BASEL CAPITAL ACCORD AND ASIAN IMPACT

Background
BASEL 2 was formulated by the Banking Committee on Banking
supervision at The Bank for International Settlements (BIS) an
international organization which was formed in 1930 to foster
international monetary and financial cooperation and serve as a bank
for central banks around the world. The BIS currently has 55 member
central 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 the
international 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. They

act as intermediaries between those who have money and those who
need it. Most banks operate on operate on wafer thin margins as a
result banks typically operate with extremely high levels of leverage or
financial gearing. So, banks are vulnerable to collapse if they are not
managed prudently.
The function of the banks capital is to provide a cushion against
downturn and to ensure that shareholders of the bank have sufficient
funds at risk so that they are likely to take a casual attitude toward
depositor’s funds. In banks capital is not synonymous with shareholder’
equity as it is with most corporations.
Before 1988, many central banks allowed different definitions of capital
in order to make their country’s bank appear as solid than they
actually were. As a result the definition of capital began to diverge
more and more. In order to provide a level playing field the concept of
regulatory capital was standardized in the first BASEL CAPITAL
ACCORD or BASEL 1. Along with definition of regulatory capital a basic
formula for capital divided by assets was constructed and an arbitrary
ratio of 8% was chosen as minimum capital adequacy.
Capital was divided into two components Tier 1 and Tier 2 capital. Tier
1 comprised of the shareholders equity and Tier 2 was mainly
comprised of subordinate debt. Similarly, the total assets were risk
weighted. Certain assets such as loans to corporation were weighted at
100 %, while others; for instance, short term loans to banks in certain
developing countries were weighted at 20%. These risk weighting were
totally arbitrary and no empirical correlation existed.
However, there were drawbacks in the BASEL 1 as it did not did not
discriminate between different level of risk. As a result a loan to
Reliance was deemed as risky to Haldirams to use an example. Also it
assigned lower weight age to loans to banks as a
result banks were often keen to lend to other banks for example if
European banks were keen to lend to THAI financial institutions they
were able to do so without allocating too much capital and depressing
their capital adequacy ration’s. It is one of the reasons why European
banks suffered larges losses in the 1996-97 South East Asian crises.
BASEL 2
BASEL 2 proposal have sought to rectify the defects of the old accord.
To accomplish this BASEL 2 proposes getting rid of the old risk
weighted categories that treated all corporate borrowers the same
replacing them with limited number of categories into which borrowers
would be assigned based on assigned credit system. While some banks
have been permitted to use the internal credit system. Most banks
would have to rely on external credit rating agencies such as Moody’s
and Standard & Poor’s. However, greater use of internal credit system
has been allowed in standardized and advanced schemes, while the
use of external rating. The new proposals avoid sole reliance on the
capital adequacy benchmarks and explicitly recognize the importance
of supervisory review and market discipline in maintaining sound
financial systems.

ASIAN IMPACT
Firstly, the most obvious impact of BASEL 2 is the need for improved
risk management and measurement. It aims to give impetus to the use
of internal rating system by the international banks. More and more
banks will use internal model developed in house and their impact is
uncertain.
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 a
worrying aspect that some of the banks will not be able to put up the
additional capital to comply with the new regulation and they will be
isolated from the global banking system.
Thirdly, banks will have to be more conservative in their lending
activities. As a result we will see that the large number of companies
will have to come out with fixed income securities, as there will be less
credit available from the banking system. This is likely to grow the
fixed income market and add more depth and breath to the market.
Finally, a large number of Asian banks have significant proportion of
NPA’s in their assets. Along with that a large proportion of loans of
banks in Thailand, Philippines and Indonesia are of poor quality. There
is a danger that a large number of banks will not be able to restructure
and survive in the new environment.
One the face value the new norms seem to favor the large
international banks that have better risk management and
measurement expertise. They also have better capital adequacy ratios
and geographically diversified portfolios. The small banks are also
likely to be hurt by the rise in weight age of inter-bank loans that will
effectively price them out of the market. Thus banks will have to
restructure and adopt if they are to survive in the new environment.
