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internal_market/
bank/docs/
regcapital/studies/2
Appendix 1 – Outline of Basel II proposals 004-04
-basel-impact-stud
y-annex_en.pdf
1.1 Background
The 1988 Basel Capital Accord (Basel I) sets capital adequacy standards for interna-
tionally active banks1. It is the work of the Basel Committee on Banking Supervision2.
In 1988, the Basel Committee introduced a Capital Adequacy Framework3 for banks.
This framework focussed on credit risk, although it implicitly covered other risks. It in-
corporated a definition of regulatory capital and set out a set of weights to be applied to
banks’ assets that was – albeit crudely – related to risk. It assessed capital requirements
relative to risk-weighted assets. The minimum ratio of capital to risk-weighted assets
was set at 8%. The Accord was amended in 1996 to also incorporate capital require-
ments for market risks (in the trading book) 4. This set out two alternative approaches to
the measurement of market risk, a standardised method and an internal models ap-
proach.
These standards have achieved a wide degree of acceptance, extending beyond the
member countries of the Basel Committee, and have acquired a scope that extends be-
yond internationally active banks. Indeed, they are applied to a wide range of domestic
and international institutions in over 100 countries. However, despite its many achieve-
ments, in recent years it became clear that Basel I required a radical overhaul if pruden-
tial regulation were to maintain its relevance and effectiveness in the face of ever-
accelerating market innovations and the development of new risk management tech-
niques.
In June 1999, the Committee issued the first proposal for a new Capital Adequacy
Framework5 to replace the 1988 Accord6. A much more detailed consultation package
on the new proposals was issued in January 2001 (CP2). Following extensive interac-
tion with banks and industry groups, a final consultative paper (CP3), taking into ac-
count comments and incorporating further work performed by the Committee, was is-
sued in April 2003. A number of press releases and papers have since been released by
the Committee, charting its progress towards agreement. The goal of the Committee is
to reach final agreement on Basel II by mid-year 2004, with implementation to take ef-
fect in member countries by year-end 2006.
The current capital requirements for banks and investment firms in the EU also derive in
large measure from the international standards set by the Basel Committee in Basel I.
These standards are adapted to EU circumstances and applied through Directives, nota-
1
International Convergence Of Capital Measurement And Capital Standards, Basel Committee on Bank-
ing Supervision, July 1988.
2
The Basel Committee was established by the central bank governors of the Group of Ten countries at the
end of 1974. The current member countries are Belgium, Canada, France, Germany, Italy, Japan, Luxem-
bourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. Coun-
tries are represented by their central bank and also by the authority with formal responsibility for the pru-
dential supervision of banking business where this is not the central bank.
3
Commonly referred to as the (current) Basel Capital Accord, the 1988 Accord, BIS I or Basel I Accord.
4
Amendment to the capital accord to incorporate market risks, Basel Committee on Banking Supervision,
January 1996.
5
Commonly referred to as the new Basel Capital Accord, the new Accord, BIS II or Basel II Accord.
6
The 1996 Amendment of Basel I for the treatment of market risk remains unchanged.
Appendix 1 – Outline of Basel II proposals Page 1 of 10

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bly the Banking Coordination Directive7 and the Capital Adequacy Directive8. While
the Basel Accord is aimed at internationally active banks, the relevant EU directives ap-
ply to all EU credit institutions and to all investment firms authorised under the Invest-
ment Services Directive. It is also worth noting that, whereas Basel is an international
agreement that has mainly moral force, the EU structure binds EU member states and
regulators with the force of law.
The European Commission has proposed that the European framework of capital ade-
quacy regulation should be updated in a manner that closely resembles the approach be-
ing taken by the Basel Committee, although it suggests a number of modifications to
take account of the specific circumstances of EU firms and markets9. The Commission
has also consulted widely, especially on issues that specifically affect EU institutions,
issuing three full consultative documents and a number of consultations on specific top-
ics. It has also sought to obtain a better understanding of the quantitative impact of the
proposals through its own quantitative work in collaboration with supervisors within the
EU.
The importance of financial intermediation in the European Union compared with, for
example the United States, the wider scope of application of the capital framework
within the EU, and the consequences of working in a legal environment, make the ques-
tion of the economic impact of the Accord and its proposed EU adaptation CAD3, a
very significant one. It is of keen interest to the European Council and European Par-
liament in particular as they begin to consider how to adapt the EU’s capital adequacy
framework.
The European Commission has consulted widely on its proposals to update the EU’s
capital framework. A first paper was issued in November 1999, followed by a second
consultation in February 2001 and a third consultation following the publication of
Basel’s CP3 in July 2003. A “structured dialogue” with EU firms and their representa-
tives on the emerging shape of the capital framework preceded this third consultation.
This dialogue took place over a three-month period starting in November 200210.
1.2 Scope
The overriding objective of the new Basel II/CAD3 proposals is to establish a more risk
sensitive capital regime and one that enhances financial stability. The new Basel Capital
Accord has been devised to apply to internationally active banks in the G10 countries;
however, in practice these rules will cover a much broader spectrum, as the Basel
Committee itself intends. In the EU, the impact will be more widely felt as the European
Commission has stated its intention to adopt the new Capital Accord for all EU banks
(not just internationally active banks subject to Basel), and to all EU investment firms
authorised under the Investment Services Directive (e.g. fund managers and securities
7
Directive 2000/12/EC of the European Parliament and of the Council of 20 March 2000 relating to the
taking up and pursuit of the business of Credit Institutions
8
Council Directive 93/6/EEC of 15 March 1993 on the capital adequacy of investments firms and credit
institutions.
9
See in particular Review of Capital Requirements for Banks and Investment Firms, Commission Ser-
vices Third Consultation Paper, European Commission, 1 July 2003.
10
Copies of all EU consultative papers relating to the capital framework can be found at
http://europa.eu.int/comm/internal_market/regcapital/index_en.htm

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firms). The European Commission has proposed a number of modifications to take ac-
count of the wider scope of application in the EU11. These modifications will be aimed
principally at facilitating the application of the new Capital Accord to a wider range of
businesses and to smaller institutions. Consequently, most EU financial institutions will
fall within the scope of the new Capital Accord for some activity (as it is likely they will
have some banking or investment business in the group). Such institutions will also in-
clude the EU-incorporated subsidiaries of US and other non-EU financial institutions
that have banking, securities or investment management operations in the EU.
Furthermore, market forces are likely to ensure that the new approaches to capital ade-
quacy become de-facto required practice. Already, and apart from the EU, many non-
G10 countries have stated that they intend to adopt the Basel II framework. As noted
above, over 100 countries have already adopted the original Basel Accord in one form
or another and it is expected that the new rules will, over time, become a similarly
global standard.
1.3 Basel II - The three pillars
The existing Basel I rules for calculating risk weighted assets reflect the true economic
risk of a transaction only to a limited extent. Under the current Basel Accord, a corpo-
rate exposure with a high rating and low risk attracts the same credit risk weighting as a
corporate exposure with a low rating and a high risk12. The arbitrary nature of both risk
classes and corresponding risk weights prompted the Basel Committee to seek to re-
place the current risk-based capital regime by one with greater differentiation and risk
sensitivity. For this reason, the Basel Committee proposes in the new Basel II Accord to
base credit risk weightings either on a simple approach based on the ratings of external
rating agencies or one of two approaches based on banks’ own internal ratings. Not only
the internal rating, but also the governance and the quality of risk management will be a
major factor in being able to use internal ratings as a basis for calculating regulatory
capital requirements. National supervisors will authorise firms to use one of the internal
ratings based approaches on a case by case basis. The new Accord also introduces capi-
tal requirements for operational risk, a risk category that was not explicitly addressed
under the existing Basel I rules.
A key feature of the New Accord is that it is structured on the basis of three pillars:
Minimum capital requirements for market credit and operational risk (Pillar 1);
Supervisory review process (Pillar 2); and
11
The new capital adequacy rules will be embedded in the so-called “Risk Based Capital Directive”
(RBCD), which is often referred to as “CAD3” in the market. (For the full text, see: European Commis-
sion, “Review of the Capital Requirements for Banks and Investment Firms”, Commission Services,
Third Consultation Paper, Working Document, July 2003).
12
The formula for calculating risk-weighted assets (RWAs) was a fairly simple one that treated all banks
equally. Individual assets were divided into four basic credit risk categories (corresponding to a well-
defined identity of the counterparty of each bank) and assigned weights in the range from 0 to 100 per
cent. The next step was to sum the weighted values of the individual on- and off-balance sheet assets.
This sum was classified as risk-weighted assets (RWAs). Basel I required banks to maintain capital of not
less than 8% of their RWAs.

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Market discipline (Pillar 3).
These pillars are interlocking and mutually reinforcing. For example, the use of the
more sophisticated approaches to credit or operational risk will bring additional disclo-
sure requirements under Pillar 3, and will affect the nature of the supervisory review
conducted under Pillar 2.
1.3.1 Pillar 1 - Minimum capital requirements
Under the proposed Basel II Accord, the definition of regulatory capital as well as the
minimum required ratio of 8% of risk-weighted assets remains substantially unchanged
from the Basel I Accord13. The treatment of position risk arising from trading activities
as set out in the 1996 Amendment of Basel I Accord also remains substantially un-
changed, although significant changes are proposed to the treatment of counterparty
credit risk that are being discussed in a joint working group established by the Basel
Committee and the International Organisation of Securities Commissions (IOSCO). The
principal modifications relate to the methodology for calculating risk-weighted assets
categories, credit and operational risk. The minimum capital requirements and methods
used to measure the risks faced by banks, as defined under Pillar 1 of the Basel II Ac-
cord, are described in more detail below.
1.3.2 Pillar 2 - Supervisory review process
Pillar 2 is aimed at ensuring “that banks have adequate capital to support all the risks in
their business”14. There are two key elements to Pillar 2:
a bank specific internal assessment and management of capital adequacy; and
the supervisory review of this internal capital assessment and of the robustness of
risk management processes, systems and controls.
Pillar 2 is based on four principles where the first principle sets out the role of the bank
and the last three principles set out the role of the supervisor. Through Pillar 2, regula-
tors are seeking to reinforce Pillar 1 requirements by ensuring that the totality of risks
that are faced by a bank are appropriately covered and, importantly, to encourage banks
to establish robust capital management processes.
1.3.3 Pillar 3 - Market discipline
Pillar 3 is intended “to complement the minimum capital requirements (Pillar 1) and the
supervisory process (Pillar 2) … [and] to encourage market discipline by developing a
set of disclosure requirements which will allow market participants to assess … the
13
As a result of the “Madrid compromise” agreed in October 2003, which will only require credit risk
capital for unexpected losses, the definition of capital will change for IRB banks and no longer include
general provisions as a component of Tier 2 capital. The minimum required risk-asset ratio still remains at
8%.
14
Basel Committee on Banking Supervision, The New Basel Capital Accord (Consultative Document),
Bank for International Settlements, April 2003, p. 138. The supervisory review of capital adequacy is de-
termined both by the risks defined under Pillar 1 and by supervisory evaluation of risks not explicitly cap-
tured in Pillar 1 (for example, interest rate risk in the banking book).

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capital adequacy of the institution”15. These disclosure requirements are aimed at pro-
viding the market with more and better information on banks’ risk assessment capabili-
ties, risk profile and capital adequacy. Banks will be required to disclose essential in-
formation regarding their capital allocation processes and the risks they take beyond the
present financial reporting framework.
1.4 Pillar 1 – Credit Risk
Three methods for calculating credit risk capital are offered. In order of increasing so-
phistication and risk sensitivity these are:
the Standardised Approach;
the Internal Ratings Based (IRB) Foundation Approach (FIRB); and
the IRB Advanced Approach (AIRB).
1.4.1 Standardised Approach
The Standardised Approach is similar to the current Basel I approach where exposures
are assigned to risk weight categories based on their characteristics. The main supervi-
sory categories in the Standardised Approach are claims on sovereigns, banks, corpo-
rates, retail loans, residential real estate and commercial real estate. Each category has a
fixed risk weight related to external credit assessments to provide an element of risk
sensitivity.
The individual borrower’s quality is reflected by its external rating. If there is no exter-
nal rating, the loan’s risk is generally weighted with 100%16 (as under Basel I). In order
to calculate the credit risk capital requirement, the loan amount is multiplied with the
risk weight and the solvency coefficient of 8% (or whatever figure the supervisor deems
appropriate under Pillar 2). The Committee has also enhanced the risk sensitivity of the
Standardised Approach by a substantial revision of the approach to credit risk mitiga-
tion. The 1988 Accord only recognised cash and government securities as collateral that
was capable of reducing risk and therefore of reducing (or eliminating) the capital
charge. There has been a considerable expansion of the range of collateral, guarantees
and credit derivatives that are eligible for risk mitigation purposes and thus capable of
reducing the capital charge.
The tables below (Table 1 and Table 2) contain an overview of the proposed new risk
weights under the Standardised Approach:
15
Basel Committee on Banking Supervision, The New Basel Capital Accord (Consultative Document),
Bank for International Settlements, April 2003, p. 154.
16
Exceptions apply to sovereign and bank exposures.

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Table 1: Risk weights for Sovereigns and Banks

AAA to BBB+ to
Claim A+ to A- BB+ to B- Below B- Unrated
AA- BBB-
Sovereign 0% 20% 50% 100% 150% 100%

Bank Option 117 20% 50% 100% 100% 150% 100%
Option 218 20% 50% 50% 100% 150% 50%
Option 2 20% 20% 20% 50% 150% 20%
short term19
Table 2: Risk weights for Corporates and real estate exposures

AAA to
Claim A+ to A- BBB+ to BB- Below BB- Unrated
AA-
Corporate 20% 50% 100% 150% 100%

Regulatory Retail 75%
Portfolios
Residential Mortgages 35%20
Commercial 100%.
Real Estate A 50% risk weighting may be applied at national discretion subject to a number
of conditions on loan-to-value ratios and historical loss rates.
1.4.2 IRB Approach
The two main principles behind the Internal Ratings Based (IRB) Approach are the us-
age of banks’ own information about the credit quality of their assets and the promotion
of best practices in risk measurement and risk management. This is in contrast to the
current approach and the Standardised Approach under Basel II, which is entirely de-
pendent on supervisory inputs to determine the capital requirement.
Under the IRB Approach, banks must categorise banking book exposures into six broad
classes of assets with different underlying risk characteristics. The main asset classes
are corporate, sovereign, bank, retail and equity, with additional classes for securitisa-
tion exposures and eligible purchased receivables. Within the corporate and the retail
segment, further sub-classes are separately identified. For each of the asset classes there
are three key elements to the requirements of the new Accord:
1 Risk components - internal or supervisory estimates of risk factors such as the

probability of default (PD), loss given default (LGD), exposure at default (EAD),
maturity (M) and size of the company (S – expressed in terms of the company’s
annual turnover). Everything else being equal, higher values for PD, LGD, EAD,
17
Under Option 1, the risk weighting to be applied to the bank depends on the credit rating of the sover-
eign of its country of incorporation, with the bank’s rating being one notch less favourable than a claim
on the sovereign of that country.
18
Under Option 2, the risk weighting of the bank is dependent on the external rating of the bank itself.
19
Under Option 2, a preferential weighting may be applied to short-term claims. These are defined as
claims with an original maturity of three months or less.
20
Subject to meeting certain criteria

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M and S lead to higher capital requirements (and vice versa). At the most ad-
vanced level, banks will calculate all of these elements.
2 Risk weight functions - the means by which the risk components for specific ex-
posures are transformed into risk weighted assets. These are determined by super-
visors and set out in the Accord.
3 Minimum requirements - the minimum qualitative requirements covering issues

such as governance, independent review and data quality must be met in order to
be able to apply the IRB Approach for a given asset class.
1.4.3 IRB Foundation Approach (FIRB)
Under the IRB Foundation Approach, banks supply their own PDs into the formulae for
calculating risk weights. The history requirements for PD data are 5 years. Banks rely
on supervisory estimates of LGD and EAD. The LGD parameters (and therefore capital
requirements) can be reduced by mitigation with financial collateral and several types of
physical collateral. The maturity (M) is set at 2,5 years.
The charts below (Figure 1, Figure 2 and Figure 3) illustrate the risk weight curves un-
der the FIRB approach21. It should be noted that the effect of the “Madrid Compromise”
in producing lower risk weighting curves are expected to be very substantially neutral-
ised by the recalibration of the Accord that is, at the time of drafting this report, being
debated in the Basel Committee.
Figure 1: Risk weight for corporate, bank and sovereign exposures

400%
350%
300%
250%
Risk Weight
200%
150%
100%
50%
0%
0,03% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00% 16,00% 18,00% 20,00
PD
Corporate CP3 Corporate Madrid
21
In all cases, they assume a supervisory LGD of 45% (representing unsecured exposures)

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Figure 2: Risk weights for retail exposures (excl. residential mortgages and quali-
fying revolving exposures)
250%
200%
150%
Risk Weight
100%
50%
0%
0,03% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00% 16,00% 18,00% 20,00%
PD
Other Retail CP3 Other Retail Madrid
Figure 3: Risk weights for residential mortgages

400%
350%
300%
250%
Risk Weight
200%
150%
100%
50%
0%
0,03% 2,00% 4,00% 6,00% 8,00% 10,00% 12,00% 14,00% 16,00% 18,00% 20,00%
PD
Residential Mortgage CP3 Residential Mortgage Madrid
1.4.4 IRB Advanced Approach (AIRB)
Under the IRB Advanced Approach, banks estimate PD, LGD, EAD and M internally.
Estimation of these parameters is based on the banks’ own data and is subject to strict
qualifying criteria. The actual value of these parameters depends on the specific banks’
practices for using risk mitigation and handling bad loans. Also, the absence of limita-
tions regarding the use of any physical collateral to mitigate credit risk (and therefore to
reduce capital requirements) is a notable development and a considerable inducement
for banks to seek to use the Advanced Approach. The history requirements for LGD and
EAD data are a minimum of 7 years.

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Because the AIRB is so dependent on the data, experience and systems of the individual
bank, it is not possible to give a sensible estimate of the risk weights that would apply
for any given probability of default.
1.4.5 IRB Approach for equity exposures
Where banks have material holdings of equities in the banking book, specific capital re-
quirements apply. Holdings are material if the aggregate value of equities in the banking
book exceeds 10% of regulatory capital. A lower threshold of 5% applies if the portfolio
contains fewer than 10 individual holdings.
A number of methods are available. The simplest and crudest assigns risk weights of
300% to publicly traded equities and 400% to all other equities. Alternatively, banks
may use – or national supervisors may require – a VAR-type model to derive capital re-
quirements, subject to a floor risk weight of 200% for publicly traded equities and 300%
for other equities.
As a final option, banks may use or supervisors may require the use of the same
PD/LGD approach used for calculating capital requirements for corporate exposures.
However, an LGD of 90% would be assumed, compared with a supervisory estimate of
45% for LGD on ordinary corporate lending exposures.
1.5 Pillar 1 – Operational Risk
Operational risk is defined as “the risk of loss resulting from inadequate or failed inter-
nal processes, people and systems or from external events”. This definition includes le-
gal risk, but excludes strategic and reputational risk. Three methods for calculating op-
erational risk capital are defined with increasing sophistication and risk sensitivity:
Basic Indicator Approach: The operational risk capital under the Basic Indicator
Approach is equal to a fixed percentage alpha (15%) of the three-year average
gross income of the bank.
Standardised Approach: Under the Standardised Approach, the banks’ activities

are divided into eight business lines (e.g. corporate finance, retail banking) and
the operational risk capital is calculated separately for each business line. The op-
erational risk capital for each business line is given by a business line specific
fixed percentage beta (ranging between 12-18%) of the three-year average gross
income of the respective business line22. The total operational risk capital for the
bank is the sum of the operational risk capital across each business line. In order
to qualify for use of the Standardised Approach, internationally active banks must
22
As a result of the QIS3, the Basel Committee recognised that the use of gross income as a basis for the
calculation of operational risk would penalise banks with high-margin lending businesses (particularly
banks in accession and other non-G10 countries with higher-risk, higher-margin lending portfolios) by ef-
fectively charging them for credit risk a second time through the operational risk charge. Therefore, an
‘alternative standardised approach’ was developed, which allows - at national discretion - supervisors to
permit their banks to use a volume-based factor (loans and other banking book assets rather than gross in-
come) for determining the operational risk charge for retail banking and commercial banking. However,
supervisors may only allow this alternative approach to the extent that they are satisfied it more accu-
rately reflects the risk profile of the bank by correcting for a double counting of credit risk.

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satisfy certain minimum qualitative criteria set by the Committee regarding their
operational risk framework.
Advanced Measurement Approaches (AMA): Under the Advanced Measurement

Approaches (AMA), operational risk capital will be calculated using the banks’
internal operational risk measurement system, provided that the system conforms
to specific quantitative and qualitative criteria set by the Committee. The qualify-
ing criteria state for example that a bank’s internal measurement system must
“reasonably estimate unexpected losses based on the combined use of internal and
relevant external loss data, scenario analysis and bank-specific business environ-
ment and internal control factors”. The banks’ measurement system must also be
capable of supporting an allocation of economic capital for operational risk across
business lines in a manner that creates incentives to improve business line opera-
tional risk management.

