurisdictions where only the standardised approach is offered, or vice

versa. Adverse selection is seen as a price worth paying to achieve a framework that canbe applied by different banks and that contains incentives to improve risk management.

But if the IRB approach is not a better form of risk management from a social

perspective, these costs may not be worth bearing.The second problem is that supervision may fail to achieve its objectives for any one of a

large number of reasons. Supervision has two advantages over formal regulation:

supervisors use a broad range of information, notably of a soft, subjective nature; and

they generally try to encourage improvements in risk management, which is for manyrisks a more efficient form of insurance than capital. However, in reality supervisors may

not have the skill, the power or the incentives to supervise effectively. A supervisory

regime such as Basel 2 requires powerful yet benevolent supervisors, the stock of which

is limited. Supervision, on the other hand, requires bureaucrats to exercise discretion,which may be used for good or ill. The effectiveness of supervision therefore depends on

the incentives of supervisors, and of others such as bankers, politicians and auditors.These incentives are affected by formal constraints, such as the law, but also by informal

constraints of culture and norm, which vary across countries and persist over time. It is

easy to build incentive mechanisms that fail to achieve regulatory objectives, and difficult

to build mechanisms that succeed. Organisational structures give even the mostpublicspirited

supervisor reasons to misbehave.

The power of supervision also depends on convention and norm, rather than on formallaw; the tools of persuasion are subtle, and persuasion is difficult to monitor. Supervision

is intrinsically interpersonal, and human relationships can distort decisions. Furthermore,

supervision is a complex activity in which the supervisor acquires and process a greatdeal of information and makes decisions under uncertainty. Rationality is bounded.

Moreover, even the richest supervisory agencies possess scant information about the

relationship, if any, between supervisors actions and bankers behaviour. Whethersupervisory actions are effective or entirely superstitious is not known. In summary, the

new regime is founded on a largely untested belief that supervision works. It is not

robust to supervisory failure.

Thirdly, a shift towards banks internal risk measures and on supervision implies a shiftfrom rules to standards. This has hugely important implications barely considered by the

Committee. Standards work better in some jurisdictions than others. High-level

principles and qualitative standards delegate to bureaucrats the task of giving content tothe law. Not all legal and political systems can easily accommodate this delegated

administrative approach. Indeed, even in the US, the courts willingness to accept

delegation of powers to administrators is a modern phenomenon, and even now, as in theUK, administrators are subject to procedural constraints in the exercise of their powers.

Elsewhere, administrative powers themselves are more strictly limited. Treating people

15

unequally (even if they are truly unequal) may be illegal: Article 7 of the Austrian


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constitution, for example, has been interpreted by legislators and regulators to require

identical treatment of evidently different banks. Unequal treatment, if not illegal, may be

politically impossible. Closely related to this is the question of fairness. Political andlegal structures are partly designed to stop those with power from exercising it unfairly.

Failing to follow precedent or otherwise acting inconsistently is generally regarded as

unfair, or worse.19 Supervision is inherently flexible and individualistic. There is greatscope for unfairness; indeed, it is hard to apply judgement fairly, particularly where, as is

inevitably the case in supervision, different individuals judge different cases. The same

issues arise with model recognition. There is no guarantee of consistency even withincountries. The supervisory approach therefore creates some overwhelmingly difficult

problems of law, politics and equity.

Fourthly, the primary purpose of the international capital adequacy regime is to protect

against international competition in laxity (Kapstein, 1989), and the new regime will failto achieve its purpose. Regulators impose externalities on each other because banks may

branch across borders under home country regulation, affecting competitive conditions in

other countries. Regulators respond strategically to other regulators laxity by increasing

their own. The 1988 Accord appears to have reversed the long-term trend towards lowercapitalisation. Unfortunately, the race to the bottom has already begun again, for two

reasons: the shift from rules to standards reduces observability, and there are more areasof national discretion.

Standards are not contractible. Another regulators standard can only be observed by

observing both the formulation of the standard and every decision and the information

used to give content to the standard in every case. Low regulatory and supervisorystandards are therefore easy to disguise, as the IMF has observed. In the new world, peer

pressure will have less disciplinary effect than in more easily observable, rule-based

regimes such as the 1988 Accord. And markets have neither the information nor theincentives to punish those inadequately supervised.

The number of areas in which national regulators are to choose between different options

has jumped sharply. National discretion is useful only when Basel Committee memberscannot agree on a single approach, and so by a revealed preference argument, they can be

expected to use that discretion differently. National discretion is equivalent to a hole in

the international regime. A national discretion checklist recently published as acompanion to a Basel Committee survey lists 44 areas of national discretion. Arguably, it

no longer makes sense to say that member countries are joined with one Accord.20 When

it comes to Pillar 2, there is little desire for coordination. Institutional arrangements and

attitudes to supervision differ widely across countries, and there is little commonunderstanding of the role and purposes of supervision.

The thirteen jurisdictions represented on the Committee are therefore likely both to

diverge and to become more lax. If the current degree of harmonisation is optimal, thislaxative divergence must be costly.

The final problem is excessive faith in disclosure requirements. The modern rationale for

bank regulation is based on asymmetries of information and externalities. Banks knowmore than their depositors and regulators, and less than their borrowers. Disclosure

requirements is that they reduce the asymmetries.