References:
www.bis.org
www.financeaisa.com
www.clarkewillmot.com
‘Position Paper on The New Basel Capital Accord – Consultative
Document from The Basel Committee on Banking Supervision (2001)’

1.1. BACKGROUND The international banking environment has

become more complex and potentially riskier since the early 1980s
due to combined effects of financial deregulations, innovations,
technological advances and rapid integration of the world financial
markets (Sahajwala and Van den Bergh, 2000:1). These factors have
contributed to changes in the way banks collect, measure and manage
their risks (Carauana, 2004:1). The fast track integration of global
markets has given the need to achieve financial stability through the
adoption of common rules of regulating the global financial system. In
the global banking sector, capital regulation can be used to achieve
the stability. As central players in the global financial system, banks
are subjected to regulatory capital requirements because this benefits
the economy when they are sufficiently capitalised and properly-
managed. Such banks are in a position to withstand unexpected losses
arising from market, credit and operational risk exposures; helping
them to extend credit to their clients throughout the business cycle,
adding to the efficiency and enhanced public confidence in the banking
system (BIS, 2004:1; Hassan Al-Tamimi, 2008:1). Satisfactory bank
capital levels serve as a base for bank growth, cushioning it against
unforeseen losses which can lead to bank failures (Accord
Implementation Forum (AIF): Disclosure Subcommittee, 2004:7). It is
important to monitor and evaluate business activities of the banks
relative to the capital necessary to cover the associated risks (Amidu,
2007:67).
Following the collapse of Bankhaus Herstatt in Germany and Franklin
National Bank in the United States in 1974, the G10 central bank
Governors agreed to come up with the Basel Committee on Bank
Supervision (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 the
1988 capital accord (Basel I). Basel I introduced the first internationally
accepted definition of, and a minimum requirement for capital of
banks, and addressed the inconsistencies in bank capitalisation. All
banks were
2 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
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 capital
standard of 8% by the end of 19923 (AIF: Disclosure Subcommittee,
2004:10). This capital accord was aimed at improving the soundness of
the international banking environment by increasing capital holdings
and reducing competitive inequalities between internationally active
banks (Cumming and Nel, 2005:641). It was intended to link regulatory
capital to the risk portfolios of different banks, creating incentives to
lower the overall risk in the system. Banks would hold higher levels of
capital and riskier banks would reduce their risk profiles in order to
reach the minimum capital to risk-weighted assets ratio of 8% (BCBS,
2001:1). After almost a decade later, the BCBS proposed the
replacement of the 1988 accord with the new risk-sensitive framework
in June 1999. The effectiveness of Basel I was becoming less and less
due to the developments that had taken place in the financial system
since it was adopted. A number of these developments that caused
Basel I not to cope include among others; increased globalisation
(supported by the increased cross-border trading, investment and
finance flows globally); technological advances and financial
innovations. Advances in managing risks, technology and banking
markets made the simple approaches of Basel I to become less
valuable for a number of banking institutions for capital adequacy
requirements (AIF: Disclosure Subcommittee, 2004:10). For this
reason, there was need to move to a more complex and risk-sensitive
framework. Almost five years later, on 26 June 2004 the BCBS
authorized the publication of the “International Convergence of Capital
Measurement and Capital Standards: a Revised Framework‖, which is
the Basel II framework (BCBS, 2004:1). Its main objective is to bring
stability and consistency in the regulation of the capital adequacy of
internationally active banks (BCBS, 2004:1). Basel II outlines the
details for implementing the risk-sensitive minimum capital
requirements for banking institutions and reinforces them by stating
the principles for assessment by banks and supervisors for their capital
adequacy 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 capital
regulation, supervision and market discipline to enhance
prudent risk management to achieve financial stability (BCBS,
2006). It is based on the 1988 accord‟s basic structure of
setting capital requirements, and better reflects the
underlying risks that banks face and provides incentives for
risk management. This is accomplished partly by aligning
capital requirements with credit risk and establishing a capital
charge for exposures to operational risk (BCBS, 2006; AIF:
Disclosure Subcommittee, 2004). Basel II can be applied to all
banks in both G10 and non-G10 countries, because it provides
a menu of approaches suitable for both sophisticated and least
sophisticated banks (Mboweni, 2004:6). Its underlying
principles facilitate the alignment of capital 4
adequacy requirements to the key elements of banking risks, and also
advance risk measurement and management capabilities of the banks.