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Appendix 2 – Interview programme with regulators, finance

ministries, industry associations and other interested bodies
In order to better understand the situation in and views of individual member states, we
implemented a programme of contact with the Finance Ministries and financial services
regulators of all fifteen member states of the European Union. In early December we
delivered a presentation to the Banking Advisory Committee (BAC) on the status of our
research and analysis.
During the period of the study we also met with a number of banks and investment
firms, and held a series of meetings with the European Banking Federation and national
banking and investment firm associations in a number of territories. We talked infor-
mally to a number of banks throughout the process to assess their views and held dis-
cussions with SME representatives and the European Venture Capital Association, as
well as with the European Parliament’s Basel II Rapporteur, Alexander Radwan, MEP
and with Chris Huhne, MEP.
These meetings proved invaluable in obtaining an insight into the likely application of
the Basel Accord and the Risk-Based Capital Directive in each country and across
Europe, and revealed a range of perspectives on the Accord. We are very grateful to all
the authorities and our other interlocutors for their time and co-operation and for the
spirit of openness and willing collaboration that they have shown us.
A number of themes emerged from these discussions:
There is strong support for the revised Basel Accord, especially in respect of its
application to internationally active institutions, and there is a strong belief that
the revised Basel Accord should encourage better risk management in financial
institutions in the EU. There is, however, some questioning whether it is appro-
priate to apply the same approach to all credit institutions and investment firms,
and especially whether it is appropriate to deploy a panoply of detailed rules to
smaller institutions whether banks or investment firms. This notwithstanding,
most countries do not anticipate that their smaller institutions will suffer exces-
sive competitive damage if the current approach is adopted, and most authorities
wish to retain very similar if not identical rules for banks and investment firms.
The largest banks will be moving to one of the IRB methods, as will many
smaller institutions. The result will be that in many countries, based on current
plans (and assuming that the regulatory authorities are able to process the applica-
tions to use the more advanced approaches in good time), a majority of banking
sector assets, and possibly up to as much as some 80% of banking sector assets
will belong to a bank using one of the IRB methods at or relatively soon after 1
January 2007. We expect there to be some transitional use of the Foundation IRB
approach from banks aiming to move to the Advanced IRB.
Relatively few banks are expected to adopt the Advanced Measurement Ap-
proaches to Operational Risk, and some regulators are unsure as to what would
constitute an acceptable approach. There is some concern that the incentives for
Appendix 2 – Interview Programme Page 1 of 4

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firms to move from the Basic Indicator to the Standardised Approach are insuffi-
ciently strong.
Many banks have launched investment programmes that anticipate the regulatory
requirements of the Basel Accord. Basel has acted as an accelerator for the devel-
opment of internal risk management processes that are already in train, rather than
simply being a wholly regulatory imposition. It is difficult, if not impossible, to
determine costs and effects (including loan pricing) that can be unambiguously at-
tributed to Basel. Compliance with the Basel Accord has, however, distorted
some investment priorities and the qualitative requirements of regulators will in-
crease implementation costs. The implementation effort will also crowd out other
developments that might otherwise have occurred.
Concern about the potential for an adverse impact on investment firms is confined
to member states where independent investment firms form an important and in-
dependent part of the financial system, such as in the UK. In many member states,
the most important investment firms are subsidiaries of the leading banks. Where
there is concern about the impact of Basel/RBCD, it goes beyond the impact of
the operational risk charge to include the impact of applying the credit risk meth-
odologies of the banking book to counterparty credit risk in the trading book, in
particular in the impact of the credit risk mitigation proposals on repo and securi-
ties lending transactions, and on the impact on the treatment of unsettled transac-
tions.
The Commission’s proposals to adapt the operational risk charge for limited li-
cence firms are felt by many regulators particularly to resolve the problem of ap-
plying the Accord to most investment firms, especially asset managers, and the
categories of investment firms that are subject to minimum initial capital re-
quirements of €50,000 and €125,000.
Broker/dealers and the category of investment firm that are subject to minimum
initial capital requirements of €730,000, remain concerned about the impact of the
new proposals. As noted above, this goes beyond the introduction of an opera-
tional risk charge. While in the banking book, regulatory capital tends rarely if
ever to exceed economic capital, regulatory capital is rather more of a binding
constraint in the trading book. Firms whose entire business is of a trading book
nature believe that this has not been taken into account in developing proposals to
date. The universal banks share these concerns, but the issue is less crucial for
them as the proportion of their trading book business relative to their banking
book is often very small.
Some uncertainty exists about the impact on loan pricing (apart from SMEs), al-
though the evidence suggests that regulatory capital plays only a relatively small
part in pricing decisions. Relatively little work has been done to date to attempt to
identify how bank behaviour might change as a result of applying the new Basel
Accord. The expectation is that the main benefit of the revised Accord should
flow from the greater awareness of risk that it will instil in banks, the incentives
for improved risk analysis and management systems, and the greater incentives
for the correct allocation of capital and the pricing of risk by banks. Most regula-

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tory authorities believe that regulatory capital will not affect loan pricing, except
possibly in marginal cases. Supply and demand, competition, perceived risk and
economic capital are seen as more powerful drivers of pricing. Nevertheless,
regulatory capital is the ultimate constraint on all regulated firms, and most regu-
lated firms seek to maximise the efficient use of regulatory capital. It can, there-
fore, be anticipated that the significant changes that have been made to regulatory
capital requirements will not be without some (mostly modest) impact, either on
the price or the availability of credit to the wider economy.
There is increasing confidence on the back of detailed research by a number of

authorities that any procyclical effects of the new Accord will be moderate and,
indeed, less accentuated than under the current Basel I approach to capital ade-
quacy1.
There is confidence especially among regulatory authorities that, on average, the

position of small and medium-sized enterprises as end-users of financial services
will not be adversely affected. This is based on a number of detailed studies, es-
pecially in countries that have national credit registers. These show that pricing
for risk is an established feature of lending to SMEs. Some finance ministries,
however, remain to be finally convinced of this.
The smaller end-users of financial services, especially SMEs in those countries

that have experienced sluggish growth in the last few years, together with some
finance ministries, fear that Basel could be used as an excuse to increase margins,
deny loans and increase lending bureaucracy. These fears arise because to them
Basel is still a “black box” that they do not understand, and because banks do not
always communicate how they will approach ratings, and explain how ratings
have been determined. In countries where SMEs are primarily based on family
ownership, often coupled with inadequate equity bases for these enterprises, there
is a fear that a more scientific approach to credit risk measurement will inevitably
lead to credit becoming more expensive, or less readily available or subject to
stricter conditionality. It will almost certainly require firms to provide more in-
formation to their banks when seeking loans.
Concern exists about the interaction of International Financial Reporting Stan-

dards and Pillar 1 capital requirements. This concern has been accentuated by the
amended approach to expected losses, following the “Madrid Compromise”
which raises issues around the recognition of provisions for regulatory and ac-
counting purposes respectively. Reconciliation of these two areas should continue
to be given priority. The potential impact of material divergence could be at two
levels. First, in terms of the additional systems costs associated with running dual
processes. Second, it could adversely impact upon management behaviour to-
wards provisioning, even possibly contributing to procyclicality.
1
Minimum capital requirements under Pillar 1 will – as a natural consequence of a more risk sensitive
capital regime – fluctuate over the cycle. However, other factors, such as the improvement in banks’ risk
management systems, the provisions of Pillar 2 and the like, are likely to dampen these cyclical swings.
For a full discussion of the issues surrounding procyclicality please refer to section 8.4 of this report

CONFIDENTIAL
There is some concern, especially among some regulators, that the combination of
Basel and the new accounting standards could lead to excessive reductions in
capital requirements, especially for lending subject to the retail IRB approach.
There is significant concern shared by the authorities and by the industry that the
new Accord and Directive should not produce an unlevel playing field. There is
concern that both the Basel Accord and the proposed Risk Based Capital Direc-
tive contain too many options and discretions in the Pillar 1 requirements for
there to be genuine competitive equality. The implementation of the new capital
framework could be significantly different between jurisdictions. There is, how-
ever, no consensus on what the unnecessary discretions might be.
In particular, there is concern that there should be a more concerted approach to

Pillar 2, which should be more tightly defined, and the duties and powers of su-
pervisors more strictly specified and circumscribed. A number of countries have
constitutional difficulties in giving supervisors unfettered discretion. The need for
international coordination at all levels (bilateral, AIG, Groupe de Contact, and the
Committee of European Banking Supervisors) has been repeatedly stressed.
Without further coordination, particularly within the EU where disparate supervi-
sory approaches exist and supervisory powers are different, there is a real risk that
the effectiveness of CAD 3 will be undermined.
Some regulators that are not part of the G10 and that have, therefore, not been
closely involved in the Basel project so far, stressed the need for more detailed
guidance about how to apply the Accord. The perplexity felt by some regulators
about what might constitute an acceptable Advanced Measurement Approach to
operational risk has already been noted.
The nature of supervision is likely to change somewhat in all territories, and in

some the change will be very radical. Although many member states have devel-
oped risk based approaches to regulation, not all have developed a link between
risk profiles and scores on the one hand and capital requirements on the other.
Implementing the Basel Accord/RBCD will pose significant skills and resource
challenges for firms and regulators alike.
Appendix 3 contains a full list of the interviews conducted.

CONFIDENTIAL
Appendix 3 – List of Interviews

European / International Associations
CESR
EU Banking Advisory Committee (BAC)
European Venture Capital Association
European Banking Federation
European Association of Securities Dealers
European Asset Management Association
Fédération Européenne des Fonds et Sociétés d’Investissement
Austria
Autrian Financial Market Authority
Federal Ministry of Finance
Oesterreichische Nationalbank
Austrian Federal Economic Chamber
Belgium
Commission Bancaire et Financière
Ministère des Finances
National Bank of Belgium
KBC
Denmark
Danish Financial Supervisory Authority (Finanstilsynet)
Finland
Financial Supervision Authority
Ministry of Finance
Appendix 3 – List of interviews Page 1 of 5

CONFIDENTIAL
France
Commission Bancaire
Direction Banque & Direction Prevision of the Tresor
Fédération Bancaire Française
French Venture Capital industry
Natexis Private Equity
Association Française de la Gestion Financière
Germany
Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin)
Deutsche Bundesbank
Federal Ministry of Finance
Banking Associations:
Bundesverband der Volks- und Raiffeisenbanken
Bundesverband der privaten Banken
Verband öffentlicher Banken
Deutscher Sparkassen- und Giroverband
Sparkassenverband Bayern
Bundesverband Deutscher Investmentgesellschaften
Representatives of German banks:
Commerzbank
Deutsche Bank
Dresdner Bank
HVB

CONFIDENTIAL
Industry Representatives:
Genossenschaftsverband Bayern
Industrie und Handelskammer für München und Oberbayern
Vereinigung der Bayerischen Wirtschaft
Other Bavarian financial and business associations
Alexander Radwan, Member of the European Parliament
Greece
Bank of Greece
Capital Market Commission
Hellenic Bank Association
Ireland
Irish Financial Services Regulatory Authority
Irish Finance Ministry
Italy
Banca d’Italia
Italian Treasury
Representatives of Italian banks:
San Paolo IMI
Banca Intesa
Unicredito Italiano
Monte Dei Paschi Di Siena
Banca Popolare di Milano
Italian Banking Association (ABI)
Assogestione

CONFIDENTIAL
Luxembourg
Commission de Surveillance du Secteur Financier
Netherlands
De Nederlandsche Bank
Ministerie van Financiën
Portugal
Bank of Portugal
Ministry of Finance of Portugal
Spain
Bank of Spain
Ministry of Finance
Sweden
Ministry of Finance
Finansinspektionen
United Kingdom
Bank of England
Financial Services Authority
UK Treasury
Representatives of UK banks and investment banks:
Alliance & Leicester
Barclays
CSFB
Goldman Sachs
HSBC

CONFIDENTIAL
Morgan Stanley
Merrill Lynch
RBS
Standard Chartered
London Investment Banking Association (LIBA)
British Bankers’ Association
Credit rating agencies
FitchRatings
Moody’s
Standard & Poors (Paris Office)
Association of Private Client Investment Managers and Stockbrokers
Investment Management Association
A selection of asset management firms
Chris Huhne, Member of the European Parliament
United States
Investment Company Institute
ICI Mutual Insurance Company

CONFIDENTIAL
Appendix 4 - CAD 3 Investment Firms Questionnaire

Please complete a separate questionnaire for each entity in your group (in Europe or USA)
that acts as an investment manager. For EU entities, please complete the questionnaire only
for those entities that are licensed under the investment services directive. Please do not in-
clude entities that operate under the current UCITS directive, banking directive or insurance
directive.
Key
[….] Tick one or more where applicable
* Delete as appropriate.
……% Insert approximate percentage
Background Information
These questions are designed to provide us the exact name of the firm, your contact details,
and information to help us categorise the firm.
1. Contact Name: ………………………………………..

Telephone Number: ………………………………………..
2. Entity name: …………………………………………
3. Legal status (e.g. Ltd., SA, …………………………………………

GmbH.)
4. Jurisdiction (e.g. United …………………………………………

Kingdom, France):
5. Lead regulator (e.g. FSA, …………………………………………

SEC, CFTC, BAFIN, COB):
6. Territories operating in (e.g. …………………………………………

Germany, France): …………………………………………
Please indicate if the firm is …………………………………………
operating through a branch in
those territories under an ISD …………………………………………
passport.
7. Activities
a) Categorisation of clients: ……% Private/Retail

(as percentage of total funds ……% Institutional
under management) ……% Internal customers
……% Other – please specify: …………………..
100 %
Appendix 4 – CAD 3 Questionnaire Page 1 of 8

CONFIDENTIAL
b) Type of management: ……% Authorised Funds

(as percentage of total funds ……% Segregated
under management) ……% Other – please specify: …………………..
100 %
c) What are the assets managed ……% Equity

(as percentage of total funds ……% Fixed Income
under management)?
……% Derivatives
……% Other – please specify: ………………………
100%
d) Active or Passive: ……% Active

……% Passive
100%
8. Risk profile
a) Do you provide custodial ser- …………………………………………

vices? …………………………………………
…………………………………………
…………………………………………
b) Do you hold client money? YES / NO*

If yes, how material is this? High / Medium / Low *
c) How many custodians do you [……]

have? …………………………………………
How do the custodians differ …………………………………………
from each other in the func-
tions they provide? …………………………………………
(e.g. X is custodian of US cer- …………………………………………
tificates] …………………………………………
9. What is your Own Funds re- €730,000 / €125,000 / €50,000 *

quirement?

CONFIDENTIAL
Capital Funding
These questions are designed to provide us with your current capital funding arrangements
and the likely future requirements if the proposed capital requirements are imposed as they
are.
We would appreciate it if the data provided is that at the 31 December 2002. However, if the
information for that date is unavailable, please provide the data nearest indicating exactly the
date in question 10. For questions 12, 13 (a) and 14 you are asked to provide the figures for
the last three years.
In question 13 b), we recognise that different jurisdictions define expenditure slightly differ-
ently. For example the FSA has determined for the UK investment firms that expenditure is
defined as the annual expenditure recorded in the profit and loss account.
10.
a) Date of data if not at 31st De- …./…./… (dd/mm/yy)

cember 2002
b) Is the date in a) your year YES / NO*

end? …./…./…. (dd/mm/yy)
If not – what is your year end
date?
11. What currency are you using

for the answers to this ques- …………………………………………
tionnaire? (e.g. £, €, $)
12. What was your gross income? …………,000 (for 2002)

…………,000 (for 2001)
…………,000 (for 2000)
13. Expenditure
a) What was the amount of your …………,000 (for 2002)

expenditure based capital re- …………,000 (for 2001)
quirement? (EBR usually
based on prior years expendi- …………,000 (for 2000)
ture)
b) How is expenditure defined [….] Staff costs + external costs + taxes

for the purposes of the EBR [….] Staff costs + other administration costs
calculation?
[….] All expenses except exceptional expenses
[….] Administration expenses + other operating costs
[….] Annual expenditure.
[….] Other – please specify: ………………………

CONFIDENTIAL
c) What was your total expendi- …………,000

ture for 2002?
d) What were your deductions …………,000 due to: …………………………

for 2002, if any, in calculating …………,000 due to: …………………
your EBR (discretionary bo-
nuses, shared commissions, …………,000 due to: ……………………
other)?
14. What were your funds under 2002 (bil- 2001 (bil- 2000 (bil-
management? Advised: lion) lion) lion)
Managed: ………… ………… …………
…. ….……… ….
Other: …….……
………… …………
….……… ………. ….
……. …………
….
For Other please specify : ……………………….
15.
a) How was your capital held? ………,000 Paid up share capital and share premium
………,000 Retained profit
………,000 Subordinated Loans
………,000 Other – please specify: ………………
b) What was your total capital ………,000 Total Capital

held?
16. By what percentage, if any, ……% above the regulatory minimum.

was your total capital held
above the regulatory mini-
mum?
Why? ……% Future investment/business development
……% Unprovided uncertainties (e.g. tax liability,
operational losses etc.).
……% Working Capital
……% Regulatory cushion
……% Undrawn funds not currently required by
owners
……% Creditor or customer expectation
……% Other - please specify: …………………
100%

CONFIDENTIAL
Impact of CAD 3
These questions are to gauge your perception of how CAD 3 will affect your firm. For ques-
tion 17 you are asked to asses the impact on your regulatory requirement based upon the
CAD3 gross income test for a solo entity using the BIA rate of 15%.
17.
a) Will CAD 3 be likely to cause YES / NO / Don’t know*

an increase to your regulatory
capital requirement (based on
CAD3 the gross income test
for a solo entity)?
If the answer is ‘NO’ please
go to question 17.
b) If yes to a), do you know by YES / NO

how much?
(please give approximate per- …….%
centage increase if known?)
c) If yes to a), how will you ……% By reducing head room between total capital
consider funding it? held and the regulatory capital requirement.
……% By new paid up share capital & premium ac-
count
……% By new loans
……% By dividend reductions
……% Other – please specify: …………………….
100%
d) If it is likely you would need [….] Reduce activities

more capital for your existing [….] Exit activities
business but decide not to
fund it, would you consider: [….] Move jurisdiction
(Tick only one answer – the [….] Seek a merger
one that is most applicable to [….] Other – please specify: ………………..
you).
18. If you will need less capital, ……% Paid share capital & premium account
what will you withdraw, if ……% Loans
anything?
……% Retained profit
……% Other – please specify: ………………..
100%

CONFIDENTIAL
19. Will implementing the pro- Increase / Reduce / Don’t know*

posals likely increase or re-
duce your profitability?
……………………………
Why? ……………………………
……………………………
……………………………
How significant is the in- ……………………………
crease /reduction? ……………………………
High / Medium / Low *
20. Will the new capital require- Advantage / Disadvantage / Don’t know*
ments put you at an advantage
or disadvantage compared
with other countries? ……………………………
……………………………
Which countries and why?
……………………………
……………………………
……………………………
How significant is the advan- ……………………………
tage/disadvantage?
High / Medium / Low *
21. If you require extra capital, YES / NO / Don’t know *

will you be able to reflect the
cost in your pricing?
……………………………
Please explain why e.g, No - ……………………………
because of significant compe-
tition. ……………………………
……………………………
……………………………
……………………………

CONFIDENTIAL
Insurance against operational losses

In the US some firms have no regulatory capital requirement but instead must take out in-
surance against possible operational losses. Question 20 and 21, enquire as to whether in-
vestment firms in the EU have either been obliged to or voluntarily taken out this type of in-
surance policy. (For US firms, please ensure to fill in question 21).
22. Do you have insurance YES / NO *

against operational losses?
If yes, why? [….] Regulatory requirement
[….] Market expectation
[….] Risk management
[….] Other – please specify: ………………..
23. If yes, what was the annual ……………………………

gross premium paid in respect
of this entity?
Group risk
24. Do the consolidated supervi- YES / NO / Don’t know *

sion rules make acquisitions ……………………………
less attractive to you? ……………………………
Why? ……………………………
……………………………
……………………………
……………………………
25. Is your organisation currently YES / NO *

subject to group capital re- ……………………………
quirements? ……………………………
If yes, why? ……………………………
……………………………
……………………………
……………………………
26. Do you hold additional capital YES / NO *

in your business to meet these
requirements?

CONFIDENTIAL
Any other comments

If you any further comments on how CAD 3 will affect your firm please use the space be-
low. (Please state question number if continuing a question above)
27 …………………………… …………………………… ……………………………

…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………
…………………………… …………………………… ……………………………
…………………

CONFIDENTIAL
Appendix 5 – Bibliography
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CONFIDENTIAL
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mimeo, World Bank, 1999
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per No. 130, LSE Financial Markets Group and ESRC Research Centre, May 2001
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CONFIDENTIAL
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CONFIDENTIAL
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CONFIDENTIAL
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CONFIDENTIAL
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Draft, December 2003

CONFIDENTIAL
Appendix 6 – NIESR Research Papers

The Structure of NiGEM
Over the last 15 years, NIESR has developed the global macro model NiGEM for use in
policy examination1. NiGEM is an estimated model, which uses a ‘New-Keynesian’
framework in that agents are presumed to be forward-looking, but nominal rigidities
slow the process of adjustment to external events. All countries in the OECD are mod-
elled separately2. All economies are linked through the effects of trade and competitive-
ness. There are also links between countries in their financial markets via the structure
and composition of wealth, emphasising the role and origin of foreign assets and liabili-
ties. There are forward-looking wages, consumption, and exchange rates, while long-
term interest rates are the forward convolution of short-term interest rates. The model
has complete demand and supply sides and there is an extensive monetary and financial
sector. NiGEM contains expectations.
Trade
These equations depend upon demand and relative competitiveness effects, and the lat-
ter are defined in similar ways across countries. It is assumed that exporters compete
against others who export (X) to the same market via relative prices (RPX), and demand
is given by the imports in the markets to which the country has previously exported (S)
∆ log X = λ[log X(-1)- log S(-1) + b*log RPX] + c1*∆log X(-1) + c2*∆log S + +
error (1)
while imports (M) depend upon import prices relative to domestic prices (RPM) and on
demand (TFE)
∆ logM = λ[log M(-1)- b1*log TFE(-1) + b2*log RPM] + c1*∆log M(-1) + c2*∆log
TFE + + error (2)
As exports depend on imports, they will rise together in the model. A similar pattern of
linkages is used for trade in services. Both systems of trade equations are ‘closed’ to en-
sure that the world balance of trade adds up, at least to its normal degree of accuracy, in
any simulation. The equations are estimated in equilibrium correction form.
Financial markets
Forward looking nominal long rates LR and long real rates have to look T periods for-
ward using expected short-term nominal and real interest rates respectively using
(1+LRt) = Πj=1, T (1+SRt+j)1/T (3)
1
See NIESR (2003) for a description of the model, and Barrell, Kirsanova and Hurst (2003) for a brief
description.
2
However, some smaller countries, such as Luxembourg, Andorra etc are aggregated with others.
Appendix 6 – NIESR Papers - NiGEM Page 1 of 5

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Forward looking exchange rates RX have to look one period forward along the arbitrage
relation involving domestic and foreign short term interest rates (SRH and SRF)
RXt = RXt+1 (1+SRHt)/(1+SRFt) (4)
Forward looking equity prices are solved out from the discounted sum of expected dis-
counted profits; where profits are the difference between nominal GDP (GDPN) and la-
bour income (which is the product of wages per unit of labour, W and labour usage, E)
after allowing for depreciation of the capital stock (KDEP), divided by the real stock of
capital (K). The discount factor is made up of the nominal interest rate, r, and the risk
premium on equity holding decisions, rpe.
EQPt = Σ i∞=1 (((Π t +i ) /( K t +i )) /((1 + r )(1 + rpe) (5)
This can be written as an infinite forward recursion that depends only on current profits
(∏) and the expected equity price next period.
EQPt = ∏t + EQPt+1/ (1 + r )(1 + rpe) (6)

The equity price will jump when any of its future determinants changes.
Wealth and asset accumulation
The wealth and accumulation system allows for flows of saving onto wealth and for re-
valuations of existing stocks of assets in line with their prices determined as above. In
the medium term, personal sector liabilities are assumed to rise in line with nominal
personal incomes, and if there are no revaluations, gross financial wealth will increase
by the nominal value of net private sector saving plus the net increase in nominal liabili-
ties. Revaluations come from the following three sources:
1 Domestic Equity Prices. These revalue the proportion of the domestic share of the
portfolio that is held in equities, both quoted and unquoted. We assume that un-
quoted shares rise in line with quoted shares. Balance of Payments data include an
estimate of the equity stock of the domestic production sector held abroad.
2 Domestic Bond Prices The scope of revaluations to bonds is calculated using in-
formation on the maturity structure of government debt. When long rates jump
down bond prices jump up. Data are available on the proportion of debt held
abroad, and this is used in revaluations.
3 Foreign Assets and Liabilities There is information on the structure of liabilities

to foreigners, and hence when equity and bond prices change, the value of Gross
Liabilities also changes. Countries receive revaluations in proportion to their
stock of Gross Assets as a share of the world total after factoring out banking sec-
tor deposit assets. Hence a change in US (and other) equity prices affects Gross
Assets and hence wealth in other countries ‘correctly’, as do changes in the value
of bonds held abroad. Cross-country differences in the importance of assets as a
percent of income, and in the structure of assets, as well as the responsiveness of
consumption to them are important factors driving the results in this note.