Some disclosure requirements are almost certainly beneficial. There is a strong case for

improving disclosure standards in most countries. Weak accounting and disclosure


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standards undermine the effectiveness of all three pillars. Barth, Caprio and Levine

(2001) also find that regimes with higher levels of bank information disclosure have

significantly lower levels of government corruption.However, that since the production and processing of information is costly, the optimal

disclosure requirement is finite. Furthermore, disclosure cannot correct for all the market

failures. Banks are large, and impose extra costs when they fail. These costs are borneby creditors deemed worthy of protection (depositors), and by the economy in general.

This last aspect is often neglected by those promoting disclosure. It is implied that those

to whom bankers shift risk will require compensation if they are adequately informed.However, if all participants in the economy suffer indirectly from a bank failure,

transactions costs may rule out such an outcome even under full information. Nordic

countries suffered a banking crisis in the early 1990s in spite of a high level of disclosure.

Disclosure requirements, therefore, cannot by themselves correct for all externalities.Moreover, some asymmetries of information are inevitable. Banks exist as agents for

depositors in lending to firms that cannot provide credible information on their financial

health. As Eichengreen (1999) says, it is unavoidable that borrowers should know more

then lenders about how they plan to use borrowed funds. This reality is a key reason whybanks exist in market economies. Bank fragility is inevitable.

Disclosure may not have the desired disciplinary effect. A supply of accurate and timelyinformation is necessary, but not by itself sufficient to discipline bankers (Karacadag and

Taylor, 2000). There are several steps in the process of market discipline, and all may

fail.

First, market participants must change behaviour in response to new information.Lamfalussy (2000) reports that bank lenders ignored relevant information in the public

domain, notably BIS statistics showing a build-up of external debt and a shortening of its

maturity, for some time before the Asian crisis hit. (The 1996BIS Annual Reportnotedthat Thailand had become the biggest debtor in the world.) They must acquire, process

and act on information. This is costly and may be subject to increasing marginal costs

and so participants will not act hyper-rationally but with bounded rationality.Satisficers use rules of thumb. Participants must also have the incentive to acquire and

process information, and so they must believe themselves to be uninsured; such a belief

would be irrational in many countries. Furthermore, particularly among those with only asmall stake in the banks survival there are externalities to monitoring and incentives to

free ride. Indeed, one reason why not all credit is allocated through the market is that

banks do not free ride in the monitoring of their own private loans; and one rationale for

regulation is that the regulator acts as a monitor on behalf of depositors.Secondly, the market price of bank liabilities must reliably reflect participants

judgements of the fundamental risks of the bank, rather than estimates of other peoples

judgements. Market efficiency requires that there be traders unconstrained by liquidityconstraints or risk-aversion willing to trade against noise traders. Even when the market

disciplines, it does not necessarily do so beneficially. Markets are driven by expectations

about average opinion. There is no reason to assume that average opinion shouldbecome more stable with more information. In fact, more information can reduce

heterogeneity among participants. Market shifts are associated with increasing

agreement among participants. Homogeneity can be the enemy of stability and of

liquidity. Anything that aids coordination can induce instability, and information can do


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that. A sunspot run on a solvent bank is an example of coordinated market discipline.

Morris and Shin (2002) argue that, while more information always helps those playing a

game against nature (making a decision under uncertainty), it does not necessarily do sowhen players have some private information and when players best actions are

complementary to others best actions. In such cases, public information has two roles: it

provides information about fundamentals (eg a banks risks); it can also provide a focalpoint for players beliefs. Agents second-guess each other as they try to herd, and it is

rational for them to do so. Market participants react to public information not only by

revising their estimates of fundamentals, but also by revising their estimates of othersactions, which also depend on public information. As a result, they place too much

weight on public information, and they overreact to noisy public signals. For some

parameters, Morris and Shin find that social welfare is decreasing in the precision of

public information.Market discipline is also procyclical. It has a deflationary impact in bad times. If there

are some in the market who trade on short-term information, perhaps constrained by

short-term liquidity, market discipline will be volatile. Informed traders should then

trade not only on long-run fundamentals, but on their expectations of noise tradersbehaviour. In good times, the market disciplines those, like PDFM, unwilling to acquire

inflated shares in companies that have never produced a profit.Regulators are well aware of the problem of overreaction when it comes to suggesting

that their own assessments of banks (CAMELS ratings, individual capital requirements)

might be published. In Europe, the latest draft directive (European Commission Services,

2002) Article 128 states that individual capital requirements above the minimum shall notbe published. The IMF/World Bank assessments of countries financial sectors are not

generally published, for the same reason.

Thirdly, for bank managers to respond to market discipline by reducing risk, theirpersonal welfare must fall with the price of the banks liabilities. This requires strong

corporate governance standards.

In the new regime, market participants will be required to understand each banks riskmeasurement system and, in comparing banks risks, somehow correct for differences in

reporting systems. They will also be expected to use the soft information required in

Pillar 3 to correct for supervisors different standards. The Basel 2 disclosurerequirements embody an optimistic view of the benefits of greater disclosure.

To summarise, in its reliance on market discipline and on internal risk estimates, the new

framework relies too much on the absence of market failure. This is intellectually

incoherent. It is market failure that justifies regulation. And in its reliance onsupervisory judgements, the framework is not robust to government failure.

basel capital accord and asian impact

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