In this way, Basel II attempts to cope with the new developments and
instruments in the financial system due to financial innovations
(Mboweni, 2004:6). Basel II will considerably affect both the banks and
supervisors, in re-engineering their organizational structures and processes
to 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 risk
management 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 different
countries 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 I Under

Basel I, the minimum total capital equal to 8% of its “risk-adjusted”
assets was set and accepted by over 100 countries internationally
(South Africa included) with its prescribed full implementation by the
end of 1992. Basel I focused mainly on credit risk, with exposures
broadly classified, and hence reflecting similar types of borrowers and
risk. According to Klaus (2001:1), it became a globally accepted
standard for credit risk measurement framework for banks. Since 1988,
Basel I was progressively implemented not only in G10 member
countries, but also in all other countries with internationally active
banks. In this section, the strengths and weaknesses of Basel I are
briefly outlined in order to understand the reasons that necessitated
the transition to Basel II. Following the implementation of this accord in
a number of countries, the international banking system was
strengthened by the provision of the standard for capital requirements
and measurements (Rime, 2001; Cumming and Nel, 2005). The playing
field for the banks was levelled by successfully raising international
capital levels and improving the competitiveness in the banking
environment. According to Dobson and Hufbauer (2001:123) the 1988
Basel Accord drew the lesson from the financial crises of the mid-
1970‟s that more adequate capital levels in international banks would
help in reducing the systematic risk of bank failure. The minimum
capital adequacy requirements set were designed to ensure that
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 banks
by improving the international financial system‟s capital base.
However, in spite of its success in enhancing global banking sector
capital and risk measurement, the accord had a number of flaws that
led to the public outcry for the need for fundamental reforms (Ong,
2004). Evidently there have been developments in the financial system
since the Basel I was introduced and implemented in a number of
countries. In particular, the banking business, risk management
practices, supervisory approaches, and financial markets have
changed making Basel I unable to cope with these developments
(BCBS, 2001:1).
Ong (2004) adds that in the past decade there have been remarkable
distortions of credit risk in banking because of financial innovations
which opened regulatory capital arbitrage opportunities through asset
securitization vehicles. Financial engineering has brought the
development of complex financial products. According to Hai et al.
(2007:3) innovations such as financial derivatives and securitization8
largely contributed to the decline of traditional banking. As a result
Basel I was no longer sufficient enough to be the benchmark for
measurement of capital adequacy and the actual risks that banks face
due to innovations supported by new technologies9. All these
developments precipitated the need to move to a more appropriate
accord, Basel II which could capture the inherent risks in the global
financial system.
8 These are new ways to un-bundle and transfer risks. 9 This also implies that there are a
growing number of methodologies for managing and measuring risks. Technological
advances imply that there is an improvement in data collection and analysis. 10 Banks
ended 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 high
capital 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 I‟s “one size fits all”
approach to risk management is considered to be one of the crucial
reasons for the need to replace it. There were no incentives for the
banks to improve their risk management systems because the same
criterion was applied to all banks in determining the minimum capital
requirements. Hai et al. (2007:3) adds that Basel I was risk insensitive,
because it failed to make a distinction between credit risk and other
types of risk and was prone to regulatory arbitrage10. It was not
sophisticated in its approach and it did not assess all the true risk
profiles of banks11. Basel I is also largely criticized because its risk
categories were only weakly correlated with the actual banking risks,
for instance all corporate exposures were given a risk weighting of
100% regardless of their credit rating (Cumming and Nel, 2005:641).