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Consumption and Personal Income
The consumption relations are based on an Euler equation for a consumer who is not li-
quidity constrained. The Euler equation embeds an optimising error correction on the
long run, preference driven, consumption, income and wealth relationship. The long run
parameters have been calibrated from Barrell, Byrne and Dury (2003) and adjustments
speeds are estimated in a panel context. We may write the change in consumption, C as
depending on the equilibrium correction between consumption, incomes (RPDI) and
real net wealth (RNW). Adjustment costs are assumed to be quadratic, and behaviour is
forward looking. The coefficient δ on the forward change in consumption is the rate of
time preference. The resulting equation with all variables in logs is:
∆log C = λ[log C(-1) – a*log RPDI(-1) – (1-a)*log RNW(-1)] +δ1* ∆ log C(+1) +δ2*∆
log RPDI+δ3*∆ log C(-1) + error (7)
As outlined above, it is assumed that besides being cumulated saving, wealth is affected
by financial market activity through equity and bond prices, and if these markets ‘ex-
pect’ something in the future then it will be reflected in prices. News that changes ex-
pectations will cause wealth to be revalued, and hence will affect behaviour now. Pub-
lished data on Net Financial Wealth3 are used, and the ratios of wealth to income.
Production
For each country there is an underlying CES production function which constitutes the
theoretical background for the specification of the factor demand equations for em-
ployment and the capital stock, and which form the basis for unit total costs and the
measure of capacity utilisation which then feed into the price system. A CES production
function that embodies labour augmenting technological progress (denoted λ) with con-
stant returns to scale can be written as:
[
Q = γ s (K )
−ρ
+ (1 − s )( Le λt ) − ρ ]
−1 / ρ
(8)
γ and s are production function scale parameters, and the elasticity of substitution, σ, is
given by 1/(1+ρ). Variables K and L denote the net capital stock and labour input meas-
ured in terms of employee hours. The parameters of the production function vary across
countries and w, c and p denote respectively labour costs per head, nominal user costs of
capital and the price of value added (at factor cost) and β denotes the mark-up. With
long-run constant returns to scale, we obtain log-linear factor demand equations of the
form:
Ln( L) = [σ ln{β (1 − s )} − (1 − σ ) ln(γ )] + ln(Q) − (1 − σ )λt − σ ln( w / p ) (9)
Ln( K ) = [σ ln( βs ) − (1 − σ ) ln(γ )] + ln(Q) − σ ln(c / p * (1 + rp )) (10)
3
Data for the G7 are discussed in Byrne and Davis (2003), and are generally available, for instance in
OECD sources. For some small countries we have constructed data in consultation with the Central Bank.

CONFIDENTIAL
The parameters are used in the construction of an indicator of capacity utilisation, which
affects the mark-up of prices over unit total costs. The capital stock adjustment equation
depends upon the long run equilibrium capital stock, and the user cost of capital is in-
fluenced by the forward-looking real long-term rate, as well as by taxes and by depre-
ciation. The speed of adjustment to equilibrium in the investment/capital stock adjust-
ment equations also depends upon the short-term real interest rate, with this effect being
similar across countries. The user cost of capital variable c/p is calculated from data for
the past, but individual firms take account of risk on their investments when undertaking
projects. The risk premium rp can be varied in simulations. If the risk premium is high,
then the equity market valuation of the capital equipment will be lower, and hence one
can link Tobin’s q and equity market effects to the level of investment by shifting the
risk premium in the cost of capital.
Labour markets
It is assumed that employers have the power to manage, and hence the bargain in the la-
bour market is over the real wage. In the long run, wages rise in line with productivity,
all else equal. Given the determinants of the trajectory for real wages, if unemployment
rises then real wages fall relative to trend, and conversely. The equations were estimated
in an Equilibrium Correction format with dynamics estimated around the long run. Both
the determinants of equilibrium and the dynamics of adjustment can change over time
and adjustment, especially in Europe, is slow. We assume that labour markets embody
rational expectations over the inflation rate and we assume that wage bargainers use
model consistent expectations, either for the immediate period ahead or over a longer-
term horizon. These compensation equations are discussed at some length in Barrell and
Dury (2003) and all these equations are dynamically homogenous.
Policy rules
Fiscal and monetary policy rules are important in ‘closing the model’ and the rules are
discussed at greater length in Barrell and Dury (2000). We use simple rules that are de-
signed to reflect policy frameworks rather than optimal rules.
Fiscal Policy rules
Budget deficits are kept within bounds in the longer term, and taxes rise to do this. This
simple feedback rule is important in ensuring the long run stability of the model. With-
out a solvency rule (or a no Ponzi games assumption) there is no necessary solution to a
forward-looking model. The simple fiscal rule can be described as
Taxt = Taxt-1 + φ [GBRT – GBR] (11)
Where Tax is the direct tax rate, GBR and GBRT are the government surplus target and
actual surplus, φ is the feedback parameter, which is designed to remove an excess defi-
cit in less that five years.
Monetary Policy Rules

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It is assumed that the monetary authorities adopt simple targeting rules that stabilise the
price level or the inflation rate in the long term. If we use different rules in different
countries then some of the difference we observe would depend on that policy choice
and in this paper we use the same rule for all countries. The European Central Bank
(ECB) has been set the objective of maintaining price stability in the medium term. It
has set itself a target for inflation within the constraints of a nominal target for the stock
of money, and it describes this as the two-pillar strategy4. A combined policy of nomi-
nal aggregate and inflation rate targeting would give:
rt = γ 1 ( Pt Y t − P * t Y t *) + γ 2 ( ∆ Pt + j − ∆ Pt + j *) (12)
The combined rule is chosen as the default monetary policy rule because it represents
the mixed framework that is used in Europe by the European Central Bank (ECB). We
choose to use it elsewhere as the proportional controller on inflation dominates re-
sponses. Note that a fiscal expansion in the model leads to inflation via changes in the
saving/investment balance – given the monetary policy rule, this will drive up short
rates and hence long rates, given equation (3).
References:
Barrell, R., Byrne J., and Dury K., (2003) ‘The implications of diversity in consumption
behaviour for the choice of monetary policy rules in Europe’ Economic Modelling
Barrell, Ray, and Dury, Karen, (2000) ‘An Evaluation of Monetary Targeting Regimes’
National Institute Economic Review No. 174 October 2000
Barrell, Ray., and Dury, Karen, (2003) ‘Asymmetric labour markets in a converging
Europe: Do differences matter? National Institute Economic Review January
4
European Central Bank (2001). We do not target money, as this is a poor indicator of the underlying tar-
get, which we take to be nominal GDP.

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BASEL II, BANKING CRISES AND THE EU FINANCIAL

SYSTEM
Ray Barrell1, E Philip Davis2 and Olga Pomerantz3
NIESR and Brunel University
London
1
Senior Fellow, 2 Dean Trench Street, Smith Square, London SW1P 3HE e-mail rbarrell@niesr.ac.uk
2
Professor of Economics and Finance, Brunel University, Uxbridge, Middlesex, UB8 3PH and Visiting
Fellow, NIESR. e- mails: philip.davis@brunel.ac.uk and e_philip_davis@msn.com. Sections of the text
are drawn from Davis (2002b and 2003).
3
Economist, NIESR, 2 Dean Trench Street, Smith Square, London SW1P 3HE e-mail opomer-
antz@niesr.ac.uk
Appendix 6 – NIESR Papers – Banking Crises Page 1 of 47

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BASEL II, BANKING CRISES AND THE EU FINANCIAL SYSTEM
Executive Summary
This paper seeks to provide an assessment of the genesis and impact of banking crises in
advanced countries, in the light of which it makes suggestions about the impact of Basel
II on banking sector stability in the EU. The first section outlines the main features of
the Basel I and II Accords as a backdrop to analysis in subsequent sections. It highlights
the fact that although Basel II will remedy a number of the shortcomings of its prede-
cessor, a number of critiques have already been made of the proposals, which we draw
on in our own analysis. For example, Basel II may not meet the need for economic capi-
tal to be boosted to a higher level of regulatory capital (capital needs may actually fall);
it depends on the accuracy of both external and internal ratings – they may be inaccurate
or lag reality; in this context, there is a lack of development of satisfactory credit risk
models (and data to use in them), and potential moral hazard from regulatory approval
of internal systems; there will be a need for a culture change by many regulators from
rules based regulation to process based supervision; disclosure alone is not sufficient for
market discipline; operational risk modelling is not possible with current information,
and no convincing reason for such regulation has been suggested (it may simply be an
ad hoc way of boosting capital). Risk is often endogenous and hence VARs – and credit
risk models - can destabilise an economy or financial system; indeed, the proposals may
induce credit cycles which may enhance systemic risk, because credit quality falls in re-
cession and capital requirements rise, inducing credit rationing.
Section 2 outlines the banking crises in a number of OECD countries (the U.S., Japan
and Nordic countries) and analyses the primary causes and direct fiscal costs of these
episodes. We contend that such accounts are essential to the understanding of potential
risks for financial instability in the EU, and the extent to which they will be diminished
by Basel II. All the examined episodes followed rapid financial liberalisation without
accompanying improvement of surveillance mechanisms. As private actors responded to
the new environment, unregulated institutions entered the financial system and com-
peted directly with established banks in some cases, exacerbating asset price bubbles.
Each crisis followed a macroeconomic shock, but vulnerability of the banking sector
was evident before the shock. Accounting figures were often inadequate to assess
banks’ robustness and regulatory forbearance worsened losses.
Reviewing the events in the light of theory, Section 3 highlights that features common
to all crises included regime shifts – first to laxity, such as deregulation, and later to rig-
our, via monetary tightening. Deregulation implied easing of entry conditions to finan-
cial markets, and led to heightened competition and risk taking. This was followed by
debt accumulation and asset price booms, generating vulnerable balance sheets across
large sectors of the economies. Liberalisation and increased competition also stimulated
financial innovation, which increases uncertainty during the crisis, since properties of
innovations have not been tested under stress. Low capital and risk concentration limit-
ing banks’ exposure to a few sectors, reduced robustness to shocks, such as monetary
policy tightening or LDC default.
How the rules in Basel II will contribute to improving EU financial stability is the sub-
ject of analysis in Section 3.3. Although EU financial markets have been largely liberal-
ised, shocks such as policy regime shifts, financial innovations, disintermediation and
new entry into lucrative markets – facilitated by the advent of the euro – will continue to

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occur. Crises typically being unprecedented events, time series of loan losses used in
credit risk assessment may not capture them, while lack of diversification across sectors
may recur, and accounting systems may continue to give a false picture of banks’
health. Asset price bubbles will continue to pose difficulties for policymakers and banks
alike; even the Basel Committee note that it is unlikely that capital standards would bind
in a real estate driven boom, because profits from real estate lending and the increased
value of real estate collateral would provide ample capital for further lending expansion.
Of the issues identified in the preceding section, Basel II will deal most directly with re-
ducing a banking system’s vulnerability by ensuring capital adequacy through finer risk
weights. If a crisis does occur, Basel II capital adequacy should reduce the incidence of
insolvency and illiquidity, but, it is not itself directed to ensure that sound liability man-
agement or sufficient liquid assets are maintained. With regards to surveillance, Basel
II seeks to put increased focus on sound process-oriented supervision, but does not ad-
dress directly regulatory structures or supervisory staffing requirements, while some EU
supervisors may find adjustment from a rules-basis difficult. There may be more fre-
quent runs in the interbank market as banks’ credit ratings are lowered, while procycli-
cality will also pose difficulties for the non-financial sectors. The latest rules do little to
address the concentration of risk directly, and do not mandate that provisions be built up
in booms to cover later losses. Pillar 3 will be weak in the EU owing to the importance
of mutual and state owned banks. A general shortcoming of Basel II is lack of consid-
eration for macroprudential surveillance, for loans that appear sound individually or
even as a class, may be less so in the context of macroeconomic developments, such as
trends in asset prices, overall credit expansion, and non-financial sector balance sheets.
Lastly, section 4 explores the costs of financial instability that motivate Basel II Agree-
ment. Following crises, economic losses may comprise inter alia losses by stakeholders,
including bank shareholders, depositors and other creditors; losses to borrowers who
lose access to funds and may find difficulty accessing other sources of capital; and fiscal
losses during resolution. More generally, a banking crisis induces a shrinkage of the
money supply that may lead to a recession. The scope of these costs depends of the
manner and speed of resolution by the authorities. The estimates of costs vary, but gen-
erally lie in the range of a 3-10 % decline in GDP relative to trend. Crises last longer in
OECD countries than developing countries (over 4 years) underlining the vital need for
prevention.
A simulation of a banking crisis in an EU country (the UK) using the NiGEM model is
driven largely by a sharp widening of bank spreads (also entailing credit rationing). As a
result, GDP declines by more than 3.5% below base for several years, with investment
showing the largest declines of over 16% per annum but consumption also 7% lower
given high household gearing. Equity and house prices fall; the adjustment in the hous-
ing market is more gradual but also more severe. With respect to trading partners,
France and Germany would be expected to suffer a fall in GDP as a consequence of the
UK recession, with the impact on the Euro Area about 10% the size of the effect on UK.
Monetary policy and exchange rate responses help to alleviate the domestic macroeco-
nomic consequences of a crisis. This points to a challenge for EMU, where these ad-
justment mechanisms are not available for individual countries, and indeed, estimated
output losses were the UK in EMU are 50% higher.

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In the conclusion, we note that the EU will face a number of future challenges that
could impact banking sector stability. These range from the growth in cross border
banking competition as a result of EMU to the outworkings of population ageing.
Introduction
This article seeks to provide an assessment of the genesis and impact of banking crises
in advanced countries, in the light of which it makes suggestions about the impact of
Basel II on banking sector stability in the EU. The article is structured as follows: we
first give an overview of Basel II, then we outline in detail three key examples of bank-
ing crises in OECD countries – those in the US, Japan and Nordic countries. We con-
tend that such accounts are essential to the understanding of potential risks to financial
stability in the EU and the extent to which they will be diminished by Basel II. There
are a number of key parallels, notably a link to financial liberalisation. We go on to out-
line a theoretical framework that helps us to understand financial instability, drawing on
the examples to illustrate the theories. Then we summarise recent estimates of the costs
of banking crises to underline why crisis prevention is crucial. We use this material at
the end of each section to assess the contribution of Basel II to improving EU stability,
areas where risks are not addressed by it, and areas where it could be counter produc-
tive. In a final section we undertake a simulation of a banking crisis with NiGEM. It is
noted that the monetary policy and exchange rate response help to alleviate the macro-
economic consequences. This points to a challenge for EMU, where these adjustment
mechanisms are not available for individual countries.
Before commencing, it is important to define financial instability. We prefer to define
systemic risk, financial instability or disorder as entailing heightened risk of a financial
crisis - “a major collapse of the financial system, entailing inability to provide payments
services or to allocate credit to productive investment opportunities”. Such a crisis in
turn would have a major effect on general economic activity domestically and on trad-
ing partners. Note that the definition excludes asset price volatility and misalignment as
independent aspects of instability4; systemic risk tends to be ultimately related to con-
cerns about solvency of financial institutions, although failure of market liquidity and
breakdown of market infrastructure may also be important. Asset price volatility is rele-
vant to the extent that it contributes to these. In most OECD countries, which are the fo-
cus in this article, systemic risk has generally been countered by the authorities, thus
preventing a crisis per se. In emerging market economies, on the other hand, a large
number of full-blown financial crises have taken place in recent decades (Mishkin
2001). Despite these differences, we note that some studies suggest estimates of costs
that are higher in OECD countries than in emerging market economies.
1 An overview of Basel II and its potential implications

It is essential to begin by outlining international capital adequacy agreements so they
can be kept in mind when discussing events, theories and estimates of costs. Basel I at-
tempted to enhance safety and soundness of banks in the wake of the LDC debt crisis
(Section 2.1.2). It also sought to ensure a “level playing field” so banks from countries
such as Japan did not “compete unfairly” with less capital than elsewhere. The focus
was on internationally active banks and the primary concern credit risk. Basel I set a
minimum risk weighted capital ratio of 8%, at least 50% of which should be Tier 1.
4
The correct definitions of financial stability and instability are a topic of controversy, which is by no
means resolved. See the discussion in groups.yahoo.com/group/financial_stability during June 2001.

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There was a crude application of risk weighting to assets, with four “buckets” of 0%
(e.g. OECD sovereigns), 20% (e.g. interbank), 50% (e.g. mortgages) and 100% (e.g.
corporate loans). The definition of capital was tightened with exclusion of some items
from capital previously included. Authorities were free to impose tighter controls. Off
balance sheet (OBS) items such as loan commitments were included in capital adequacy
calculations for the first time. By 1993 virtually all international banks qualified.
Criticisms of Basel I included that 8% became a target and not a minimum. There were
crude risk classes e.g. 100% for loans to all non-financial companies regardless of credit
quality. They were manipulable, e.g. by renaming loans as mortgages, capital require-
ment could be cut to 50%. There was also an incentive to maximise risk within the
“buckets”, for example by shifting to higher risk and higher return corporate loans. Ini-
tially, Basel I covered credit risk only (there was a later extension to market risk in
1996, when banks were allowed to use approved value-at-risk models). There were con-
cessions e.g. to Japanese use of equity values in capital – now a mixed blessing for them
as shown in Section 2.3, given collapse of the equity market. And non-equity items
were included in definitions of equity (e.g. subordinated debt).
No account was taken of whether banking risk might differ cross-country (e.g. due to
differing scope of banking relationships); no consideration was given to portfolio as-
pects (where, as shown in Davis (1993) some types of loan loss such as those on prop-
erty and construction are more correlated with the cycle than others). And there were no
satisfactory rules for dealing with asset valuation, loan loss recognition and provision-
ing. Basel I failed to keep up with the development of banks’ internal systems and with
financial innovations such as credit derivatives and securitisation.
Basel II seeks to deal with some of these aspects. Again, there is a focus on international
banks and their credit risks – seeking to limit arbitrage by aligning capital with risks and
dealing with innovation. After the first proposal in 1999, Basel II is undergoing exten-
sive consultation process, and is currently planned to be implemented in 2006 at the ear-
liest. Supervisors will be less involved in establishing rules for determining capital ade-
quacy and will focus instead on ensuring the adequacy of internal risk management pro-
cedures. More generally, there is a “shift from rules based to process oriented regula-
tion” akin to the shift for pension funds from quantitative restrictions to prudent person
rules (Davis 2002a).
Three approaches will be available. The standardised approach is for simple banks to
complement process oriented supervision, with more differentiated risk buckets and use
of ratings generated by rating agencies. More complex banks can use internal risk mod-
els as a basis for allocating capital in (i) the “foundation” approach – the bank estimates
the probability of default and the supervisor supplies other inputs (ii) the “advanced”
approach – banks run models and determine their own parameters, and hence capital al-
location. But banks are not free to set correlations between losses. There will be en-
hanced sensitivity to collateral, guarantees, credit derivatives, netting and securitisation.
Finally, an enhanced role is sought for market discipline, via disclosure. Indeed, market
discipline is called the “third pillar” of Basel II after capital adequacy per se and super-
vision.
Some issues relevant to a view of whether Basel II will ameliorate or worsen systemic
risks are presented by Caracadag and Taylor (2000), Danielsson et al (2001) and
ESFRC (2003). According to Caracadag and Taylor (2000) Basel II does not meet the
need for economic capital to be boosted to a level of regulatory capital (where economic

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capital is that which the bank seeks to hold, which is less than socially optimal level of
regulatory capital since banks disregard the externalities of systemic risk that their ac-
tivities may provoke). Basel II depends on the accuracy of both external and internal
ratings – they may be inaccurate or lag reality. If they underplay risk they may lead to
inadequate capital, while if they overplay it they may lead to unnecessary credit ration-
ing. There is a lack of development of satisfactory credit risk models, and potential
moral hazard from regulatory approval of internal systems. More generally there is a
lack of information on banks’ internal systems. There will be a need for a culture
change by many regulators from rules based regulation to process based supervision.
Disclosure alone is not sufficient for market discipline (uninsured debt is also needed to
give a class of creditors with the incentive to monitor and a broader market signal – the
spread over government debt yields – of their concerns).
Danielsson et al (2001) suggest that risk is endogenous and hence VARs – and credit
risk models - can destabilise an economy or financial system, because the response to an
initial shock can amplify the size of the disturbance. Better risk measures are available
than those used by the Basel Committee. Again there is concern that rating agencies
give conflicting and inconsistent view of creditworthiness – and are unregulated. Opera-
tional risk modelling is not possible with current information, and no convincing reason
for such regulation has been suggested (it may simply be an ad hoc way of boosting
economic capital to a regulatory level). And finally the proposals will induce credit cy-
cles which may enhance systemic risk because credit quality falls in recession and capi-
tal requirements rise inducing credit rationing. Overall, progress on Basel II to date has
not dealt with these issues.
ESFRC (2003) express concerns that the complexity of Basel II and the role assigned to
national supervisors make an arm's length relation between regulators and the regulated
nearly impossible. While the traditional role of supervisors is to oversee banks' imple-
mentation of rules designed to enhance consumer protection and financial stability, the
CP3 assigns supervisors roles that make them deeply involved in the micro decisions of
risk management. This could lead to “regulatory capture” and worsen moral hazard.
They also expressed concern that the issue of capital requirements for SMEs has be-
come a political issue rather than an economic one, with introduction of ad- hoc ap-
proaches favouring SMEs, such as differentiated capital requirements based on the size
of the borrower or reclassification of smaller loans as retail.
2 Three case studies of banking crises
In this section we outline the main events and economic background of three major
banking crises in OECD economies, namely those in the US, Japan and Nordic coun-
tries; see Table 1 for an overview. These provide concrete material to judge the impact
of Basel II, also in the light of theory and assessment of the costs of crises. The focus
here is on OECD country crises because conditions for these were closest to those in EU
countries. The focus on banking crises is particularly relevant since the EU countries
remain mostly dependent on banking finance, and Basel II seeks to address banking
problems most directly. At the same time, we note that as shown in Davis (2003), bank-
ing crises are only a subset of the systemic risks to which advanced countries are sub-
ject, the others being market price volatility after a shift in expectations (e.g. the 1987
stock market crash, the 1992-3 ERM crisis and 1994 bond market reversal) and a col-
lapse in debt securities market liquidity and issuance (e.g. Russia/LTCM in 1998, the
collapse of junk bonds in 1989 and Penn Central and the US CP market in 1970). These

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can impact banks indirectly, for example through losses on loans to the hedge fund
LTCM in 1998. Those already familiar with the events in question should turn to Sec-
tion 2.4 where we make a preliminary evaluation.
Table 1: Selected Episodes of Banking Distress in OECD Countries
direct cost to output loss (%
date duration taxpayers* of GDP)
U.S. thrifts 1980-1994 14 years 2.5 -
U.S. banks 1982-1994** 12 years 0.5 -
Japan 1991-2001 10 years 14.0 71.7
Norway 1989-1992 4 years 3.4 27.1
Sweden 1991-1994 4 years 2.1 3.8
Finland 1991-1994 4 years 10.0 44.9
* per cent of annual GDP at end of episode
**several different episodes
Sources: Nakaso (2001), Ongena et. al (2000), Englund (1999), Hoggarth and Sapporta (2001)
2.1 U.S. Banking Crises, 1980-1994
The distinguishing feature of U.S. banking in the 1980s was the extraordinary upsurge
in the number of failures. Between 1980 and 1994, 1617 banks and 1295 savings &
loans institutions, otherwise known as thrifts, failed and were liquidated. The estimated
total cost of Federal Deposit Insurance Corporation (FDIC) failed-bank resolutions in
1980-1994 is $36.3 billion. The estimated cost of the savings and loan debacle is $160.1
billion, of which approximately $132.1 billion was borne by taxpayers5(FDIC, 1997;
Chapter 1). On the other hand, it is worth noting that the impact of the crises on US
economic performance was low, especially compared with the other cases cited in this
section (see Table 1). The scope of bond finance may have a role to play in this (Davis
2001b).
Although immediately relevant circumstances differed somewhat for banks and thrifts,
it is widely suggested that regulatory structures no longer appropriate in the prevailing
economic climate and ill-considered deregulation caused or at least exacerbated exces-
sive risk taking in lending and investment practices, which were ultimately responsible
for the exceptionally large number of failed financial institutions. In the case of thrifts,
regulatory forbearance, motivated by political pressure, in the absence of a visible plan
for recovery, led to heightened risk taking and a costly debacle. Among banks, difficul-
ties were met along several dimensions; many were due to specific regional conditions,
such as agricultural bubble or oil-based boom in Texas (Davis 2001a); for internation-
ally active banks, the LDC crisis played a major role. Given the number of failures, it is
not possible to analyse each in detail in this document, but it is important to note that
bank failures not explicitly discussed here were also often rooted in the causes identified
here (see also United States General Accounting Office 1997).
2.1.1 The U.S. Savings and Loan Crisis
5
These figures represent the largest estimates. Curry and Shibut (2000) suggest slightly smaller figures.

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US savings and loans institutions – otherwise known as thrifts – developed strongly in

the aftermath of the 1929-33 financial crises. In the general tightening of regulation and
compartmentalisation of the US financial system, thrifts were assigned responsibility for
provision of long-term, fixed-rate residential mortgages secured by property within a
fifty-mile radius of the institution’s home office (England, 1992). To finance such mort-
gage loans, they gathered the savings of households in short-term deposits, which were
federally insured. Regional Federal Home Loan Banks were available to lend member
institutions funds at subsidised rates and the industry had an official advocate in the
Federal Home Loan Bank Board, located in Washington D.C.
Since mortgages constitute one of the safest forms of consumer debt, savings and loans
institutions historically faced relatively little credit risk, which was nevertheless com-
pounded by the fact that each institution served a limited geographic area (so they were
vulnerable to local shocks). As long as interest rates remained fairly stable over long pe-
riods of time, borrowing short and lending long was fairly profitable, since interest rates
on long-term contracts were higher than those on short-term deposits, and houses were
often resold and refinanced before the loans were fully repaid. To protect themselves
from high funding costs, the savings & loans industry lobbied for ceilings on deposit
rates, which were imposed in 1966.
In the early 1970s, increased economic uncertainty coupled with rising interest costs
depressed the housing market. Mortgage portfolios that had traditionally turned over
every five years stagnated and the thrifts’ earnings stagnated with them: in 1980 the av-
erage effective yield on S&Ls’ portfolios was 8.79%, while the annual inflation rate
stood at 12.4% and government bonds yielded 11.5%. Not surprisingly, the liabilities of
the savings & loans industry exceeded its assets at market value by $110 billion in the
same year (England, 1992), owing to such interest rate and maturity-mismatch risk.
High rates of inflation also wreaked havoc with the industry’s funding, as interest rates
rose for long periods above the deposit ceilings. The ceilings prevented their liability
rates exceeding asset yields, but their customers/depositors became increasingly dissat-
isfied, as returns on savings of 5¼ to 5½ per cent fell far short when annual inflation ex-
ceeded 12 per cent. Deregulation of U.S. financial markets and liberalisation of interest
rates enabled small depositors to shift to recently established money-market institutions,
where returns were commensurate with prevailing inflation rates. Between 1978 and
1981 money market mutual funds grew from $9.5 billion to $188.6 billion in assets,
with many of their customers coming from thrifts (England, 1992).
As the regulatory structure governing the operating conditions of thrifts was no longer
appropriate in the economic climate of the 1970s, policymakers sought to adapt regula-
tions to the current conditions (Davis, 2001a). To help Savings and Loans to diversify
their portfolio away from long-term, fixed-rate assets, the federal government granted
the industry new investment opportunities, such as adjustable rate mortgages, short-term
consumer loans, credit cards and commercial real estate loans. Funding problems were
also supposed to be relieved via a six-year phase out of deposit interest rate ceilings and
expanded federal deposit insurance, which now covered $100,000 per bank deposit per
institution.
However, the thrift industry was deregulated without an accompanying increase in su-
pervision resources – for some years examiner resources actually declined (Curry and
Shibut, 2000). In the late 1970s and early 1980s the supervisory authorities believed that
the use of computer technology would enhance off-site surveillance thereby reducing

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the need for on-site examination. In addition, both the Carter and Reagan administra-
tions restricted federal hiring in an attempt to reduce the size of the federal government.
As a result, between 1979 and 1984 the total number of examiners in federal banking
agencies declined by 20 per cent (FDIC, 1997; Chapter 1).
The need for re-capitalisation coupled with highly imperfect industry monitoring in an
environment of newly available wide choice of investment options produced disastrous
consequences in terms of credit risk. As many thrifts tried to grow out of their problems
by rapid expansion, they diversified into high-yield and high-risk assets such as land,
development, construction, commercial real estate and junk bonds. Risk was often con-
centrated in narrow types of business activity and geographically. Real estate was par-
ticularly favoured to generous depreciation provision in the tax code at the time. Real
estate related expansion was particularly marked in Texas, which experienced an oil-
related boom over 1983-85. Fraud was also prevalent, as many managers who entered
the industry de novo or taken over faltering institutions, had little reputational or mone-
tary capital at risk. Since federal deposit insurance protected most savings and loan de-
positors from losses, equity holders had little to lose and were therefore content to fi-
nance such ventures, particularly for thrifts that were in financial distress. Moreover,
healthy thrifts were asked to pay increasing deposit insurance premiums to protect de-
positors in failing institutions (England, 1992). Multiple reorganisations of supervisory
bodies coupled with reductions in their budgets over the 1980s significantly reduced the
quality and timeliness of industry watch dogs’ outputs.
After declines in commodity prices in 1985-86, and withdrawal in 1986 of federal tax
laws (enacted in 1981) that benefited commercial real estate investments, the office and
to a lesser extent residential real estate markets collapsed and many of the other specula-
tive loans proved non performing. By the end of 1986 the federal insurer for the thrift
industry was insolvent along with 441 thrifts which held $113 billion in assets. Another
533 thrifts, with $453 billion in assets, had tangible capital of no more than 2 per cent of
total assets. These 974 thrifts accounted for 47 per cent of industry assets (Curry and
Shibut, 2000).
The policy response focused on guaranteeing deposit-insurance liabilities to prevent
widespread runs on thrifts and banks and consequent failures. Finally, in response to the
deepening crisis, a Resolution Trust Corporation (RTC) was set up in 1989 to acquire
ailing thrifts, close them or sell them to other institutions (FDIC 1998). The remaining
thrifts were subjected to tighter capital standards and limits on types of investment. Re-
serves were required against risk of future defaults on higher risk assets; this in turn re-
duced ability to meet the new capital standards. As a consequence the industry shrank in
a relatively short period of time: by the mid 1990s less than half of the institutions pre-
sent in 1980s still existed (Davis, 2001a).
So, why did it take a decade to resolve the thrift crisis? The regulators’ ability to dispose
of insolvent thrifts was constrained by inability of successive administrations to with-
stand political pressures. Although a large proportion of the nation’s S&Ls were insol-
vent in 1980, powerful industry lobbying coupled with concerns over continued avail-
ability of housing funds in the wake of country-wide S&L failures protected the ailing
industry and amplified the eventual resolution costs.

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2.1.2 LDC debt and the US Banking Crisis of the 1980s
In the case of US banks, the regulatory framework was not as inappropriate as for S and
Ls, but substantial deregulation of the financial sector coupled with insufficient supervi-
sory diligence meant that weak banks were not identified in a timely manner. Neverthe-
less, the authorities’ response to the escalating crisis should be noted, as they largely
succeeded in preventing economy-wide destabilising effects of such a large number of
bank closures.
In the late 1970s and 1980s, intra-state banking restrictions were lifted, allowing new
players to enter once-sheltered markets. Regional banking compacts were established
and direct credit markets were expanded. Liberalisation of the financial sector adversely
affected U.S. commercial banks: on the one hand, they were losing their share of house-
hold savings to other types of intermediaries including money market funds and to the
capital markets; at the same time banks were losing some of their best clients to the
commercial paper and corporate bond market, which grew rapidly in the 1970s and
1980s. In search of new markets and profit opportunities, U.S. banks shifted their focus
to lending to finance commercial real estate and to less-developed countries.
On the eve of the 1980s, few banks gave obvious signs that serious troubles lay ahead.
At banks with less than $100 million in assets (the vast majority of banks), net returns
on assets rose during the late 1970s and averaged approximately 1.1 per cent in 1980 – a
level that would not be reached again until 1993. For this group of banks, net returns on
equity in 1980 were also high by historical standards, equity/asset ratios were moving
upward, and charge-offs on loans averaged what they would again in the early 1990s.
The fact that key performance ratios in 1980 compared favourably with those in 1993-
94 – a period of extraordinary health and profitability in the banking sector – empha-
sises the absence of obvious problems at most banks at the beginning of the 1980s.
Large banks, however, showed clearer signs of weakness. In 1980 return on assets and
equity/assets ratios were much lower for banks with more than $1 billion in assets than
for small banks. Market data for large, publicly traded banking institutions suggest that
investors were valuing these firms with reduced favour. During the 1960s and 1970s
price/earnings ratios for money-centre banks trended generally downward relative to
S&P500. For the 25 largest bank holding companies in the late 1970s and early 1980s,
the market value of capital decreased relative to – and fell below – its book value, sug-
gesting that to investors, the franchise value of large banks was declining (FDIC, 1997).
Differences in performance between large and small banks in 1980 were not surprising.
At that time, because of branching restrictions and deposit interest-rate controls, many
small institutions operated in still-protected markets. Accordingly, they were affected
more slowly by external forces such as increased competition (as a result of deregula-
tion) and increased market volatility. Dependent more on the CD and eurodollar mar-
kets, large banks faced a higher average cost of funds. Also, larger banks were much
more likely to have been hit by the onset of the LDC debt crisis and its aftermath.

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The general developments leading up to the LDC debt crisis are well documented6. Ro-
bust growth of LDCs in the decades prior to the oil price shocks generated U.S. corpo-
rate investment in these markets. Faced with loss of depositor and customer bases at
home, large U.S. banks followed by establishing a global presence to support lending to
US multinationals. This multinational activity in providing financial services was an
important contributor to the emergence of a new international financial system, the
Eurodollar market, which gave U.S. bank access to funds with which they could under-
take Third World loans on a large scale. (Other contributors were US regulatory devel-
opments in the 1960s that drove a large part of intermediation offshore, see Davis
(1992).)
The sharp rise in crude oil prices in the mid 1970s caused serious balance of payments
problems for developing nations by raising the cost of oil and imported goods. To fi-
nance these deficits, many began to borrow large sums from banks on the international
capital markets. Syndicated loans drew in a range of banks, not all of which had the
necessary skills in credit assessment – they relied on a lead bank which took a small
share of the loan and all the fees, with incentives to underplay risks. The oil price that
caused deficits also increased the quantity of funds available in the Eurodollar market
through the dollar-denominated bank deposits of oil-exporting countries, thereby fuel-
ling the lending boom. Nevertheless, as noted in Davis (1995) there was no “inevitabil-
ity” about such recycling, and banks could have lent elsewhere and/or lowered offered
rates to stem the inflow of deposits.
In the years leading up to the outbreak of the crisis, bank regulators were aware of the
heavy concentration of Third World lending in the large international banks and the
threat it posed to bank capital. In 1979, the OCC attempted to limit the amount of loans
a bank could make to a single borrower to 10 per cent of the bank’s capital and surplus.
In reality, at least some of the largest U.S. banks had loaned more than 10 per cent of
their capital to various government agencies of single countries, like Brazil and Mexico.
The OCC decided that public sector borrowers did not have to be counted as part of a
single entity if each borrower had the means to service the debt. In so doing, the regula-
tory authorities gave the banks tacit approval to continue lending to LDCs. At the time,
the U.S. administration espoused the view that the process of recycling petrodollars to
the less developed countries was beneficial. Many believed that resources would be al-
located more efficiently through private financial intermediaries. Moreover, creditor
governments and international organisations such as the World Bank and the IMF did
not possess sufficient resources to deal with the recycling issue.
The spark that ignited the LDC crisis was Mexico’s announcement in August 1982 that
it would be unable to meet its obligation to service its $80 billion dollar denominated
debt. By October of the following year, 27 countries owing $239 billion had resched-
uled their debts to banks or were in the process of doing so. Of that amount, roughly
$37 billion was owed to the eight largest U.S. banks; this sum constituted approximately
147 per cent of their capital and reserves at the time (FDIC, 1997; Chapter 5). Needless
to say that if eight of the ten largest banks in the U.S. were deemed insolvent during the
LDC crisis, this would have precipitated an economic and political crisis. They were al-
lowed to continue operating.
6
For example, see FDIC (1997, Chapter 5), Seidman (1993), Wellons (1987).

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Much of the 1980s was spent restructuring existing loans, setting aside loss reserves and
attempting to protect the solvency of the U.S. financial system. More than a decade
would pass before the banks would clear their books of the bad loans. Immediately after
the Mexican crisis, U.S. banking officials chose the policy of regulatory forbearance
and did not require that large reserves be set aside on the restructured LDC loans. Full
provisioning was not feasible at the time because the total LDC portfolio held by the
average money-centre bank was more than double its aggregate capital and reserves at
the end of 1982. This strategy proved to be successful in avoiding a major domestic fi-
nancial crisis. Forbearance gave the lending banks time to make new arrangements with
their debtors and meanwhile acquire enough capital so that losses on Latin American
loans would not be fatal.
2.1.3 The Continental Illinois Failure
The failure of Continental Illinois illustrates a number of important aspects of the US

experience. First, the crisis involving Continental Illinois National Bank and Trust
Company is the largest bank resolution in U.S. history to date. As importantly, immedi-
ate causes of the bank’s failure were widely shared by many other failed U.S. banks in
the 1980s. In this sense, the analysis of this case illuminates a full spectrum of causes of
U.S. banking crises in the 1980s.
Although the story of Continental Illinois is now well known, few observers before
1982 would have nominated it as the institution that would fail just two years later. The
bank had long been conservative, but by the mid-1970s its management began to im-
plement a growth strategy focused on commercial lending, explicitly setting out to be-
come one of the country’s largest commercial lenders (FDIC, 1997). By 1981, this ob-
jective was accomplished: Continental was the largest commercial and industrial lender
in the United States. In pursuing its strategy of expansion, the management of Continen-
tal Illinois chose to focus on selected industries, one of the most significant of which
was the energy sector, where Continental had a long history and seeming expertise.
High oil prices in the 1970s helped to stimulate the U.S. energy sector, which grew rap-
idly during this period. Therefore, such focus was not without its merits. Nevertheless,
Continental Illinois employed rather aggressive pricing; a Chicago competitor noted in
1981 that the bank was issuing 16 per cent fixed rate loans when the prime lending rate
was several percentage points higher (The Wall Street Journal, 1981).
With oil prices coming down in the early 1980s, the energy sector companies – and
Continental Illinois with them – began to have severe problems, as many of its loans to
the energy sector became non-performing following major losses and near-bankruptcies
among the bank’s customers. The problem came to a head when Penn Square Bank
failed. Penn Square had generated billions of dollars in extremely speculative oil and
gas exploration loans, many of which were nearly worthless, and Continental had pur-
chased $1 billion in participations from Penn Square. Continental’s lending involvement
with three of the largest corporate bankruptcies of 1982 helped turn perceptions of the
bank increasingly negative. This was reinforced by the advent of the less-developed-
country (LDC) debt crisis brought on by Mexico’s default in August 1982. Continental
had significant LDC exposure. The faults in the bank’s management, internal controls
and loan pricing were now examined in the financial press with some regularity.
While Continental furnished an image of a sober institution dealing with its problems,
the bank’s mistakes had meant a loss of credibility in the domestic money markets. This

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was particularly significant because Continental had little retail banking business and
therefore relatively small amounts of core deposits. The bank’s ability to generate retail
business was severely circumscribed by the combination of federal banking laws re-
stricting geographic expansion and Illinois state law prohibiting branching. Within three
weeks of Penn Square’s failure, Continental was removed from the list of top-graded
banks whose CDs traded interchangeably in the secondary markets. Unable to fund its
domestic operations adequately from domestic markets, Continental increasingly turned
to foreign money markets at higher rates.
The first quarter 1984 results confirmed that Continental Illinois was in trouble: non-
performing loans increased to a record $2.3 billion, with more than half the increase
coming from Latin American loans. The deterioration in Continental’s condition and
earnings, coupled with its reliance on the eurodollar market for funding, helped make
the bank vulnerable to the high-speed electronic bank run that took place in May 1984.
As rumours of the extent of the bank’s financial difficulties grew, anxious foreign inves-
tors whose deposits were not protected by the U.S. federal government began to shift
their deposits away from Continental. This marked the beginning of the end.
Failure to stop the run on Continental Illinois presented bank regulators with a precari-
ous situation; they were faced with a potential crisis that might envelop the entire bank-
ing system. Adverse rumours had already caused difficulties at Manufacturers’ Hanover
bank, and ex post calculations by the FDIC suggested that 2,299 banks had deposits in
Continental and of these 179 might fail if Continental failed (Davis, 2001a). Acquiesc-
ing to the notion that Continental Illinois may be “too big to fail”, the authorities insti-
tuted a major rescue operation. Three bank regulatory agencies provided a $2 billion as-
sistance package to Continental: the FDIC provided $2 billion, the Federal Reserve met
all of Continental’s liquidity needs, and a group of 24 major U.S. banks provided a $5.3
billion line of credit while a permanent solution was sought. In what was perhaps the
most controversial move by the regulators, the FDIC promised to protect all of Conti-
nental’s depositors and other general creditors, regardless of the $100,000 limit on de-
posit insurance. Partly as a result of these actions, there was no contagion to other insti-
tutions or markets. As part of the resolution of Continental’s failure, Continental’s top
management and board of directors were removed and government-selected representa-
tives were put in place as executive officers of CIC and CINB. As of 1997, the esti-
mated cost to the FDIC of resolving Continental was approximately $1.1 billion, which
was considerably smaller than the costs of several Texas banks that were also liquidated
in the 1980s (Davis 2001a). If one considers estimated losses as a percentage of assets,
Continental ranks far behind at least half a dozen subsequent bank closing operations
(FDIC, 1997).
2.2 Banking Crises in Scandinavian Countries in the early 1990s
The banking crises in the Nordic countries during the early 1990s were remarkably
similar to one another (see Hagberg and Jonung (2002), Drees and Pasarbasioglu 1998).
Each started with rapid deregulation of financial markets without the accompanying
changes in supervisory and regulatory frameworks; all countries experienced a subse-
quent boom in bank lending, which fuelled astronomical increases in the real estate
prices – a sort of asset bubble. Then, tighter monetary policy – in response to different
exogenous shocks – precipitated a decline in economic activity and the bursting of asset

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bubbles. Strong lending growth in an environment of poor decision making, high risk-
taking and occasional fraud meant that banks became highly vulnerable to customers’
fortunes declined. It was only a matter of time until each country experienced severe
and costly banking crises; Norway spent the equivalent of 3.4 per cent of annual GDP to
restore its banking system to health; the Swedish banking crisis cost its taxpayers just
over 2 per cent of GDP; while Finland paid out the equivalent to 10 per cent of the
country’s domestic product. Of course, the economic and social costs – in terms of out-
put lost and sharp rise in unemployment – were considerably higher, as discussed more
generally in Section 4.
2.2.1 Norway, 1989-1992
In the mid-1980s Norway underwent rapid liberalisation of financial services. Prior to

the mid-1980s, regulations limited both the quantity and rates at which Norwegian
banks could lend. Restrictive reserve requirements, regulations requiring banks to invest
in government bonds, and direct controls on lending by state-owned banks facilitated
the rationing of credit at the artificially low loan rates, made yet lower in effective terms
by generous tax-deductibility of interest. Bank profitability was ensured by the absence
of inter-bank and international bank competition (Ongena et. al, 2000).
Between 1984 and 1986 substantial deregulation overhauled much of Norway’s banking
system. Authorities relaxed reserve requirements and opened Norway to competition
from foreign banks. In 1985, all interest rate declarations were lifted, bond investment
requirements were phased out and all bank oversight responsibilities were consolidated
under one authority – the Banking, Insurance and Securities Commission (BISC). By
1986, the foreign banks, as well as some newly created domestic banks, intensified the
competitive pressure on the existing financial institutions. Banks began to expand credit
aggressively in an attempt to maintain market share – between 1984 and 1986, the
Kroner volume of lending by financial institutions to firms and households in Norway
grew at an annual inflation-adjusted rate of 12 per cent, roughly three times the average
growth rate in the years prior to deregulation.
During 1986, the price of crude oil fell by almost 50 per cent, precipitating a sharp de-
cline in real asset values in the oil-dependent Norwegian economy. Total bankruptcies
increased from 1426 enterprises in 1986 to 4536 in 1989. Paralleling these develop-
ments commercial loan losses, measured as a percentage of total bank assets, rose from
0.47 per cent in 1986 to 1.60 per cent in 1989. The rapid transition from a tightly regu-
lated to a more competitive financial marketplace accentuated the losses through poor
decision-making, high risk-taking, and outright fraud (Ongena et al, 2000).
The first signs of distress came from northern and western Norway, the regions in which
most business failures were occurring. At the time of initial troubles, the Norwegian
government had no programme for shoring up the capital of troubled banks, nor did it
sponsor any form of deposit insurance. Instead, the banking system managed its own
deposit insurance system, which first injected capital into troubled banks. Until 1990,
only one commercial bank was taken over by the government, while the capital injec-
tions and consolidations proposed by the BISC appeared to put to rest the outbreak of
bank insolvencies.