Given the broad risk categories, it can be argued that the 1988 accord
actually increased the overall systematic risk because it allowed
regulatory capital arbitrage. In this respect, it did not adequately take
into account the hedging strategies available to banks. According to
Cumming and Nel (2005:641) banks engaged in ―cherry-picking‖,
which involved shifting the composition of a portfolio towards higher-
risk assets within a particular risk category. This gave the chance for
banks to arbitrage their regulatory capital requirements. 12
Globalization of the financial markets is also regarded among the
factors that contributed to the replacement of Basel I. With
globalization, integration and expansion of the global financial markets
coupled 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 markets
has seen the growth of cross-border trading, finance and investment.
However, this implies that there are sophisticated risks that need to be
accounted for, with a more risk sensitive framework. In conclusion, the
recognition of these important developments highlights the factors
that necessitated the introduction of Basel II which is a more risk-
sensitive framework (Pagia and Phlegar, 2002). The hallmark of Basel II
is ultimately combining effective bank-level management and
supervision with market discipline to restore safety and soundness of
the ever-changing and complex financial system
 The New Capital Accord: Basel II
According to BIS (2007:1) Basel II intends to bring improvements in the
way regulatory capital requirements mirror the underlying risks,
considering the financial innovations such as asset securitization
structures that has occurred in recent years. As mentioned above, it
does not only focus on capital, but also on maintaining a level playing
field and strengthening incentives to foster sound systematic risk
management through the three mutually reinforcing pillars12
(Caruana, 2003:1). Pillar 1 strengthens the minimum capital
requirements set out in the 1988 accord, while pillars 2 and 3
represent the innovative additions to capital supervision (BCBS,
2001:7). The new accord aims at raising the capital that banks must
hold to cushion against credit risk losses resulting from the internal
factors 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 II
framework seeks to enhance capital supervision that is governed by a
forward-looking approach and help banks to identify the risks (for
example credit, market and operational13) they may face, presently
and in future and thereby developing and improving their ability to
manage those risks (BCBS, 2006:12-14).
12 Minimum capital requirements (pillar 1), the supervisory review
process (pillar 2) and market discipline (pillar 3). 13 Credit risk is the risk of
loss that is incurred when a creditor defaults. Market risk refers to the risk of losses
resulting from fluctuations in prices in the financial markets (Dupuis, 2006:5).
Operational risk refers 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
The overarching objective of Basel II is to promote stability of the
financial system by ensuring that banks are adequately capitalized and
have 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 bank‟s
actual risk of economic loss14 (BCBS, 2001:3). This improves risk
measurement, i.e. the calculation of the denominator of the capital
ratio15 which comprises of the credit, market and operational risk. The
objective of pillar 1 is to clearly align the level of the regulatory capital
more closely with risk (Bailey, 2005:5). It achieves this by linking risk-
weights to credit ratings, meaning that a loan to a corporate will
attract a risk-weight that reflects the individual credit-worthiness of the
counterparty, rather than one that simply acknowledges the
counterparty as a corporate (Bailey, 2005:5). In this way, there is
better alignment of capital with the underlying risks and this helps to
maintain the required level of capitalisation of banks. There are two
options for measuring credit risk, i.e. the standardized approach and
the internal rating based (IRB) approach. According to BCBS (2001:4),
the standardized approach allows a bank to assign risk-weights to its
balance and off-balance sheet assets to derive the total risk-weighted
assets. This implies that if a risk-weight of 100% is assigned, it means
that the full value of an exposure is included in the calculation of the
risk-weighted assets and this translates into a capital charge equal to
8%. In the 1988 Accord, individual risk-weights depended on the broad
categories of borrowers (i.e. sovereigns, banks or corporates). Under
Basel II, risk-weights are refined by reference to a rating provided by
external credit rating agency under the standardized approach. The
risk-weights are determined by the supervisor depending on the nature
and characteristics of the exposure. There are five risk-weightings
available, 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 provides
four risk categories (20%, 50%, 100% and 150%) (BCBS, 2006:19).