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However, by February 1991, Norway’s three largest commercial banks had announced
large loan losses and confirmed that funds previously available through international
markets had now dried up or become prohibitively expensive. The bailout of the third
largest bank alone had depleted nearly all of the remaining funds in the private insur-
ance fund. Without government aid, the entire banking system was in danger of collaps-
ing. On March 5, 1991, the Norwegian parliament allocated Kr 5 billion to establish the
Government Bank Insurance Fund (GBIF). However, by June of that year it became ap-
parent that the initial allocation was inadequate for bailing out all three of Norway’s
largest banks. After months of debate as to how to resolve the crisis, the Norwegian par-
liament increased the GBIF and amended existing laws to force each bank to write
down its share capital. By the time the final bailouts were arranged, the Norwegian gov-
ernment had spent 3.4 per cent of the country’s GDP and controlled 85 per cent of the
commercial bank assets in Norway (Drees and Pazarbasioglu, 1998).
2.2.2 Sweden, 1991-1993
As in Norway, during the three decades following WW2, Swedish banks and credit
markets were heavily regulated. Interest rate regulation imposed a cap on interest rates,
while placement requirements and lending ceilings required banks to invest heavily in
government-issued bonds. Apart from formal regulations, bank actions were continu-
ously scrutinised – the Riksbank’s views on proper bank behaviour were communicated
in weekly meetings between the Governor and the representatives of the major banks. In
this environment, risk analysis and aggressive lending were largely absent. In an envi-
ronment of low competition, banks could make satisfactory profits from low risk busi-
ness, at a cost of poor quality financial services to the economy.
Prompted by rapid development of international financial markets, which made regula-

tions increasingly inefficient, as well as desire to improve economic performance,
Swedish authorities liberalised domestic banking with a swiftness that surprised most
observers (Englund, 1999). Liquidity ratios for banks were abolished in 1983, interest
rate ceilings were lifted in the spring of 1985, and lending ceilings for banks and place-
ment requirements for insurance companies were abolished in the fall of the same year.
Finally, currency regulations were abolished in 1989. All types of financial services
providers were now free to compete on the domestic credit market.
The institutions most directly affected by regulations now expanded most rapidly; bank
lending increased by 174 per cent between 1986 and 1990, while mortgage institutions
grew by 167 per cent during the same period. Finance and insurance companies, which
had largely thrived as a result of regulatory arbitrage, lost market share at a rapid pace.
The impact of deregulation was most profoundly expressed in the commercial real es-
tate boom – from 1986 to 1990 prices for prime location Stockholm non-residential real
estate more than doubled (Englund, 1999).
The first signs of trouble surfaced in late 1989, as reports of difficulties in finding ten-
ants at current rent levels suggested that the commercial property market had reached its
peak. The stock market reacted rapidly; the construction and real estate stock price in-
dex fell by 25 per cent in a year, compared with 11 per cent for the general index. By
the end of 1990 the real estate index had fallen by 52 per cent from its August 16, 1989
peak. Simultaneously, the Swedish economy was subjected to sharply increasing inter-

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est rates – the real after-tax interest rate jumped from -1 per cent in 1989 to +5 per cent
in 1991. This was the result of increased international interest rates after German unifi-
cation (to which a currency peg was maintained), tighter monetary policy which focused
on combating inflation, and changes in marginal tax on capital income and less gener-
ous interest rate deductions, as part of a major tax reform of 1991.
In September of 1990, one of the finance companies, with heavy exposure to real estate,
found itself unable to roll over maturing company investment certificates (a form of
CP). This was a sort of run; previous holders of certificates, otherwise routinely rein-
vesting, now refused renewed funding, in order to secure their investment in the face of
an imminent bankruptcy. The crisis spread to the whole market for such investment cer-
tificates, which dried up in a couple of days (Davis 1994). Surviving finance companies
had to resort to bank loans. The crisis then quickly spread to other parts of the money
market with sharply increasing margins between Treasury Bills and certificates of de-
posit.
Banks were competitors to the finance companies, but they were also doing business
with them – in December 1990 lending to finance companies accounted for 5 per cent of
all bank lending compared to 1 per cent in December 1983. Owing to the close competi-
tion between banks and finance companies, banks had highly incomplete information
about the credit portfolios of the finance companies; later the banks would find borrow-
ers that they themselves had earlier turned down for loans now showing up in the books
as credit losses in the portfolios of bankrupted finance companies (Englund, 1999).
The crisis now spread rapidly to banks. By the end of 1991, losses were running at 3.5
per cent of loans and at the peak of the crisis in the final quarter of 1992 at 7.5 per cent
of lending, about twice the operating profits of the banking sector. Over the period
1990-3, accumulated losses totalled nearly 17 per cent of lending. The crisis coincided
with a sharp downturn of the real estate market, with prices in downtown Stockholm
falling by 35 per cent in 1991 and another 15 per cent in the following year, and the re-
sale market dried up. Lending related to real estate accounted for between 40 and 50 per
cent of all losses, but only 10-15 per cent of all lending. Handelsbanken, the only major
bank to go through the crisis without need for government support, had the lowest rate
of expansion and the lowest fraction of real estate loans, whereas Gota Bank, with by
far the largest losses, was at the other end of the scale.
The first signs of solvency problems among banks came in the autumn of 1991, when
two of the six major banks needed new capital to fulfil their capital requirements. The
state injected new equity and provided a loan that enabled banks to fulfil their capital
requirements, but that proved inadequate. Six months later, the government was forced
to recognise that what was happening was a systemic crisis (Ingves and Lind, 1997).
Sweden had no formal deposit insurance at the time, but the government announced that
it guaranteed all forms of bank debt, but not equity, on the very day that the country’s
Gota Bank declared bankruptcy. Two weeks later, this guarantee was extended to all
banks.
In dealing with the banking crisis, the government followed the principle of saving the
banks but not the owners of the banks; in other words, the objective was to rescue the
financial system with a minimum of wealth transfer to the original shareholders. In the

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summer of 1992, the government formally established Securum, a ‘bad bank’ for deal-
ing with non-performing loans (Bergstrom et al 2003).
The country’s banking crisis was further exacerbated by the ERM crisis and a run on
Swedish krona in autumn 1992. As a result, the Riksbank raised the overnight interest
rate to 16 per cent in August. This deepened problems for many bank customers and
threatened to have an adverse effect on Swedish banks’ international funding. With
more than 40 per cent of their lending in foreign currency, banks were heavily depend-
ent on access to international financial markets, and with increasing signs of a currency
crisis, loan maturities shortened. In early September, the pound and lira touched the
lower limits of their currency bands (later falling out of the system) and the Finnish
markka started floating. The announcement of Gota bank’s bankruptcy on September 9
increased the speculation against the krona and by the middle of September, the Riks-
bank increased the overnight rate to 500 per cent to defend the krona. In this situation,
the government’s general bank guarantee was crucial in securing continued international
funding for Swedish banks. The Riksbank also provided liquidity, by depositing a part
of the foreign exchange reserves in the banks, thereby insuring bank liquidity against
problems with international funding.
The Swedish economy went into a major recession, with GDP falling for three consecu-
tive years, by a total of -5.1 per cent in 1991-3, and private investment plummeting by
35 per cent during the same period. While the banking crisis was aggravated by the
macroeconomic crisis, it was eased by interest rates coming down as the krona was al-
lowed to float. At the end of 1993, the overnight interest rate was 7¾ per cent, the low-
est rate in over a decade.
On January 1 1993, Securum started operating as an independent company, whose as-

sets were a portfolio of non-performing assets and whose primary task was to rescue
whatever value these contained. Disposing of assets – after ensuring that the underlying
economic activities were run efficiently and having repackaged the assets to maximise
potential market value – was done with an eye to the development of the real estate
market. Securum owned between 1-2 per cent of all commercial real estate in Sweden,
so selling off by auctions would have led to large losses and depressed the real estate
market even further. Instead, assets were sold in three ways: through IPOs on the Stock-
holm stock exchange; via corporate transactions outside the stock exchange; and in
transactions involving individual properties. Most sales were completed in 1995-6 and
Securum was dissolved at the end of 1997, earlier than initially anticipated. Estimating
the fiscal costs of Sweden’s banking crisis, Englund (1999) reports the final bill to the
taxpayer to be 35 billion SEK, or 2.1 per cent of 1997 GDP (much less than the initial
injection).
2.2.3 Finland, 1991-1994
Until the early 1980s, Finnish financial markets were also heavily regulated (Halme
2001). Most cross-border borrowing and lending was subject to quantitative restrictions
by the central bank. Interest rates on bank loans and deposits were regulated at low lev-
els, either directly by the central bank or indirectly by tying tax exemption on interest
earnings to a given uniform deposit interest rate. Deposits of all types of banks were
fully covered by deposit insurance, provided by the respective security funds of the

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commercial, savings and co-operative banks. Membership in a security fund was man-
datory, but the insurance premium was a low flat rate so that the accumulated funds re-
mained small (Vihriälä, 1997).
As a result of deregulation in the 1980s, capital imports and pricing of bank lending had
been liberalised by the end of 1987. However, tax rules continued to favour bank depos-
its and borrowing in general. Prudential regulation and supervision of banks and other
financial intermediaries remained effectively unchanged, although tighter capital regula-
tions under Basel I became effective at the beginning of 1991. Liberalisation of lending
rates and the simultaneous changes in the central bank’s operating procedures facilitated
the emergence of a true money market. Banks could now pass through to the borrowers
the cost of money market funds. As the central bank chose its own CDs and those of the
banks as the instruments for market operations in early 1987, bank CDs became liquid
instruments. The CD market provided a basis for the rapid development of market for
other financial instruments such as forward contracts. On the whole, the money market
allowed the banks much more freedom in choosing the speed of credit expansion, as
they became less dependent on retail deposit financing.
Major financial liberalisation measures were taken in an environment of relatively rapid

and stable growth unaffected by the second oil shock of the late 1970s. The general
government budget showed a slight surplus and the public sector had hardly any debt.
There was no pressing need for fiscal consolidation and monetary policy was geared
towards maintaining the shadow ERM parity. The central bank succeeded in defending
the existing parities with exceptionally high interest rates for a short time in autumn
1986, which presumably increased the credibility of the fixed exchange rate policy,
leading many borrowers to discount the future possibility of a significant depreciation of
the markka.
Financial liberalisation was followed by rapid credit expansion and new borrowing by
the private sector. Nonfinancial firms invested heavily in new capacity in the retail
trade, hotels and restaurants and recreational facilities, which all involved substantial
construction activity, while dwellings remained the main object of household invest-
ment, although purchases of durables also increased strongly. Given the inelastic supply
of land and dwellings, this led to a steep rise in housing and real estate prices. Bank
profitability improved relative to that of the early 1980s, as revenues increased rapidly
while cost increases were more moderate. The boost to domestic demand was reinforced
by buoyant demand in the OECD export markets in 1988 and 1989. Annual GDP
growth exceeded 5 per cent in 1988 and in 1989, while annual unemployment rate de-
clined to just over 3 per cent in early 1990. However, the external balance weakened,
driven by a deterioration of trade balance but also increasingly due to larger outlays on
the rising foreign debt.
In response to rapid credit growth, weakening external balance and accelerating infla-
tion, monetary policy was tightened during the late 1988 and early 1989. An extra cash
reserve requirement was levied on deposit banks of up to 4 per cent of deposits and
other funding items, with the purpose of penalising those banks whose lending growth
did not decelerate below a target path by the end of 1989. Stock and housing prices
peaked in 1989 and credit growth started to decelerate. Economic activity also deceler-
ated rapidly: there was no growth in 1990. On top of the weakening domestic demand,

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“eastern” exports collapsed with the political turmoil in the Soviet Union and other
Warsaw Pact countries. As a result, GDP declined by over 7 per cent in 1991. At the
same time, the exchange rate came under repeated speculative attacks, and the markka
was devalued by 12.6 per cent despite record high interest rates. Interest rates remained
high, production and asset prices continued to decline. GDP dropped by a further 3.8
per cent in 1992 and markka was floated, depreciating almost immediately. In February
1993 a trade-weighted basket of foreign currencies cost 36 per cent more than prior to
the 1991 devaluation. In the process, unemployment increased to an unprecedented
level of almost 20 per cent of the labour force. While GDP registered growth in 1994, it
did not lead to a renewed growth of credit, and property prices remained at low levels
through 1995.
Beginning in 1989, higher short-term interest rates, declining asset prices, weaker credit
growth and increased credit losses weakened bank profitability. The dramatic decline in
borrowers’ incomes and higher interest rates significantly reduced borrowers’ capacity
to service debt. In 1991 the situation worsened with many banks reporting losses. In
September an acute crisis of confidence in the money market nearly forced the closing
of Skopbank (a commercial bank owned by some 250 savings banks). The Bank of
Finland took over the bank, injected fresh capital of about FIM 2 billion and removed
those assets with the greatest risk for write-offs to separate holding companies. In
March 1992, the Government announced more general support measures; Finnish de-
posit banks were offered an aggregate capital injection of FIM 8 billion or 14 per cent of
the sectors’ regulation-prescribed capital. In addition, the Government Guarantee Fund
(GGF) was established to safeguard the stable functioning of the deposit banks and the
claims of the depositors. The Fund was authorised to use up to FIM 20 billion for neces-
sary support operations.
Nevertheless, by summer 1992 many larger savings banks were on the brink of collapse.
The newly created GGF stepped in, merging the problem banks to form the Savings
Bank of Finland (SBF). In the process, existing capital was fully written off to cover
losses and the SBF was transformed into a joint-stock company in government owner-
ship.
Despite these measures, confidence in the Finnish economy weakened considerably dur-
ing 1992. The credit ratings of the Finnish state, major Finnish banks and non-financial
corporations had been lowered several times during the year, the rate premium on Fin-
nish government debt in foreign currency rose to almost 1 percentage point by the end
of the year, and anecdotal evidence suggests that Finnish banks and large corporations
were unable to borrow from abroad long term and faced significant rationing in short-
term borrowing as well. To stem the erosion of confidence in the country’s banking sys-
tem, Parliament passed a resolution in February 1993 to guarantee that the Finnish de-
posit banks would be able to meet their contractual commitments on time. Simultane-
ously, the government bank support authorisation was doubled to FIM 40 billion.
As 1993 wore on, the situation stabilised, but almost all banks continued to make sub-
stantial losses until 1995. During the period 1991-1995, the Finnish deposit banks
posted losses on the order of FIM 62 billion. This was over 8 per cent of banks’ total as-
sets at the end of 1990 and clearly exceeded the regulatory capital of deposit bank
groups. With losses of this magnitude most if not all banks would have failed without

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massive government intervention. The total bank support commitment of the authorities
amounted to over FIM 80 billion at the end of 1995. The final cost of the support opera-
tions for the public sector was estimated by the GGF at FIM 45-55 billion or some 10
per cent of annual GDP. This is the largest bank support undertaking during the early
1990s in OECD countries by a wide margin.
The banking problems have led to a large-scale restructuring and consolidation of the
banking system. Many banks were merged or became bankrupt and the remaining insti-
tutions aggressively cut costs – the number of bank employees declined markedly from
1989 to the end of 1995. There were strong parallels with the situation in Sweden
(Englund and Vihriälä 2003).
2.3 The banking crisis in Japan, 1991-2003
Since Japan has not yet fully recovered from the banking crisis of the 1990s, the total
costs and number of closures are difficult to estimate. However, the final figures are
likely to be enormous. From 1994 to March 2002, 180 deposit taking institutions were
dissolved and the total amount spent dealing with the problem of non-performing loans
from April 1994 to September 2001 was equivalent to 20 per cent of the country’s GDP
(Basel Committee 2003, IMF, 2003).
Japan shared some features of the Nordic crises – deregulation (albeit gradual) of the fi-
nancial services sector without improving the supervisory framework, followed by rapid
expansion of credit and real estate boom (see Craig (1998) for details of the deregula-
tion). Again, similarly to Scandinavian countries, the turning point came with tightened
monetary policy. What sets Japan apart is the unusually long time it has taken to remedy
the banking sector’s problems. This is at least partly due to the nature of Japan’s bank-
ing distress: it took almost 7 years from the time of initial bank failures for a systemic
crisis to erupt. Until the need to inject substantial public funds and set a comprehensive
safety net became plain for all to see, there was little political and public support for
major reforms. In the words of Mayes (2001), “Crises not only force regime changes but
they also provide the willingness to accept the difficulties that are inherent in such a
change.” This is as true of Japan’s banking crisis as that of U.S. and Scandinavian ex-
periences.
As one of the consequences of a slowdown in economic activity after the first oil price
shock, the Japanese government began to run sizeable deficits, which were largely fi-
nanced by increased bond issuance. In 1977, the Ministry of Finance opened a secon-
dary market for government bonds and started issuing some bonds through public auc-
tions in the following year. The expansion of the secondary market for government
bonds undermined interest rate controls and provided (large) savers with a wider choice
of investment vehicles. Institutions resembling money market mutual funds began to
appear, as well as other new financial instruments such as commercial paper. Concur-
rent with such innovation in the domestic market, international markets were being de-
regulated to a large degree. In 1980 the U.S. abolished additional costs of foreign ex-
change transactions and in 1984 the requirement for foreign exchange transactions to be
backed by foreign trade was abolished. Following the suggestions in the Yen-Dollar
Commission report, the Euro-market was substantially deregulated and the Tokyo off-
shore market opened in 1986.

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As a consequence of significant liberalisation of financial markets, borrowers, particu-

larly large, non-financial firms that had been primary customers of big banks, turned
away from banks toward securities markets. During the 1980s the number of firms per-
mitted to issue unsecured domestic bonds grew from two to five hundred (Hoshi and
Kashyap, 1999). However, deregulation did not proceed at the same speed in the bank-
ing sector – having lost large borrowers to the bond and equity markets, banks could not
move into investment banking, for example owing to continuing separation, as in the
US, between commercial and investment banking. The introduction of CDs in 1979 and
liberalisation in time deposit interest rates that began in 1985 increased the cost of funds
for banks and forced them to look for high return lending opportunities with low screen-
ing costs to keep operating costs low. An attractive asset was real estate related loans,
where credit analysis relies strongly on estimating the future path of real estate prices.
Given that the 1990s have been the only post-war period in which land prices have ex-
hibited major downward tendencies in Japan (with the possible exception of 1975), the
perceived risk of such loans must have been low (Ueda, 1999). To replenish their cus-
tomer base, large banks also looked for customers among smaller firms. This meant a
loss of customers for smaller banks, some of which also increased real estate loans.
Meanwhile, non-bank-banks including jusen housing loan companies developed, often
funded by wholesale commercial bank loans and also lent predominantly to real estate.
Rapid growth in lending into real estate related sectors was further supported by the lib-
eralisation of controls on bank behaviour by regulators, which had long been a substi-
tute for risk management by banks themselves and for monitoring by shareholders and
depositors. This created a vacuum in bank risk management: banks had not yet started
using modern risk management techniques, while depositors still had faith in regulators’
ability to protect them.
In hindsight, lax monetary policy of the late 1980s fuelled rising asset prices, which
were further supported by bank lending7. Following the Plaza Accord, the sharp – 100
per cent – appreciation of the yen threw the Japanese economy into a mild recession.
The Bank of Japan responded by cutting the discount rate five times between 1986 and
1987. As the economy started to recover in the first half of 1987, the BoJ increased
short-term market rates in the summer of 1987.
After Black Monday in October 1987, the U.S. applied significant pressure on Japan to
maintain low interest rates, as evident from the communiqués issued after the Reagan-
Nakasone and Reagan-Takeshita meetings in 1987 and 1988. In 1988, other economies
such as Germany started tightening. In Japan, the Nikkei 225 went above the pre-Black
Monday level, and real GDP was expanding at around 6 per cent. The BoJ sought rea-
sons to raise rates, but they were hard to find. The reason was simple: CPI inflation was
only 0.7 per cent in 1988, although stocks and real estate prices were skyrocketing.
There was optimism about Japan, its current account surplus, the Japanese style of man-
agement, and the increased presence of Japanese financial institutions in the world.
People were pointing to increases in productivity and falling unit labour costs.
As the state of high growth and near-zero inflation persisted, it became increasingly dif-
ficult to distinguish cyclical upswing from structural shift. According to Ueda (2000),
7
On monetary policy issues in Japan see Ueda (1997) and Yamaguchi (1999).