14 Basel II improves credit risk sensitivity by requiring higher capital levels for
borrowers who are likely to present higher levels of credit risk. 15 Total capital = The
bank’s capital ratio (minimum 8%). Credit risk + Market risk + Operational Risk.
The internal ratings based approach (IRB) allows the use of the bank‟s
estimates of the creditworthiness of each borrower to approximate the
possible future losses, and this forms a basis of minimum capital
requirements under stringent methodological and disclosure
requirements (BCBS, 2006:12). Unique analytical frameworks are
available for loan exposures of different types, with varying loss
characteristics. Under the IRB approach, banks are required to
categorise the “banking-book” exposures into broad asset
classes with different underlying risk characteristics. The five classes of
assets include: corporate, sovereign, bank, retail and equity16 (BCBS,
2006:48). Since the IRB approach can be categorized into the
foundation and advanced methodologies for corporate, sovereign and
bank exposures, it gives a diverse range of risk-weights than those
under the standardized approach and hence the greater sensitivity to
risks (BCBS, 2006:12). The Foundation IRB (FIRB) approach and the
Advanced IRB (AIRB) approach only differ in the sophistication applied
in the quantification methodology. When using the FIRB methodology,
banks come up with estimates of the probability of default (PD) of
specific borrowers and the supervisors contribute other inputs. When
using the AIRB methodology, a bank that has an advanced internal
capital 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 parameters
that are used to determine the estimated credit risk when the IRB
approaches are applied17(BCBS, 2006:48). The new accord also sets
out that banks should come up with a suitable capital charge for
operational risk which was not included in the previous accord. This
makes a greater improvement in the new accord because banks need
to quantify the risk of losses from failure of internal processes and
systems versus damages from external disruptions. There are three
specific approaches that will help to capture operational risk i.e. the
basic indicator, standardized and internal measurement. Pillar 2,
Supervisory review process, emphasises the need for conducting
supervisory reviews of bank‟s internal assessments of their overall
risks to ensure that adequate measures are available for such risks
(BCBS, 2006:204). Supervisors must ensure that every bank has
internal processes available for its capital adequacy assessment
(BCBS, 2001:4). Basel II emphasizes the development of a bank‟s
internal assessment processes and determination of targets for capital
in line with its risk profile and control environment (BCBS, 2001:4).
After evaluation of the bank‟s activities and risk profiles, supervisors
are mandated to decide if the banks must hold higher capital levels
above the 8% level set in Pillar 1. These internal processes are subject
to 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, three
subclasses 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 the
examination 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
diminishing the capital charge. Exposure at Default (EAD) and Maturity of the loan (M)
are self explanatory parameters. 15
Pillar 3, market discipline, reflects how bank management can be
improved through transparency in public reporting. It points out the
disclosures that banks must report for the public to have better insight
into their capital adequacy (BCBS, 2006:226). Market participants can
only understand the risk profiles and capital adequacy of the banks
through the disclosure which enhances market discipline (BCBS,
2001:5). By understanding the bank‟s activities and its ability to
manage its exposures, consumers will be in a position to reward banks
that 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 with
different levels of complexity (BCBS, 2001:2). It provides a menu of
approaches per risk and given the existence of a supervisory review, it
is more flexible in risk and capital management and measurement.
This ensures that there is improved corporate governance and
transparency. More importantly, there are improved regulatory
frameworks and supervisory policies, practices and processes. The
benefits of adopting Basel II can be summarised in terms of the loan,
portfolio and organizational levels (Skosana Risk Management
Company, 2006). At loan level, Basel II help in differentiating between
risky borrowers (given the probability of default, PD), differentiating
the risk of the facility (LGD), improving provisioning and pricing of the
financial products. At the portfolio level, Basel II help in recognizing the
power 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 fund
managers, rewarding smart risk taking, and hence adhering to
transparency and good corporate governance (Skosana Risk
Management Company, 2006). It is often argued that Basel I was
centred on the bank‟s total capital with the aim of reducing chances of
bank insolvencies that would negatively affect depositors (BIS,
2001:1). Basel II improves safety and soundness in the financial
system by emphasizing the application of the three pillars consistently
(BCBS, 2001:2; Bauerle, 2001). Although Basel II maintains the overall
level of regulatory capital, it provides comprehensive and sensitive
approaches 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 minimum
capital requirements are calculated, but also in the responsibilities of
banks and regulators within the prudential regime (Bailey, 2005:3;
Caruana, 2004). A summary of the main differences between Basel I
and Basel II are shown in Table 2.1 below.