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the managing director of the IMF arrived in Japan in February 1989 and stated “there is
absolutely no fear of inflation. Japan should keep its current monetary policy stance and
play the role of the monetary anchor for the world.” Seeing some signs of inflation, the
BoJ finally raised interest rates five times between May 1989 and August 1990. After
ignoring the first 3 interest rate hikes, stock prices finally started to decline in early
1990 and by September of that year were already down by 50 per cent. Land prices
started their descent in 1991 and continued declining through 2000. The boom-bust cy-
cle in asset prices generated severe bad loan problems that plunged many of Japan’s
banks into crisis.
Japan began to experience sporadic failures of financial institutions after 1991 once the
bubble burst. These, however, were confined to relatively small institutions and were
generally regarded as isolated events with limited systemic implications. Although stock
prices had been declining since the beginning of 1990, there was a general optimism
that once the aftermath of the bubble economy had been cleaned up, the economy would
be back on track towards a more balanced and sustained growth. The economy contin-
ued to grow, albeit at a slower pace. This led to an expectation that asset prices, and thus
collateral values, would sooner or later pick up again and eliminate the threat to the fi-
nancial system’s solvency. The authorities adopted a wait-and-see policy.
The first major bank failures happened at the end of 1994, when two urban credit co-
operatives with a combined deposit size of ¥210 billion failed. In the absence of an es-
tablished procedure for a resolution, one had to be tailor-made. To prevent large-scale
bank runs, depositors were to be protected with the financial assistance by the Deposit
Insurance Corporation (henceforth DIC). As DIC did not have sufficient funds to as-
sume all the liabilities of the failed co-operatives, private financial institutions were
drawn into the resolution process. The Bank of Japan and private financial institutions
established a new bank – Tokyo Kyoudou Bank (TKB) – to assume the businesses of
the failed institutions. The capital base of the new enterprise was established with funds
from the Bank of Japan, with the other half of the amount coming from private banks.
The DIC provided the TKB with financial assistance within its limit, while private fi-
nancial institutions would provide the remainder of the necessary funds via a low-
interest loan to support the profitability of the new bank. This approach, combining li-
quidity from the Bank of Japan with financial assistance from private financial institu-
tions, was used in several subsequent bank failures, but it proved to be a short-term so-
lution.
The failure of Kizu Credit Co-operative in western Japan tested the limits of the new
resolution system, as losses were expected to exceed ¥1 trillion. The sum was too large
to collect the necessary amount of money from the private financial institutions. These
had already become frustrated about being asked to contribute every time a financial in-
stitution failed. Increasingly they were fearful that the prospect of an endless series of
financial contributions would erode their profitability. A mechanism that managed to
work in the first few cases of failure to complement the deposit insurance system now
seemed unsustainable.
By 1995, “jusen” trouble, which first hit the headlines in 1993, became a major issue.
Jusen were housing loan corporations, founded by banks and other financial institutions
in the 1970s to complement the housing loans offered by banks. In the 1980s, the jusen

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companies shifted their lending towards real estate developers but this strategy proved
to be a major error, because they had little expertise in commercial lending. The aggre-
gate losses of the seven jusen companies were found to be ¥6.4 trillion, which was far
beyond the amount that founder banks could possibly cover. Once again, the govern-
ment stepped in, and after a fierce debate in the Diet, a package that allowed the use of
taxpayers’ money was approved.
Although the public funds used to address the jusen problem was about one tenth of the
total amount, the first case in which taxpayers’ money was used directly to deal with fi-
nancial instability led to strong public resentment. This might have been at least partly
due to the fact that the jusen companies were non-depository institutions that had little
to do with the daily life of most Japanese taxpayers. The public resentment was so
strong that it became almost a political taboo to refer to any further use of public funds
to address the banking problem.
In June 1996, the first major legislative measures were taken to improve the safety net.
The amendment of the Deposit Insurance Law temporarily removed the payoff cost
limit, which meant that the DIC was able to make financial assistance covering all of the
original losses incurred by a failed financial institution. The insurance premium was
raised sevenfold to reinforce the DIC’s financial resources. The Tokyo Kyodou Bank
was reorganised into the Resolution and Collection Bank (RCB) and was given the
wider role of assuming bank for failed credit co-operatives, when no private assuming
bank could be found. It was also given capacity to purchase non-performing loans from
failed financial institutions. Finally, a new Chief Executive Director of DIC was ap-
pointed by the Finance Minister – until then the Deputy Governor of the BoJ served as
the Director of the DIC.
The reformed deposit insurance system provided the authorities with improved flexibil-
ity to deal with the failed financial institutions without having to depend on the private
sector for funds. However, the main focus continued to be on credit co-operatives,
which were though to be the most damaged part of the financial system. Failures of lar-
ger banks were still unforeseen. The size of the DIC’s fund assumed failures of smaller
institutions at the frequency experienced in the previous few years. The shortcomings of
the improved safety net surfaced with the outbreak of a major financial disruption in
1997.
By early 1997, it had become obvious that the NPL problem threatened the viability of
some of the major banks. Nippon Credit Bank and Hokkaido Takushoku Bank appeared
to be particularly close to insolvency. The deposit insurance fund was far too small to
deal with a potential failure of a major bank. Yet an institutional framework that en-
abled capital injections into weak but viable banks was absent. Although the authorities
again opted for private sector involvement, this time it was limited to existing large
shareholders and the other two long-term credit banks. As the contributions from the re-
lated parties proved insufficient to provide a robust capital base for the new NCB, the
BoJ had to provide a sizeable chunk of capital, in the form of preferred stocks. How-
ever, this bailout did not improve profitability and 17 months after the capital injection,
NCB failed and was nationalised.

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The financial crisis of autumn 1997 dashed any remaining hopes that any part of Japan’s
financial system was immune. Sanyo was a medium-sized securities house, and as such
was supervised by the MoF, and was outside the coverage of the deposit insurance sys-
tem. On November 3, 1997 Sanyo filed an application for the commencement of reor-
ganisation under the insolvency law. As the most clear-cut way of dealing with a failed
financial institution with the least possibility of creating moral hazard, the business of
Sanyo was suspended. The BoJ considered that the case had low systemic implication
because securities houses do not provide payment and settlement services. However,
Sanyo was a money-taker in the interbank call market. When it was ordered to suspend
its business, it inevitably defaulted on the repayment of the unsecured call money. Al-
though the amount of the default was relatively small, it sent shock waves through the
market. Lender banks preferred to place their money with the BoJ rather than risking
another default. The liquidity in the interbank market was drying up and its intermediary
function was being undermined. In late November the BoJ stepped in with a major li-
quidity injection to stabilise the market.
Three weeks after the Sanyo case, Yamaichi Securities, one of the four largest securities
houses in Japan, collapsed. This time, instead of closing it down, the authorities opted
for an orderly winding down of its operations, with the BoJ providing liquidity support
and assuming responsibility for the liabilities of Yamaichi’s overseas subsidiaries to
avoid contagious disruption in overseas financial markets. As expected, Yamaichi’s fi-
nancial condition deteriorated rapidly and it was declared bankrupt in June 1999. Two
years later, the issue of who and in what way was going to bear the final costs of this
collapse remained unsettled.
The collapse of Tokuyo City Bank in the same month was the straw that broke the
camel’s back. This was the fourth collapse in a month and its psychological impact
proved significant. Rumours and speculations spread that certain other banks were on
the brink of collapse. This triggered a run on regional banks by their depositors. Japan’s
financial system was beginning to melt down. Keeping in mind that the Asian financial
crisis was also in full spate at that time, the outbreak of the autumn crisis paved the way
to serious discussion by the politicians and authorities on the use of public funds to ad-
dress the unprecedented financial disruption.
In February 1998, new legislation explicitly introduced public funds to address the fi-
nancial crisis, with a total of ¥30 trillion committed to this purpose; this figure was sub-
sequently doubled. The money was to be used by the DIC to cover the losses of failed
financial institutions and for capital injections into banks. The newly created Financial
Crisis Management Committee handled the issues related to capital injection. The
committee was responsible for identifying the weak banks and deciding on the amount
to be infused, but it lacked supervisory power, and thus direct access to supervisory in-
formation related to individual banks was limited.
The capital injection in March 1998 calmed the market turmoil temporarily. In May,
however, the financial system trembled again, this time with the emergence of a crisis at
Long Term Credit Bank of Japan (LTCB), another internationally active bank. This was
the largest bank failure the authorities encountered. This bank provided a wide variety
of financial services, the loss of which was likely to adversely affect borrowers and
other clients of the bank. In addition, the banks large derivatives portfolio posed sys-

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temic concerns. The bank was wound down in an orderly way for purchase by new in-
vestors. Again, the mechanisms that enabled this kind of winding-down were non-
existent. Still another framework had to be introduced to handle the failure of a bank of
this size and complexity. The LTCB crisis led to two pieces of important legislation.
The Financial Reconstruction Law enabled the temporary nationalisation of troubled
banks to occur, to prepare them for sale. The other important piece of legislation estab-
lished the Financial Reconstruction Commission (FRC), as an independent administra-
tive body to operate the entire safety net under a variety of laws. The FRC was vested
with the authority to inspect and supervise financial institutions as the parent organ of
the Financial Supervisory Agency (FSA). With respect to the financial resources for the
new framework, available public funds were doubled to ¥60 trillion.
Throughout 1999, public funds were used to inject capital into weak financial institu-
tions. In calculating the required amount of capital injection into 15 major banks, the
FRC took both unrealised and potential loan losses. In exchange, the FRC required the
banks to submit plans for improving profitability; these plans were made public. The
newly established Resolution and Collection Corporation (RCC) provided the necessary
infrastructure for the removal of bad loans from banks’ balance sheets. A legal frame-
work for the securitisation of bad loans using special purpose companies was made
available. A wave of consolidation in the banking industry began. As a result, the Japan
premium began to decline.
What emerged by the end of 1990s was a fairly comprehensive framework to address
financial instability. However, it was a moral hazard-encouraging system in the sense
that public money was used to protect all depositors, and other creditors were protected
unconditionally. Once the systemic threat subsided, a new, more comprehensive and
less moral hazard supporting safety net was to be established. As of March 2002, the
comprehensive protection measures were replaced by a new system in which large de-
positors – in excess of ¥10 million per depositor – and other general creditors would not
be protected in principle. Next, a resolution method, commonly referred to as the Japa-
nese version of Purchase & Assumption (P&A), was put in practice under the amended
Deposit Insurance Law approved by the Diet in May 2000.
According to the new safety framework, once a bank is found unviable, a prompt reso-
lution is essential, with large depositors and creditors required to assume part of the
resolution costs of the failed bank. The financial function and the franchise value of the
failed bank should be preserved where significant value remains. To that end, in a well-
prepared P&A, insured deposits and the uninsured portion of insured deposits are trans-
ferred to an assuming bank along with normal assets. A preparatory period of a few
months was prescribed during which on-site examination by the FSA and the DIC
would be conducted to check the latest quality of the balance sheet and due diligence by
the candidate assuming banks would be exercised during this period. If no assuming
bank has been found, a bridge bank will be established by the DIC. The new safety net
also features a “systemic risk exception” approach, in order to maintain flexibility to
adapt exceptional measures beyond those for a P&A, in the event that a failed institution
posed a systemic risk. The exceptional measures comprise three options: capital en-
hancement, financial assistance by the DIC in excess of the payoff cost and temporary
nationalisation. With regard to the financial resources needed for these exceptional
measures, the annual insurance premium collected by the DIC from member financial

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institutions would be drawn on first. If this proves insufficient, a special surcharge may
be added to the insurance premium. In the event that such a surcharge still cannot meet
the necessary amount of funds, public funds could be used.
The BoJ’s role in a P&A is diminished as compared with its role under the previous de-
posit insurance system. Under the new framework, the DIC instead of BoJ will provide
the necessary liquidity. In a systemic case, the Bank plays a wider role. The Governor of
the BoJ is a member of the Conference that decides whether a case is systemic. The
Bank may provide liquidity as the lender of last resort in all three forms of the excep-
tional measures to address a systemic crisis. The new regulatory and safety net frame-
work became effective in April 2002, with select parts coming into force in the follow-
ing year (Hilbers et al 2003).
2.4 An interim assessment
Before turning to theory and cost estimates, we can note a number of key common as-
pects of the events that we contend are equally relevant to the EU:
The crises followed financial liberalisation (OECD 1995) when both banks and
regulators were unfamiliar with risk assessment. This aspect should be less impor-
tant now financial system liberalisation is long established, although as noted by
Davis (2001a), EMU may generate a new and unfamiliar environment over time.
The crises were unprecedented events in the domestic economies – which would
hence not be detected by time series of loan losses derived for credit risk assess-
ment via models in the domestic economy.
There was generally a lack of diversification across types of borrowers or type of

collateral which left the banks vulnerable to shocks hitting that type of borrower.
Commercial real estate is the classic example. It is not clear that Basel II will re-
duce this problem, notably in respect of the foundation approach, focusing as it
does on risk of individual loans. Risk models in the advanced approach may also
not be able to deal with such wider sectoral risks, given constraints and lack of
data.
There was often disintermediation that increased the scope of risk taking, both
on the asset and liability side. Again disintermediation is outside the scope of
Basel II, and implications of such structural change for risk may be hard to cap-
ture using historic time series.
In this context, the crises often involved unregulated institutions – such as the
Jusen and Swedish finance companies – that were new entrants to the financial
system and competed with established banks. Basel II only deals with banks – and
outside the EU, only internationally active ones.
There were failures in regulation of banks' risk taking. Basel II seeks to put in-
creased focus on sound process-oriented supervision, but it does not address regu-
latory structures or staffing however. Furthermore as noted in Section 1, for some

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supervisors shifting to process oriented supervision will be a steep learning curve

when errors are possible.
Accounting figures for earnings etc. were often misleading in respect of banks’
robustness – in a number of cases, until the crisis capital adequacy generally ap-
peared to be satisfactory. This suggests the need for supplementation of such data
with forecasts, and ensuring data do not obscure economic reality (e.g. by fair
value accounting).
On the other hand there were some cases where capital was clearly inadequate,
which Basel addresses directly.
An important role was often played by the interbank market, where “runs” gen-
erally took place triggering the crisis. Basel II does not focus on liabilities; by ap-
plying correct risk weights to interbank claims it may reduce the amount of inter-
bank borrowing but it could also contribute to runs on banks that are downgraded.
The crises accompanied asset price bubbles. There is no evidence that such bub-
bles are diminishing in frequency or intensity, and nor is the appropriate monetary
policy response easy to calibrate.
On the other hand, apart from in Scandinavia, the crises were not accompanied
by currency or balance of payments problems as in the classic “twin crises” of
emerging market economies.
The crises themselves generally followed a macroeconomic shock but vulner-

ability was evident before the shock. Macroeconomic shocks show no sign of
diminishing in frequency or intensity. Basel II seeks to deal with shocks by ensur-
ing capital adequacy, and finer risk weights should help reduce vulnerability.
In this context, inappropriately loose monetary or fiscal policy often contrib-

uted to the run up to crises, while tight policy to address inflation often accompa-
nied its onset. While the framework for fiscal and monetary policy is improved by
EMU, a single monetary policy and constraints on fiscal policy could yet generate
risks in EMU, see also Section 4.2.
Delay in correction appears to be costly. Basel II does not lay down guidelines
for crisis resolution. Political pressures often delayed resolution.
We return to these after evaluating theory in Section 3.

3 Theory and its evaluation
We now turn to an overview of theory which is employed to help understand the mechanisms
underlying the crises described above, and to help further to critically evaluate Basel II.
3.1 Understanding financial crises
A theoretical framework for analysing and seeking to predict periods of financial insta-
bility is set out in detail in Davis (1995 and 1999a) and summarised in Davis (2003),

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from which this section is drawn. We suggest that many of the strands of the theory of
financial instability have a contribution to make to our understanding of financial crises,
but that the explanations are in most cases partial. A selective synthesis drawing on the
evidence of actual crises is the correct approach to adopt.
The basic theories include those of:
"debt and financial fragility", which suggests that financial crises follow a credit
cycle with an initial positive shock (displacement) provoking rising debt, mispric-
ing of risk by lenders and an asset bubble, which is punctured by a negative
shock, leading to a banking crisis. These patterns are seen as a normal feature of
the business cycle (Fisher (1933), Kindleberger (1978), Minsky (1977));
"monetarist" that bank failures impact on the economy via a reduction in the sup-
ply of money. Crises tend to be frequently the consequence of unpredictable,
wholesale policy shifts by monetary authorities generating “regime shifts” that
unlike the business cycle, are impossible to allow for in advance in risk-pricing
(Friedman and Schwartz 1963);
"uncertainty" as opposed to risk (in the sense of Knight 1921) as a key feature of
financial instability, in that unlike the cycle, one cannot apply probability analysis
to rare and uncertain events such as financial crises and policy regime shifts and
hence price risk of them correctly. Financial innovations are subject to similar
problems when their behaviour in a downturn is not yet experienced. Uncertainty
is linked closely to confidence, and helps to explain the frequently disproportion-
ate responses of financial markets in times of stress (Shafer 1986);
"disaster myopia" that competitive, incentive-based and psychological mecha-

nisms in the presence of uncertainty lead financial institutions and regulators to
underestimate the risk of financial instability, accepting concentrated risks at low
capital ratios. The pattern leads to sharp increases in credit rationing when a
shock occurs (Guttentag and Herring (1984), Herring and Wachter (1999), Her-
ring (1999)); and
"asymmetric information and agency costs" that these aspects of the debt contract,
which generate market failures of moral hazard and adverse selection, help to ex-
plain the nature of financial instability e.g. credit tightening as interest rates rise
and asset prices fall (Mishkin 1991, 1997), or the tendency of lenders to make
high risk loans owing to the shifting of risk linked to agency problems (Allen and
Gale 1999, 2000);
Complementing these, we must highlight:
"bank runs" that the basic ingredient of crises is panic runs on leveraged institu-
tions such as banks which undertake maturity transformation, generating liquidity
crises (Diamond and Dybvig 1983); such theory can also be applied to failures of
securities market liquidity, as all market participants seek to sell simultaneously
(Davis 1994, 1999b);

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"herding" that institutions copy each other in strategies regardless of underlying

fundamentals; among banks there may be herding to lend at excessively low risk
premia owing to inadequate incentives for loan officers to assess credit risk; and
among institutional investors herding is a potential cause for price volatility in as-
set markets, driven e.g. by peer-group performance comparisons, that may affect
banks and other leveraged institutions (Scharfstein and Stein 1990, Davis and
Steil 2001);
"industrial" that effects of changes in entry conditions in financial markets can

both encompass and provide a supplementary set of underlying factors and trans-
mission mechanism to those noted above (Davis 1995a), as for example entry of
new intermediaries leads to deterioration of information for existing players and
heightened uncertainty about market dynamics.
Inadequacies in regulation may heighten tendencies to take excessive risks. Mis-

priced “safety net” assistance generates moral hazard8, which if not offset by en-
hanced prudential regulation may lead to heightened risk taking (McKinnon and
Pill 1996). This pattern may be particularly threatening as developments such as
deregulation and increased competition reduce franchise values of financial insti-
tutions (Keeley 1990). Moreover, lenders in the interbank market – notably cross-
border - may not have the correct incentives to discriminate between banks (by
price or quantity rationing) and discourage risk–takers if they expect central
banks to support their banks (Bernard and Bisignano 2000).
There is also a need for consideration of the role of international capital flows. Tradi-
tionally, the focus of the literature on exchange rate crises (Krugman 1991) has been on
the possible gains from speculation against a depreciation of a fixed parity, given the
size of the nation’s foreign exchange reserves. The process is akin to a bank run. The
contribution of international capital flows to recent crises and their international trans-
mission introduce a number of additional elements:
exchange rate pressure, resisted by the authorities via interest rate increases,
which may trigger or aggravate financial instability;
complications introduced by the financing of the banking, public or private sector

in foreign currency, which makes balance-sheet positions sensitive to exchange
rates, and leads to a potential link from depreciation in the context of a currency
crisis to credit as well as market risk, leading to more general financial instability;
capital flight from weakened domestic banks which also puts downward pressure
on the exchange rate;
the increasing role of institutional investors as a conduit for capital flows, “herd-
ing” into rising markets and to seek rapid withdrawal from falling markets, desta-
bilising domestic financial markets and exchange rates (Davis and Steil 2001);
8
Risks can arise from agency problems independently of the safety net (Allen and Gale 1999).

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a possible link of contagion where there are cross-country similarities in trade

patterns (Glick and Rose 1998).
3.2 Viewing the events in the light of theory
It is instructive to view the events set out in Section 2 in the light of the theory outlined
in Section 3.1. These on the one hand give insights into which aspects of theory are
most important, and on the other enable us to develop a set of generic features of crisis
that can be of considerable assistance in assessment of vulnerability of EU financial sys-
tems, and the role that Basel II can play.
Concerning "debt and financial fragility" theory, a prior displacement can be seen for
Japan, in the deregulation of securities markets in the early 1980s and loss of top quality
corporate lending business (in Japan and the US), as well as banking deregulation in all
cases. All the events entailed a growth in debt (to property for all cases except the US
LDC debt crisis), with higher leverage incurred by the borrowers. There were also rises
in asset prices of real estate. Ex post it appears that risk was under priced in each case,
and to some extent the underpriced risks were solely “normal business cycle risks” as
the theory suggests. This point is strengthened since the crises tended to occur at busi-
ness cycle peaks, with the exception of most of the events in the US.
Nevertheless, following the "monetarist" approach it can be argued that the events to
some extent followed “regime shifts” and are hence hard to price for; such as financial
liberalisation and the trend to counter inflationary US monetary policy in the early
1980s. The crisis events were unprecedented in terms of the speed of occurrence, size of
adjustment and scope of institutions affected (this of course underlines the need for
capital adequacy as a buffer separately from loan pricing). Monetary contraction in
terms of declines in the money supply after the crisis were generally absent, however,
due to a monetary policy response.
There was also "uncertainty" owing to the above-mentioned regime shifts. Financial in-
novations featured in Japan (money market funds and active corporate bond issuance),
the US (money market funds) and in Sweden (commercial paper), which had not been
fully tested over the cycle. The onset of the crises was accompanied by loss of confi-
dence in the markets and institutions concerned, although in the case of Japan the loss of
confidence came many years after the crisis began.
Equally, "disaster myopia", was generated prior to all the crises by competition, inexpe-
rience and arguably also moral hazard due to the existence of the safety net. It can be
argued that regulators as well as their banks suffered from disaster myopia. Risk was
concentrated before the crises in property or LDC debt. Credit rationing affected the in-
stitutions directly concerned, notably via “runs” in the interbank market, but the feed-
through to the macroeconomy was partly forestalled by crisis management measures,
and in the US by the existence of bond markets as an alternative source of corporate fi-
nance (Davis 2001b). The credit rationing suffered by Japanese banks came in 1998,
long after the onset of the crisis.
Concerning "asymmetric information and agency costs", Japan and Savings and Loans
in particular were argued by some commentators to be a case of agency costs whereby

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the safety net was exploited by undercapitalised institutions , although others argue for
simple lack of competence in credit evaluation. In all cases an increase in credit ration-
ing followed falling asset prices, which themselves generated moral hazard and adverse
selection. Regarding "bank runs", as noted, there were runs in the case of Continental Il-
linois, some S and Ls and in Scandinavia, as well as long after the Japanese crisis be-
gan, in 1998. "Herding" by banks and non banks into property helped generate the cri-
ses. In all cases herding in effect generated an endogenous aspect of risk, where mild
exogenous shocks were amplified by balance sheet structures and portfolio responses.
For "industrial" aspects, the entry behaviour of financial institutions was instructive
prior to all the crises. In the case of Japan it was the entry of non banks to property lend-
ing and also investment banks to corporate bonds issuance that in effect generated credit
risk for Japanese banks. Scandinavian banks and S and L’s entered markets for com-
mercial property where they had previously not played a role. LDC debt was also a new
market, spread beyond the largest institutions by the innovation of the syndicated loan.
Inadequacies in regulation were evident where regulators failed to act over growing ex-
posures of the banking system to property prices and (in Japan and Savings and Loans)
thereafter exercised forbearance over capital ratios that were low or zero. Moral hazard
due to generous explicit or implicit deposit insurance contributed to risk taking in the S
and L and Japan crises. A role of international capital flows were not strongly apparent
in these events, showing that OECD country crises tend to be “home grown” whereas
EME crises (LDC debt, Mexico, Asia) are often directly related to them.
Following on from this discussion of theory seen in the light of experience as summa-
rised in Section 2.4, we can identify certain common features to all the crises, which are
helpful in anticipating crisis events (Davis 2003). Key aspects are:
regime shifts, first to laxity (such as deregulation), later to rigour (e.g. monetary
tightening);
easing of entry conditions to financial markets, leading to heightened competition

and risk taking;
debt accumulation and asset price booms, generating vulnerable balance sheets in
the financial and non financial sectors;
innovation in financial markets, which increases uncertainty during the crisis; and
risk concentration and lower capital adequacy for banks, which reduces robust-
ness to shocks.
The crises themselves also featured property and equity price collapse, together with
credit rationing leading to widespread failure of borrowers, illiquidity, runs and insol-
vency of institutions. Although sometimes the policy tightening itself triggered the cri-
sis, it was at times rather broader external shocks (such as the collapse of trade for
Finland). Responses included use or expansion of deposit insurance and lender of last
resort facilities, there was later on bank recapitalisation. And the crises tended to lead on
to a prolonged recession.