Table 2.1. BASEL I BASEL II
Basel I versus
Basel II.
FOCUS
Risk measure Single. Broad.
Risk Broad brush Enhanced risk-
Sensitivity approach. sensitive.
Credit Risk Limited Comprehensive
Mitigation recognition. recognition.
Operational Excluded. Included.
Risk
Flexibility One size fits all. Menu
approaches.
Supervisory Implicit. Explicit.
Review
Market Not addressed. Addressed.
Discipline
Incentives Not Addressed. Explicit and
well defined.
Economic Divergence. Convergence.
Capital
Source: Oothuzien (2005:24).
An analysis of Table 2.1 combined with the discussion above, makes it
clear as to why there was a transition from Basel I to Basel II. The next
section focuses on the literature survey on Basel II, discussing the
general implementation issues.
2.5. THE IMPLEMENTATION OF BASEL II:
GENERAL ISSUES
The new capital accord has received diverse commentary since
its first proposal in June 1999 with regard to its
implementation and effects on the whole banking system. In
this section, the common concerns around the implementation
of Basel II are discussed to gather insights into the
implementation issues. The BCBS and a number of
commentators concur that Basel II will bring financial stability
in the financial system, because it provides sophisticated risk-
sensitive methodologies (BIS, 1999; BCBS, 2004; Cumming and
Nel, 2005; van Rixtel, Alexopoulou and Harada, 2003;
Jacobsohn, 2004). However, Basel II is also entangled with
some criticism and scepticism with regards to the promotion of
sounder banking environment, volatility and consequences for
developing and emerging market countries (Griffith-Jones and
Spratt, 2001). These concerns are worth noting because they
help to form the basis for comparison of the implementation of
the new accord in the countries covered in this study
2.5.1. Basel II and Developing Countries
An ongoing debate about Basel II has been on its impact on developing
countries. It is often claimed that the adoption of Basel II, particularly
the IRB approach will lead to a significant reduction of bank lending to
the developing countries and/ or a sharp increase in the cost of
international lending to the developing countries (Griffith-Jones and
Spratt, 2001:14). Additionally, there is a common view that Basel II will
result in an increase in the cost and volatility of bank lending to
developing countries. Furthermore, developing countries will need to
implement Basel II at a considerable cost to their regulators and
banking sectors (Bailey, 2005:4).
Bailey (2005:4) argues that the returns to such an investment will be
lower because the accord was not designed for, nor is it appropriate for
developing countries because the original idea came from the G10
countries which are predominantly developed countries. Given these
cases, local banks may find themselves increasingly capital
constrained, making them more vulnerable to acquisition by advanced
international banks which are able to offer huge injections of capital
and expertise required by the regulators (Bailey, 2005:4). Dupuis
(2006:8) adds that Basel II tends to unfairly favour larger banking
institutions because they have abundant resources and capacity to
enforce the capital requirements. In the long-run, internationally active
banks will completely dominate the domestic banking sector, posing a
threat to the domestic supervisors and regulators. Another
consequence for developing countries is that they may fail to attract
international banks18 in the event that they fail to adopt this new
accord (Bailey, 2005:4).