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3.3 Comments on Basel II in the light of theory
Regime shifts and other shocks will continue to occur. Equally, in a deregulated finan-
cial system there can always be new entry to lucrative markets that in the EU may be
facilitated by the advent of the Euro. Financial innovations will continue to occur and
will also continue to offer risks since their behaviour in a crisis is not yet known. Credit
derivatives are a topical example. Regime shifts may be hard to deal with in Basel II,
except to the extent that adequate capital is a backup in such cases. The need for stress
testing (which is encouraged by Basel II) is underlined. Basel II seeks to deal with inno-
vations, but the problem of lack of experience in stressful periods will remain. Supervi-
sors may need to impose concentration limits till risks are better known.
Rising debt and asset price booms are likely to continue to occur, and imply also that
profitability will not be correlated with vulnerability. The finer risk weights in Basel II
may help ensure the lending is correctly priced, there is pressure to improve overall
credit risk management, But, credit risk models are only allowed to take into account
correlations in a circumscribed manner. Meanwhile, the heightened procyclicality in
Basel II may worsen the tendency for lending to rise in booms and fall in recessions,
with consequent credit rationing. As noted by Basel Committee (2003), it is unlikely
that capital standards would bind in a real estate driven boom, because profits from real
estate lending and the increased value of real estate collateral would provide ample
capital for further lending expansion. While long-term capital adequacy should be main-
tained, Basel II does not mandate any build up of provisions during good times that
might provide a buffer (Spain has instituted such a policy on a domestic basis).
Withdrawal of credit in recessions due to Basel II may in future trigger more frequent
runs in the interbank market as banks’ credit ratings are lowered, as well as posing diffi-
culties for the non financial sectors. Correlations of losses may be highly unstable in
banking crises and accompanying deep recessions, while historical data on loan losses
may underestimate risks. Concentration of risk may this not lead to higher capital re-
quirements. Lags in adjustment by internal or external ratings may entail inaccurate risk
weights.
Basel II will help most obviously in the case of capital adequacy. As noted, whether it
will reduce risk concentration in itself is less clear – this is rather an area where Pillars 2
and 3 (supervision and market discipline) need to play a role. In that context, Pillar 3
will be weak in many EU countries because of the number of publicly owned or mutual
banks not subject to equity market discipline. In the EU, risk concentration measures
will have to take into account that an individual EMU country is vulnerable to asymmet-
ric shocks due to centralised monetary policy, in a way that was not the case before (and
may not be captured by historic data). The pillars 2 and 3 must also seek to reduce dis-
aster myopia – this may require comparison of current financial conditions with norms
at a macro and cross-country level. As regards the crisis itself, Basel II capital adequacy
should reduce the incidence of insolvency and illiquidity, but as noted it is not itself di-
rected to ensure that sound liability management or sufficient liquid assets are main-
tained. Another area outside Basel II but contributing to banking sector risk is moral
hazard from over generous deposit insurance or earlier bailouts.

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A general lacuna in Basel II is lack of consideration for macroprudential issues (see

Davis 1999a, BIS 2001, Borio 2003). Loans that appear sound viewed individually, or
even as a class in credit risk models, may be less so in the light of macroeconomic de-
velopments (asset prices, overall credit expansion, non financial sector balance sheets,
vulnerability to the economy of asymmetric shocks, sustainability of macroeconomic
policies) or in the light of the overall condition of the banking system (capital adequacy,
underlying trends in profitability, bad debts, structural change). Historic or cross-
country norms for such data are an essential ingredient. It is essential that such elements
be developed in parallel with Basel II, otherwise overall supervision risks to be ineffec-
tive.
In outlining the role of macroprudential surveillance, following Davis (2003), a useful

distinction to employ when interpreting such generic developments is between shocks
and propagation mechanisms9. Following “financial fragility” theory, in our view crises
follow a pattern whereby there is an initial positive shock (what Kindleberger (1978)
calls a “displacement”) which leads to propagation of vulnerability via credit expansion,
asset price rises etc. Finally there is a secondary negative shock or trigger, which leads
to the crisis. Shocks resulting in failure of certain institutions or markets lead to more
general instability in two complementary ways. They may lead on directly to failure of
another institution or market with strong counterparty links, which generates contagion
via further balance sheet links to the rest of the financial system. Or they may generate
uncertainty about solvency for institutions or markets, whose balance sheet/instruments
outstanding are both opaque and share some characteristics with the failed firm. These
may in turn lead on to macroeconomic consequences as estimated in Davis and Stone
(2003). Note that shocks are of very variable nature (deregulation, war, natural resource
discovery, adjustment of monetary or fiscal policy regime…) but propagation mecha-
nisms are more common, and much of the useful work of surveillance lies in outlining
the current state of “vulnerability” in terms of them. Davis (2003) provides an outline of
a possible way forward, see also Carson and Ingves (2003).
4 Costs of banking crises
It is the costs of financial instability that motivate Basel II. In the first section we exam-
ine some estimated costs, while in the second section we outline a NiGEM simulation
on the macroeconomic effects of a banking crisis in the UK.
4.1 Estimates of the cost of banking crises
Whereas there are many examples of studies, which estimate the causal factors underly-
ing instability (such as Demirguc Kunt and Detragiache 1998), those which estimate the
costs are rather less common. A key paper is by Hoggarth and Saporta (2001), which
adopts a number of approaches to measuring banking crises’ impact and surveys extant
work. We draw on their analysis in this section.
The components of economic losses following crises include the following: First there
are losses by stakeholders in the bank including shareholders, depositors and other
creditors. Losses may also be incurred by borrowers who lose access to funds and may
9
I am indebted to Darren Pain of the Bank of England for this insight.

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find difficulty accessing other sources due to asymmetric information, (see Bernanke et
al (1983) on this issue in the Great Depression). Taxpayers may also face costs as the
public sector seeks to resolve the crisis. More generally, a banking crisis in the monetar-
ist tradition induces a shrinkage of the money supply that may leads to a recession. Ra-
tioning of credit by price or quantity due to failures or capital constraints may impact on
expenditure by consumers and business, leading to output contractions. Reduced in-
vestment may hit economic growth over the longer term. Finally, if the payments sys-
tem is impaired because consumers are unwilling to deposit cash in banks there may be
yet more severe impacts on overall economic activity.
The scope of these costs is likely to depend strongly on the manner and speed of resolu-
tion by the authorities. Rapid resolution is often thought better than forbearance, which
leaves bad loans outstanding and can heighten moral hazard, while also slowing eco-
nomic growth. But the fiscal costs of a rapid resolution can be considerable. We note
that the crises in Japan and the S and L crisis as opposed to the Scandinavian events
seem to bear out these predictions, the US banking problems after LDC debt (forbear-
ance with less risk taking) rather less so.
A first issue is to assess the timing of a banking crisis. A crisis may be pinpointed as a
period when much or all of banks’ capital is exhausted (systemic crisis) or when there
are problems such as bank runs, bank closures, mergers or government take-overs (bor-
derline crisis). There are generally fiscal costs. But these can also be transfers of wealth
from taxpayers to the current and future stakeholders in the bank. The output costs are
also not easy to estimate, because banking crises typically take place during periods of
recession when output would have been weak in any case.
Concerning fiscal costs, Caprio and Klingelbiel (1999) and Barth et al (2000) report es-
timates of 12% of GDP for developed countries, 4.5% with a banking crisis only and
16% when there is a currency as well as a banking crisis (i.e. a 25% depreciation which
accelerates by 10% in the crisis year). Such fiscal costs include recapitalisation of banks
and reimbursement of insured depositors. The resolution costs are greater in Emerging
Market Economies, possibly due to larger overall shocks, weaker capital adequacy and
regulation generally, as well as the role of state banks that are most likely to be bailed
out. Costs are also higher where banking intermediation is dominant as witness higher
costs reported in Section 2 in Japan (20%?) than in the US (3%). Honohan and Klinge-
biel (2000) suggest that fiscal costs rise with liquidity support, regulatory forbearance
and unlimited deposit guarantees.
Most studies of output losses due to banking crises have sought to measure them as dif-
ferences from trend in terms of output growth. In IMF (1998) and Aziz et al (2000) it is
relative to the three years preceding the crisis. For Bordo et al (2001) it is over five
years. The end of the crisis is then defined as when output growth returns to trend.
Hoggarth and Saporta (2001) note that this method may be inferior to an approach
which sums the levels of output losses relative to trend, where trend is measured over
ten years prior to the crisis. Concerning results, IMF (1998) found that cumulative out-
put losses in OECD countries were 10.2% with the average length of crisis being 4.1
years. Hoggarth and Saporta (2001) found that crises lasted a similar time (4.6 years)
but found that cumulative output losses were much greater (23.8%). Bordo et al (2001)
did not distinguish between developed countries and emerging market economies but

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had a figure of 6.2% for output losses from banking crises and 18.6% for twin crises.
Aziz et al (2000) found 9% for twin crises.
As regards reasons why crises last longer in OECD than emerging market countries, and
this often leads to greater output losses, Hoggarth and Saporta (2001) suggest that
shocks needed to destabilise the financial system are larger and hence so are output
losses. Higher losses could also link to less flexible real wages in developed countries.
The authorities may be misled by the initial small effect of a crisis due to seeming ro-
bustness of the financial sector to take less radical action, as in Japan. Meanwhile,
Bordo et al (2001) showed that output losses are greater where were are liquidity sup-
port operations (possibly supporting insolvent banks, thus generating moral hazard) and
an exchange rate was previously pegged (possibly as it exposes institutions to greater
market risk).
As noted, most measures of output losses due to banking crises are based on a meas-
urement of output growth or level relative to that in the past. This could exaggerate
costs if recessions would have occurred anyway, thus coinciding with or even causing
the banking crisis. Bordo et al (2001) sought to overcome this by comparing recessions
with banking or twin crises with those without, in the same country’s experience. They
found banking crises worsened the downturn in recessions by 5% of GDP and twin cri-
ses by 15%. Hoggarth et al (2001) compared output losses cross-sectionally by compar-
ing recessions with banking crises with those for other countries at the same time, which
were otherwise comparable but did not suffer banking crises. For developed countries
they found that output losses in recessions with banking crises were 32% of GDP com-
pared to 6% without a crisis. In emerging market economies it is 16% compared to 6%.
Thus banking crises appear more severe in OECD countries. Complementary regres-
sions showed that banking crises explain most of the output loss difference in high-
income countries and currency crises in low to middle income countries.
Davis and Stone (2003) sought in a different way to deal with the recession problem by
taking the trend over 5 years in the past and the future, i.e. allowing for the crisis in-
duced recession in the average, which may be balanced by growth well in excess of
trend in the preceding boom. They also sought, unlike the work cited above, to assess
which components of GDP were most relevant to the output contraction in a banking
crisis. Then, the data for real GDP and its components are expressed in terms of contri-
butions to deviations of growth from trend, rather than as growth per se.
The response to banking crises is a decline in GDP relative to trend of 3.1%. This is
lower then in the earlier papers since it only covers the first two years of the crisis and
also the trend is lower, taking into account the recession itself which follows the bank-
ing crisis. Domestic demand takes the brunt in these crisis-induced recessions (-5.1%
contribution to change in GDP relative to trend). Indeed, on average foreign demand
(exports less imports) positively contributes to growth (by 1.9%), probably because the
trade balance must shift in a positive direction to offset the sudden cessation of capital
inflows that often trigger the crisis. The change in public sector demand following the
crises (the sum of public sector consumption and investment) is broadly neutral (0.2%).
The post-crisis change in real GDP is dominated by private domestic demand (-5%).
Private investment explains the bulk of the contraction (-3.1%). Inventory decumulation
is also an important drag on economic activity in the wake of a financial crisis (-0.4%).

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In contrast to these investment effects, consumption is rather robust in the wake of the
crises (-1.4%). Consumers seek to draw on saving to sustain consumption, while labour
income is typically more stable than profits.
Davis and Stone also looked at flow of funds responses to crises. Although based on
simple calculations, the results are of considerable interest. There is a fall in total exter-
nal financing; the fall is on average -2% of GDP. The fall is more than accounted for by
the decline in bank lending which is -2.2%. On the other hand, there is a rise in bond is-
suance of 0.3% of GDP, showing the benefits of “multiple avenues of intermediation”
(Davis 2001b). Liquidity shrinks. Equity issues fall in OECD countries but rise in
EMEs, while trade credit rises in the OECD and falls for EMEs. Direct comparison of
these data with the expenditure components is not possible, since the expenditures are
defined relative to trend GDP growth. However, given that for both OECD countries
and EMEs, trend growth is positive, it can be suggested that the falls in external finance
as well as trade credit and liquidity may account for a substantial part of the fall in cor-
porate expenditures.
4.2 NiGEM simulation of a banking crisis in the UK
To seek to calibrate the macroeconomic outworkings of a banking crisis, we prepared

simulations using the NiGEM Global Model10. The simulation was designed in the light
of the descriptions in Section 2 and the estimated costs in Section 4. For purely illustra-
tive purposes, the country selected for the crisis was the UK. The main imposed changes
to the model run were:
The spread between personal borrowing and lending rates increased by 8 percent-
age points in the first quarter, declining over 3 years, with most of the decline in
the second and third year
The spread between business sector borrowing and lending was increased also by
8 percentage points in the first quarter declining over 3 years, with most of the
decline in the second and third year
The split between higher borrowing and lower deposit rates was 0.5 each
Corporate sector profits were cut by 17% (£5 bn a quarter) mainly to reflect loan
losses by banks.
House prices were reduced endogenously by 2.5% in each of the first 2 quarters,
leading to a sustained but temporary fall in house prices
10
NiGEM is an estimated model, which uses a ‘New-Keynesian’ framework in that agents are presumed
to be forward-looking, but nominal rigidities slow the process of adjustment to external events. All coun-
tries in the OECD are modelled separately. All economies are linked through the effects of trade and
competitiveness. There are also links between countries in their financial markets via the structure and
composition of wealth, emphasising the role and origin of foreign assets and liabilities. There are for-
ward-looking wages, consumption, and exchange rates, while long-term interest rates are the forward
convolution of short-term interest rates. The model has complete demand and supply sides and there is an
extensive monetary and financial sector. NiGEM contains expectations and uses the Extended Path
Method to obtain values for the future and current expectations and iterate along solution paths See
NIESR (2003) for a description of the model, and Barrell, Kirsanova and Hurst (2003) for a brief descrip-
tion.

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Equity prices were reduced by 6% initially but declining impact using a declining
endogenous shock on the forward looking equation. This effect is in addition to
any risk premium and profit related reasons for a fall in equity prices
The increase in the equity risk premium of 8 percent was spread into investment
(half) in the same proportions as Barrell and Davis (2003)
Interest rates lowered immediately by 1.5 for 5 quarters ahead of the fall in infla-
tion (“emergency liquidity assistance”).
The key driver of the macro impact of the crisis is the widening spread between borrow-
ing and lending rates, which captures the increase in credit rationing to be anticipated as
a result of the crisis, and correspondingly of banks’ efforts to raise profitability to offset
loan losses and recapitalise. This affects the cost of borrowing, personal income and
corporate profitability, given loans are flexible rate for the most part. The effects on as-
set prices are those to be expected during a financial crisis – they mainly affect con-
sumption via wealth effects but also investment via the cost of equity capital. Mean-
while, monetary policy is assumed to react immediately to the crisis with a loosening, as
emergency liquidity support is provided. Although the cut is in advance of the fall indi-
cated by the standard interest rate reaction function, which responds to deviations of
output and inflation from target, it achieves the same level after 6 quarters, and the cu-
mulated extra cut is 1.0 in the first 5 quarters.
As shown in Table 2, the impact is greatest on fixed investment – both housing and non
residential – which fall by up to 16% owing to higher interest rates and risk premia af-
fecting the cost of capital, as well as declines in overall output. Consumption is hit by a
maximum of 7% reflecting lower real personal disposable income (which falls more
than consumption) and by falls in wealth as asset prices decline (Table 3). On the other
hand, the current balance improves, largely due to the recession caused by the banking
crisis, albeit also helped by a currency depreciation (Table 3). Hence the fall in GDP is
around 4% at maximum and the total shortfall over four years just over 10%. Note that
this outturn is comparable to the falls recorded in Davis and Stone (2003) but are far be-
low estimates by Hoggarth and Saporta (2001). Note that no additional confidence ef-
fects have been assumed, driving consumption and investment below their equation pro-
jections – although this might plausibly be the case in a full blown banking crisis. How-
ever, we might describe the additional impact of the crises on equity prices as reflecting
confidence in some sector, whereas the additional fall in house prices is presumed to re-
flect rationing above that indicated by the increase in spreads. The fiscal deficit rises for
cyclical reasons – we have not assumed large expenditures on recapitalisation, although
again this could be a consequence of these events.
Table 2: Impact of a banking crisis on expenditure and sector balances
Consump- Business Housing GDP Current Fiscal
tion Invest- invest- balance deficit
ment ment
% Diff % Diff % Diff % Diff % of GDP % of GDP
from base from base from base from base diff from diff from
base base
2003 -3.17 -5.22 -5.26 -0.92 1.70 -1.90
2004 -6.90 -16.10 -16.09 -3.56 4.00 -1.70

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2005 -7.30 -15.09 -15.10 -3.63 3.91 -0.06

2006 -5.47 -6.74 -6.74 -1.95 2.57 1.87
As noted, there is a sharp easing of monetary policy which attenuates the recession –
rates are held down by 1.5 percentage points for 5 quarters until such a cut is itself war-
ranted by lower inflation projections. This additional cut in rates absorbs 0.2 percent of
the potential fall in output in the first two years. Long rates, which are the rational ex-
pectations forward convolution of future short rates, are lower by 1% at the start, which
tapers off. As regards the detailed effects on asset prices, exchange rates depreciate by
around 7% for monetary policy reasons. Both long rates and the exchange rate also help
to attenuate the effect of the crisis on the economy. More contractionary effects come
from equity prices and house prices which fall because of the impacts of other shocks
and by residual, driving equity prices down 8% initially and house prices by an eventual
14%, as can be seen from Table 3. Equity prices being forward looking soon recover,
aided by the cut in interest rates. The relatively gradual response of house prices is plau-
sible given the more sluggish adjustment of that market.
Table 3: Effects of a banking crisis on asset prices and yields

Exchange Equity House Long rate Short rate
rate prices prices
% Diff % Diff % Diff % points % points
from base from base from base difference difference
from base from base
2003Q1 -6.80 -8.17 -2.31 -1.05 -1.50
2003Q2 -6.49 -6.21 -6.42 -0.99 -1.50
2003Q3 -6.18 -4.24 -9.45 -0.94 -1.50
2003Q4 -5.89 -2.21 -11.57 -0.88 -1.50
2004Q1 -5.60 -0.14 -12.95 -0.82 -1.50
2004Q2 -5.33 1.93 -13.72 -0.77 -1.50
2004Q3 -5.07 3.86 -14.00 -0.71 -1.63
2004Q4 -4.79 5.57 -13.92 -0.65 -1.80
2005Q1 -4.47 7.00 -13.60 -0.58 -1.88
2005Q2 -4.14 8.13 -13.12 -0.51 -1.91
2005Q3 -3.80 8.94 -12.60 -0.44 -1.89
2005Q4 -3.46 9.41 -12.12 -0.38 -1.86
2006Q1 -3.13 9.82 -11.73 -0.31 -1.80
2006Q2 -2.80 9.42 -11.40 -0.25 -1.76
2006Q3 -2.48 8.98 -11.11 -0.19 -1.71
2006Q4 -2.16 8.49 -10.80 -0.13 -1.67
It may be added that France and Germany would suffer a fall in GDP as a consequence
of the UK recession, as can be seen from Table 4. The impacts on the Euro Area are
around 10% of the size of the effect on the UK, and largely come from the decline in
import demand in the UK reducing export growth in the first two years of our analysis
by about 1% a year The impact of the depreciation of the UK exchange rate is largely
absorbed by a cut in interest rates of 0.5 per cent by the end of two years, and the appre-
ciation of the euro is less than half the fall in sterling.. The US would be much less af-
fected because its trade links with the UK are weaker, and exports are a noticeably

CONFIDENTIAL
smaller proportion of output. All countries will be affected by the fall in UK asset
prices, as wealth in the US, France and Germany is affected by the change in the value
of holdings of overseas equities.
Table 4: Spillover Effects: Impact of a banking crisis on output

Euro Area French German
GDP GDP GDP US GDP
% Diff from % Diff % Diff from % Diff from
base from base base base
2003 -0.16 -0.14 -0.13 -0.02
2004 -0.38 -0.34 -0.34 0.01
2005 -0.32 -0.32 -0.22 0.10
2006 -0.08 -0.15 0.08 0.20
A separate simulation addressed the differences likely to occur if the banking crisis oc-
curred in the UK were it to be a member of EMU. We accordingly fixed the interest rate
and exchange rate of the UK to the euro, and included UK inflation and nominal output
in the targeting system for the (expanded) ECB. The effect on GDP in the UK was
around 50% greater than those discussed above, because country specific monetary pol-
icy shock absorbers were absent. This underlines the need for adequate arrangements
for regulation to prevent crises and also mechanisms for resolving banking crises in
EMU countries. We should however, note that we consider a banking crisis in the UK to
be one of the least likely events following the introduction of Basel II regulations.
Conclusions
In the light of the case studies, as well as theoretical and empirical work quoted above,
crises appear to be triggered by shocks that may arise autonomously from macroecon-
omy or from policy shifts. Financial liberalisation and monetary or fiscal policy errors
often played a role. However, crises only occur and become costly in financial systems
that have become “vulnerable” in terms of exposure to default and inadequate capital
buffers. In this context, a policy that makes the banking system less prone to risk taking
can reduce the likelihood of banking crises, while robustness is a key aspect of minimis-
ing the cost of banking crises. Both of these should be improved by Basel II, but with
reservations linked to aspects such as procyclicality, the limitations of credit risk models
and rating agencies, and cultural change for regulators, as well as aspects omitted from
Basel II such as liquidity, disintermediation and crisis resolution.
A key proviso is that appropriate attention is paid to macroeconomic aspects of financial

sector vulnerability via so called macroprudential surveillance. This is not mandated by
Basel II but is developing currently in a number of countries, spurred in the EU inter
alia by the ESCB Banking Supervision Committee and its sub groups. In this context, it
is interesting to note that crises last longer in OECD than emerging market countries,
and this often leads to greater output losses. These observations make avoidance of
banking crises all the more crucial.
A few additional points can be made about specific conditions in the euro area, drawing
on Davis (2002b). Financial liberalisation has already occurred for countries concerned
so the direct fallout from this risk should be less than in the episodes shown in Section

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2. Most historic periods of financial instability in Europe have linked to the banking cri-
ses as reflected in this draft, with market crises occurring in, or largely originating in the
US or international capital markets. The likely securitisation of euro area markets may
pose challenges in adaptation, whereby securities market problems are likely to general-
ise across the monetary area while banking crises can remain local. On the other hand,
the presence of both banks and securities markets as a source of financing in a monetary
area is beneficial in offering a form of diversification for the financial system (Davis
2001b). European economies should thus become less vulnerable to economic repercus-
sions of banking crises as securities markets develop. The period of adjustment may be
a vulnerable one, however.
In Davis (2001a) we also suggest that in a large and diverse monetary area with seg-
mented local banking markets, regional crises can pose a major challenge to policy
makers – not least given the impact on local GDP highlighted in Section 4.2 - while the
existence of a large monetary area in a global sense means that there will inevitably be
international transmission of shocks generated within it. There is also a need for special
care in the case of new monetary arrangements that have not yet experienced major fi-
nancial instability. Meanwhile money and securities market liquidity become of great
systemic importance in a securitised financial system; equity prices too may become of
major importance for financial stability; disintermediation becomes a major factor with
which banks must contend and adjust as best they can; non banks such as investment
banks and even hedge funds may become of systemic importance; and even institutional
investors’ strategies can cause major asset price shifts which threaten systemic stability.
Meanwhile, as noted in Davis (2001c), in the longer term, population ageing may also
generate major threats to financial stability in the EU.