As regulatory capital becomes aligned with risk, there will be an
increase in capital requirements for loans to developing countries
which tend to be less creditworthy (Griffith-Jones and Spratt, 2001). In
so doing, borrowing costs will increase as banks seek to cover their
higher capital charges (Bailey, 2005:6). However, contrary to the views
of Griffith-Jones and Spratt (2001), Bailey (2005) concludes that Basel
II implementation in developed countries holds no serious implications
for developing country lending because costs will not be affected as
international banks price using economic capital, not regulatory
capital19. Additionally, Basel II will not exacerbate the business cycles
of recipient developing countries because Pillars 2 and 3 will prevent
international banks from behaving procyclically. Pillar 2 will increase
the scope for regulatory forbearance and corruption, and
underdeveloped capital markets mean that Pillar 3 is likely to be
ineffective, and Pillar 1 is unable to offer any significant improvements
over Basel I due to poor data environments (Bailey, 2005:40).

Sharing the same view, the IMF (2005) points out that the risk
sensitivity of Basel II will likely lead to higher capital charges on loans
to the developing and emerging market economies because of their
relatively higher credit and operational risks. Consequently, this
increases the costs of borrowing and reduces capital inflows to these
so-called high-risk destinations (IMF, 2005). A similar concern is that
most banks in developing countries lack the necessary resources for
the implementation of Basel II. It is therefore argued that the new rules
may constrain accessibility to credit for a number of developing
countries (Dupuis, 2006:8).
2.5.2. Basel II and “Procyclicality”
It is often argued that Basel II may destabilize the financial system
because 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 charge
will rise in all exposures and banks will be less willing to extend credit
to corporates20; making it difficult to secure loans when they are most
needed, causing firms to fail and ultimately exacerbating the effects of
the recession (Cumming and Nel, 2005:644). Credit charges tend to fall
during an upswing, giving an incentive for firms to expand. Similarly,
banks are likely to attach risk-weights that are higher during an
economic slowdown, raising the bank‟s cost of extending credit, which
might in turn restricts bank lending (IMF, 2005). IMF (2005) believes
that this is a reality in risk-based capital management and therefore
Basel II potentially leads to relatively accurate pricing of risk although
business cycles can be aggravated by procyclicality. It can be
concluded that Basel II capital requirements tend to be
‗countercyclical‘, increasing during recessions, inducing procyclical
lending behaviour on the banks‟ side and hence financial instability in
the financial system.
According to Heid (2007:3886)21 some sceptics fear that Basel II will
unduly increase the volatility of regulatory capital. By limiting the
banks‟ ability to lend, capital requirements may exacerbate an
economic downturn22. Arguably Basel II makes the required minimum
capital more cyclical because it increases the sensitivity to credit risk.
This potentially poses severe capital management problems because
capital charges are likely to increase in an economic downturn at the
time when banks are confronted with the
erosion of their equity capital as a result of write-offs in their loan
portfolios. Such instabilities in the financial sector can then be
transferred into the real sector (Jacobsohn, 2004:82; Heid, 2003:1). As
the banks are forced to hold more capital during a downturn, they shift
the incidence to borrowers. Without other sources of finance,
companies will reduce spending for investment purposes, thereby
aggravating the economic meltdown. The impact on the
macroeconomy may be even more severe if the capital strained banks
are forced to reduce their lending (Heid, 2007:3886). Therefore, the
capital buffer that banks hold on top of the required minimum capital
plays a significant role in mitigating the impact of the volatility of
capital requirements. Likewise, Jacobsohn (2004:82) points out that
due to increased risk sensitivity of capital charges, continuous
procyclical effects may arise when the quality of the bank‟s assets is
attached to the business cycle movements. Consequently, this distorts
the central objective of capital regulation to foster stability in the
whole financial system (Heid, 2003). Procyclicality also affects
developing countries in the sense that capital allocations will become
entangled 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 II
requires very complex systems for risk measurement and
management and this is a challenge to banks because they need to
improve their internal systems, processes and staffing (Dupuis,
2006:8). Banks must have compatible infrastructural systems for data
reporting, verification and validation in place for the successful
implementation of the advanced methodologies (IMF, 2005). In some
cases, the implementation process may be delayed because financial
institutions, particularly in developing and emerging countries put
great 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 by
planning and resource constraint of the national supervisors and banks
(Cornford, 2005:16). This shows that the banks need to plan carefully
and set aside resources for the implementation process to be
successful.

Basel II: Requirements For and Choice of Approaches

Basel II adoption in any country demands that banks must meet the
minimum supervisory requirements, internal controls and risk
management, although the selection of the advanced approaches and
other options largely depend on its ability to fulfil all the expected
requirements (Cornford, 2005:19). For instance, for a bank to use the
IRB approaches, it must meet stringent eligibility criteria which mainly
depend on its management and internal controls (Cornford, 2005:17).
In some instances, different rules may be applied to a bank by the home and host
supervisors. 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
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 can
potentially 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 the
risk-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 also
entangled 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. It
attempts 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 trends
in banking sector variables. This is done in light of the implementation issues raised in
this chapter.

2. The new Basel proposals

Basel Accords 1988 and 2003
The 1988 Basel Capital Accord (Basel Committee, 1988) is a commitment by financial
authorities within the G-103 countries to apply a minimum capital requirement to
internationally-active banks in the G-10.4 It defines a measure of capital and a measure
of risk, the latter measure known as ‘risk-weighted assets’. The rule is that a bank’s
capital 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 explicit
sanction 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 that
are 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 reduced
the cost of reacting to marginal incentives, and competition has sharpened banks’
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. For
sophisticated 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 to
publish 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 the
capital 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 of
prudential 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 Basel
Committee 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 more
price-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, will
increasing 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 is
capital 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 menu
of 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 set
capital 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 the
process 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
risk weight is now based on the borrower’s rating. There are rules determining what kind
of rating agency’s 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 in
two flavours. The foundation approach uses banks’ estimates of a borrower’s 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 from
input 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 capital
remains 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. Unlike
formulaic 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 simple
rules do not. The more sophisticated approaches require supervisors to make skilled
judgements, and so contain a large element of discretion. While the addition of two
pillars 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 vague
and 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 defending
these 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 legally
transferred 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 1
is 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 also
includes 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 flexibility
to 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
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 explain
both 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 net
realisable 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 to
collude 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.14
So 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. It
is 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 the
Committee 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, that
is, 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 risk
management 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
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 and
credit 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. There should be incentives for
regulatory 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. There
are two protections against this distortion: ex post punishment 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
regime
relies 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 behaviour
of banks and other financial institutions. If banks manage risk in the same way, shocks,
news and changes of opinion have greater effect.
Daníelsson, Shin and Zigrand (2002) show that adding a value at risk constraint affects
the 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 same
authors 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.18
As 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 requirements
do 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
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 if
they 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 can
be 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 many
risks 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 most
publicspirited
supervisor reasons to misbehave.
The power of supervision also depends on convention and norm, rather than on formal
law; 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 great
deal 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. Whether
supervisory 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 shift
from 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 to
the 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 the
UK, 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
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 and
legal 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 great
scope 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 within
countries. 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 fail
to 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 lower
capitalisation. 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 areas
of national discretion.
Standards are not contractible. Another regulator’s 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 supervisory
standards 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 the
incentives 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 members
cannot 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 a
companion 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 common
understanding 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, this
laxative 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 know
more 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
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 borne
by 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 why
banks exist in market economies. Bank fragility is inevitable.”
Disclosure may not have the desired disciplinary effect. A supply of accurate and timely
information 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 1996 BIS Annual Report noted
that 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 a
small stake in the bank’s 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 people’s
judgements. Market efficiency requires that there be traders unconstrained by liquidity
constraints 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’ should
become 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
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 so
when 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 bank’s risks); it can also provide a focal
point 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 others
actions, 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 traders’
behaviour. 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 not
be 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, their
personal welfare must fall with the price of the bank’s liabilities. This requires strong
corporate governance standards.
In the new regime, market participants will be required to understand each bank’s risk
measurement 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 disclosure
requirements 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 on
supervisory judgements, the framework is not robust to government failure.