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Appendix 7 – Glossary of basic terms1

Banking Book
A Bank’s portfolio which consists of financial instruments that are (in principle) held
to maturity or for longer-term investment purposes. These financial instruments are
created through the issuing of credit to individuals, corporate entities, and govern-
ments.
Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a model describing the relationship be-
tween risk and expected return that is used in the pricing of risky securities such as the
equity of quoted banks. The CAPM is used to calculate the Cost of Equity.
Cost of Equity is calculated as Rf + (β x Rp)+Pss where: Rf is the risk free rate; β is

the beta value; Rp is the equity risk premium; Pss is the small stock premium which
only applies to smaller firms.
Concentration
Concentration is a measure of the proportion of a market accounted for by the larger

firms operating within it. There are different ways of measuring concentration such as
the Herfindal Index.
Consolidation
The measurement of a bank’s risk on a group-wide basis.
Cost of Equity (COE)
Cost of Equity is the rate of return required by a company's common stockholders.

COE has been calculated based on the Capital Asset Pricing Model (q.v.).
Credit risk
The risk that a loan will not be repaid according to an agreed schedule when the credi-
tor or counterparty defaults. Consequently, a bank will be required to reduce (perhaps
to zero) the value of the asset on the balance sheet resulting in a loss.
Credit Risk Mitigation
A range of techniques whereby a bank can partially protect itself against loss resulting
from counterparty default (for example, by taking guarantees or collateral, or buying a
hedging instrument).
1
The glossary is meant to clarify technical terms and concepts. This means that in some cases the exact
wording of some definitions may differ from those given in official technical background documents.
Clearly, their meaning is not different.
Appendix 7 – Glossary Page 1 of 5

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Economic capital
The amount of capital that a financial institution requires, based on its own assess-
ment, in order to support the various economic risks it faces in doing business. For
example, the amount of capital that a bank would allocate to a transaction or a portfo-
lio so that in the event of losses, the probability that these losses would be less than
capital is consistent with the bank’s risk preferences. Economic capital represents
therefore the evolving best practice for measuring and reporting all kinds of risk
across a financial organisation. It is called “economic” capital because it measures
risk in terms of the economic realities of the firm rather than capital based on other
concepts such as regulatory or accounting rules. It is called "capital" because part of
the measurement process involves converting a loss distribution to the amount of
capital that is required to act as a buffer for the various kinds of risks, in line with the
institutions’ internal and external objectives on financial strength (for example, credit
rating). For example, for a bank rated AA, economic capital should cover losses re-
sulting from various kinds of risk at a one-year horizon, 99.97% of the time.
Equity market risk premium (EMRP)
The EMRP is the extra return (over the yield on Treasury securities) that investors ex-
pect to receive from an investment in a risky security such as common stocks. This is
to compensate for undiversifiable, systematic risk. The EMRP is the expected return
on a diversified, market-weighted portfolio of common stocks, less the expected re-
turn on a long-term risk-free bond.
Expected losses (EL)
This is calculated as follows: EL=EAD*PD*LGD, using a time horizon of one year.

Expected losses should ordinarily be covered by provisions or, if provisions are insuf-
ficient, by regulatory capital.
Exposure at default (EAD)
This corresponds to the amount legally owed by the bank client in the event of de-
fault, calculated at a time horizon of one-year. By convention, it is equal to the
amount drawn at the moment that the ratio is calculated, plus a fraction of off-balance
commitments calculated by applying a credit conversion factor. In the AIRB ap-
proach, the bank itself estimates the latter factor, while in the standardised and FIRB
approaches it is specified by the supervisor.
External Credit Assessments
Ratings of credit risk issued by private or public sector agencies. (i.e. rating agencies)
Fair value
This is the amount for which an asset can be exchanged (or a liability settled) between
knowledgeable (and willing) parties in arm’s length transactions. In practice, the fair
value is often equal to the (observed) market value or, when not available, estimated
using a financial model.

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Group 1 banks
Group 1 banks are larger, internationally active banks with Tier 1 capital in excess of
3 billion EUR.
Group 2 banks
Group 2 banks are smaller (and generally less-complex) not internationally active
banks.
Hedging
This is a financial technique whereby one or more hedging instruments are designated
(usually derivatives such as futures and swaps) in such a way that their change in fair
value is wholly or partially offset by the change in fair value or cash flows of the
hedged financial instrument (e.g. loans, bonds or deposits).
IFRS
The International Accounting Standards Board (IASB) sets International Financial

Reporting Standards (IFRS). The IASB's prime objectives are the development and
rigorous application of a single set of global accounting standards, which will produce
high-quality financial information to help participants in the world's capital markets to
make sound economic decisions.
An IFRS applies from a specified date. A new IFRS sets out transitional provisions to
be applied on initial application. An entity will either have to adopt new guidance ret-
rospectively and restate past transactions for the effect of the requirement, or prospec-
tively to transactions that occur after the date the IFRS was introduced, depending on
the transitional guidance.
Interest rate risk
If a bank has a mismatch between fixed and floating rate assets and liabilities, then the
bank is exposed to the risk that short-term interest rates may change such that the rate
of interest on floating rate liabilities rises above the fixed-interest rate on some assets.
This exposure of a bank’s financial condition to adverse movements in interest rates,
is a normal part of the business of banking.
Internal Ratings
The proces by which banks use their own internal measures of credit risk to assess
risk inherent in their credit portfolios.
Internal Ratings-Based Approach (IRB)
A procedure proposed by the Basel Committee in which ratings are assigned by the
bank to its counterparties concerning credit risk. These internal ratings are used to
calculate regulatory capital requirements. This procedure has two variants. In the sim-

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plified version, referred to as the foundation IRB (or FIRB) approach, the bank pro-
vides only the probability of default (PD) within a one-year time horizon for each of
its exposures. In the more sophisticated version, referred to as the advanced IRB (or
AIRB) approach, the bank is permitted to use its own estimates of the other parame-
ters for the purposes of determining regulatory capital: loss given default (LGD), ex-
posure at default (EAD), and the maturity of the exposure (M).
Liquidity risk
The risk that the bank is unable to immediately repay depositors because it is holding
an insufficient level of liquid (immediately realisable) assets on the balance sheet.
Limited licence firms
These are firms that (i) are only authorized to provide certain specific low risk in-
vestment services - notably, reception and transmission of orders, execution of such
orders on behalf of their clients, placing of issues with no firm commitment, and in-
vestment advice; and (ii) are not allowed to come into possession of money or instru-
ments belonging to investors to which they provide investment services.
Loss given default (LGD)
This corresponds to the economic loss sustained by the bank as the result of the de-
fault of its counterparty, after taking into account any guarantees or collateral. This
loss is calculated separately for each advance to the defaulting counterparty.
Market risk
The risk of losses in trading positions when the price of marketable assets (such as se-
curities) held by a bank will fall thereby reducing the mark-to-market value of the as-
sets.
Maturity (M)
The remaining term to maturity that borrowers are permitted to take to fully discharge
their contractual obligations (principal, interest and fees) under the terms of a credit
facility. Maturity enters into the calculations implicitly in the FIRB approach (where
it is fixed at 2.5 years), and explicitly in the AIRB approach.
Operational risk
The risk of loss resulting from inadequate or failed internal processes, people and sys-
tems, or from external events.
Pillar 1
The rules that define the minimum ratio of capital to risk weighted assets. Pillar 1 is
intended to be compatible with the best and most widely adopted practices today for
managing exposures to credit and operational risk. By aligning regulatory capital re-

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quirements more closely with the actual degree of underlying risk that a bank faces,
Basel II is creating an economic incentive for bankers to refine their measures of risk.
Pillar 2
The supervisory review pillar, which requires supervisors to undertake a qualitative

review of individual bank’s capital allocation techniques and compliance with rele-
vant standards. Pillar 2 is based on the idea that no two banks have identical risk pro-
files; risk profiles vary as do skills and strategies. The supervisory review process is
premised on a bank’s responsibility to exercise sound judgement regarding the most
appropriate way to manage its own risk profile - and on the duty of supervisors to
evaluate that judgement.
Pillar 3
These are the disclosure requirements, which facilitate market discipline. – Pillar3
seeks to leverage the influence that other market participants can bring to bear on a
bank to manage its risks appropriately. By enhancing transparency in a bank’s public
reporting, counterparties, rating agencies, and even customers will have better access
to timely and meaningful information about a bank’s activities and exposures. They
will, in turn, be better able to make business or investment decisions. That will help
markets to reward banks that manage their risks judiciously while penalising those
that do not.
Return on Equity (ROE)
ROE is calculated as ROE = NOPAIT/SF, where NOPAIT is Net Operating Profit Af-
ter Interest and Tax and SF is average Shareholders’ Funds (equity plus reserves aver-
aged over the year in question).
Risk-Adjusted Return On Capital (RAROC)
The more sophisticated financial institutions use economic capital and Risk-Adjusted
Return On Capital (RAROC) to manage their businesses. Economic capital and
RAROC can be used to link risk, capital and shareholder value in a framework that al-
lows performance to be evaluated efficiently and effectively at all levels of a com-
pany.
Risk weighted assets (RWAs)
The Basel Accord establishes risk weights attached to each asset class with the
weights reflecting a measure of risk attached to the asset. RWAs reflect the adjust-
ment to the carrying value of the asset to reflect the risk weight and are calculated by
multiplying the carrying value of the asset by the risk weight. Overall capital require-
ments are calculated for each bank on the basis of the sum of risk-weighted assets
rather than the sum of the nominal value of assets.
Securitisation

CONFIDENTIAL
The packaging of assets or obligations into securities for sale to third parties.
Trading Book
A Bank’s portfolio made up of freely tradable financial instruments that are held for
short-term trading purposes, or for hedging other elements of the trading book.
Unexpected losses (UL)
The probability distribution of losses within a one-year time horizon makes it possible
to calculate a threshold level of losses at a confidence interval, which Basel II sets at
99.9%. Unexpected losses correspond to this threshold amount, minus expected
losses. Such losses should normally be covered by regulatory capital.

CONFIDENTIAL
Appendix 8 – Data Sources

1.1 Point 1 Analysis
The following table sets out the information available from the QIS3 by individual
country.
QIS Data Standardised FIRB AIRB

Country Country
Group 1 Group 2 Group 1 Group 2 Group 1 Group 2
Report Annex1
Austria Y Y NA Y NA Y NA N
Belgium Y Y Y N Y NA Y NA
Denmark Y Y NA Y NA Y NA Y
Finland Y Y NA Y NA N NA NA
France Y Y Y Y Y Y Y Y
Germany Y Y Y Y Y Y Y Y
Greece Y Y NA Y NA NA NA NA
Ireland N N N N N N NA NA
Italy N N N N N N N NA
Luxembourg N N NA N NA N NA NA
Netherlands Y Y Combined Combined NA NA
Portugal Y Y N Y N NA NA NA
Spain Y Y Combined Combined Combined
Sweden Y Y Combined N NA N NA
United Kingdom Y Y Y Y Y Y Y NA
Legend:
Y Data made available
N Data not made available
NA Data does not exist (i.e. not provided by country as part of the QIS)
Combined Data made available for Group 1 and Group 2 in aggregate only
1.2 Point 2 Analysis
Austria
Austrian Bankers’ Association, Annual Report 2002
Economist Intelligence Unit - ViewsWire, Austria: 5 year forecast table, 10 September

2003
Oesterreichische Nationalbank, Statistische Monatshefte (Internet version), available at

http://www2.oenb.at/stat-monatsheft/englisch/state_p.htm
Oesterreichische Nationalbank, Financial Stability Report 5, Vienna 2003
1
The country annex refers to the information made available in the tables contained in the Methodology
Annex to the QIS3 results published by the European Commission. This information was also made
available to us on an individual country basis where indicated.
Appendix 8 – Data sources Page 1 of 4

CONFIDENTIAL
Belgium
Banque Nationale de Belgique, Financial Stability Review 2003
Belgostat online, Financial Statistics and Markets
Denmark
Economist Intelligence Unit- ViewsWire, Denmark: 5-year forecast table, 4 September

2003
Danmarks National Bank, Financial Stability Report, 2003
Danmarks National Bank, Financial Statistics, January 2003
Finland
Bank of Finland, Report on Finnish banking system, 17 September 2003
Finnish Bankers’ Association, Banks 31 December 2002, April 2003
Financial Statements of Finnish banks
France
Banque de France, Monetary Statistics France, August 2003
Federation Bancaire Francaise, La banque en chiffres 2002-Environnement economique

des banques
Xerfi, Le marché bancaire francaise en 2003, 18 December 2002
Germany
Associations of German Banks’ website, German banks-Facts & figures, October 2003
Deutsche Bundesbank, Monthly Report, September 2002 and June 2003
Deutsche Bundesbank, Bankenstatistik, July 2003
Greece
Bank of Greece, Annual report 2002, April 2003
Bank of Greece, Monthly Statistical Bulletins, March-April 2003
UBS broker report, Greek Banks, 12 September 2003

CONFIDENTIAL
Ireland
Central Bank of Ireland, Financial Stability Report 2002
Central Bank of Ireland, Quarterly Bulletin, Spring 2003
Goldman Sachs, Ireland Banks, 10 October 2003
Goldman Sachs, Ireland Financials, 3 September 2003
MPFS, Bank Lending Survey, 30 October 2002
The Irish Bankers’ Federations, Irish Banking Review, Autumn 2003
Italy
Banca d’Italia, Bollettino Statistico, December 2002 and March 2003
Italian Bankers’ Associations, Rapporto sul sistema bancario italiano, December 2002
Financial Statements of Italian banks
Netherlands
De Nederlansche Bank, Statistical Bulletin, January 1998- September 2003
De Nederlansche Bank, Annual Report, 2002
ING Group website, Banking Environment, December 2003
Portugal
Banco de Portugal, Statistics Bulletin, June 2003
Banco de Portugal, Annual report, 2002
Spain
Banco de España, Memoria de la supervision bancaria en España, 2002
Bank of Spain, Financial Stability Report, May 2003
Banco de España, Boletin estadistico, December 2002
Economist Intelligence Unit, Spain: Country Outlook, 10 December 2003

CONFIDENTIAL
Sweden
The Independent Swedish Savings Banks Association, Review of new capital require-
ments for credit institutions and investment firms, statement of comments 2003-01-24
Sveriges Riksbank, The Swedish Financial Markets 2002, 2003
Sveriges Riksbank, Finansiell Stabilitet 2003:2
Statistiska Centralbyrans website, Riksbankens finasmarknadsstatistik
United Kingdom
The British Bankers’ Associations, Banking Business, volume 20, 2003
Bank of England, Statistical releases
The Office of National Statistics, Statistical data

CONFIDENTIAL
Appendix 9 – Information on accession countries

Table 1: Assets owned by EU and non-EU investors (billion EUR)
Country EU Non-EU Total
Poland (data 2002) 67.7 43.3 111

Czech Republic (data 2003) 57.7 2.3 60
Hungary (data 2002) 26.5 15.8 42.3
Total 151.9 61.4 213.3
Table 2: Market share of EU and non-EU investors

Country EU Non-EU Total
Poland (2002) 61 % 39 % 100 %

Czech Republic (2003) 96 % 4% 100 %
Hungary (2002) 63 % 37 % 100 %
Total 71 % 29 %
Table 3: Market share of EU banks in CEE

Assets owned by
N° of banks Total assets of EU 15 Banks
Country1 Total n° of banks controlled by banking sector
foreign investors (EUR billion) Amount % share of
(€Bn) total assets
622 commercial banks

Poland
47 commercial banks 111 67.7 61
(2002) 605 cooperative banks
(all Polish)
Czech Re- 26
public 353 (9 are foreign bank 60 57.7 96
(2003) branches)
Hungary
334 commercial banks 26 42.3 26.5 63
(2002)
1
Source: PricewaterhouseCoopers’ analysis
2
Source: Poland Central Bank, Annual report and statistics, at http://www.nbp.pl/en/statistics/wyniki_dwn/synteza2003_06_en.pdf.
3
Source: Czech National Bank, at
http://www.cnb.cz/en/bd_ukazatele_tab01.php?PHPSESSID=f027f47579d2604254f76c24d783f9df
4
Source: Hungary National Bank, Report on Financial Stability, at http://english.mnb.hu/dokumentumok/2003.stab.jel1_en.pdf
Appendix 9 – Information on accession countries Page 1 of 3

CONFIDENTIAL
Table 3:Top 5 banks in Poland, Czech Republic and Hungary (2002/3)

Controlling % share of to-
Country Name
shareholder
Country Assets (€Bn)
tal bank assets
Poland PKO Bank Polski Polish State Poland 20.5 18

(100%)
Bank Pekao S.A. Unicredito Italy 16.2 15
Italiano (53%)
Bank Przemyslowo- Bank Austria Austria 10.6 10
Handlowy PBK (HVB group) (Germany)
(PBH) (71%)
Bank Handlowy Citibank (89%) USA 8 7
ING Bank Slaski ING Bank (88%) Netherlands 6.8 6
Czech CSOB KBC Belgium 15.9 27
Republic
Komercni Bank Société Générale France 13.9 23
Ceska Sporitelna Erste Bank Germany 14.4 24
HVB HVB Germany 4 7
Commerzbank Commerzbank Germany 2.7 4
Zivnostenska bank Unicredito Italy 1.5 2
Hungary OTP Widely held, Hungary 11.5 27
Hungarian bank
K&H Bank KBC Belgium 5.2 12
MKB Bayerische Germany 4.1 10
Landesbank
CIB Bank Intesa Italy 3.5 8
HVB Bank Austria Austria 2.4 6
Creditanstalt

CONFIDENTIAL
Table 4: Investment by EU 15 banks in major local banks in some other accession

countries
Name of the bank EU 15 Investor % Holding
Slovakia
Slovenska Sporitelna a.s. Erste Bank AG 67
Vseobecna uverova banka a.s. - IntesaBci 26
VUB
Tatrabanka a.s. Raiffeisen Zentralbank Österreich AG 72
Ceskoslovenska obchodni banka KBC Bank NV 76
- CSOB
Ludova Banka a.s. Volksbank International AG 86
ING Bank NV ING Holding 100
Prva stavebna sporitelna a.s. Bausparkasse Schwäbisch Hall AG 32
Raiffeisen Bausparkassen Management- 32
service und Beteiligungsgesellschaft
m.b.H
HVB Bank Slovakia , a.s. HVB Group 100
Istrobanka a.s. BAWAG 100
Slovenia
NLB d.d. KBC Bank 34
SKB Banka d.d Société Générale 97
Bakart d.o.o. LHB Internationale Handelsbank 50
Adria Bank AG 28
Romania
Banca Transilvania SA European Bank for Reconstruction and 15
Development
Banca Română Pentru Desvol- Société Générale 51
tare SA
Estonia
Hansapank Ltd. Swedbank 60
AS Sampo Bank Plc Sampo Insurance Company Plc 95
Eesti Uhispank AS Skandinaviska Enskilda Banken 95
Latvia
Rigas Komercbanka- European Bank for Reconstruction and 23
Development
Latvijas Unibanka A/s Skandinaviska Enskilda Banken 99
Hansapank Swedbank 50
NORD/LB Latvija Norddeutsche Landesbank Girozentrale 96

CONFIDENTIAL
Appendix 10 – Issues for ISD firms
1. The nature of operational risk in asset management
The business line operational risk indicators and income calibration factors in the draft
Directive are primarily based on banking experience and are not applicable to the very
different risk profile of most investment firms. This may result in firms having to main-
tain operational risk capital that does not meet their business risks.
Two studies, referred to as “OXERA1” and “Toulouse2” respectively, asked samples of

European asset and fund managers to set out the frequency and impact of particular
types of operational risk3. They found similar sets of loss events, as set out in the charts
below (Figure 1, Figure 2 and Figure 3 respectively):
Figure 1: Sources of operational risk in terms of potential financial impact
1
‘Risks and regulation in the European investment fund industry: is there a role for capital requirements’,
a report by Professors Franks and Mayer and OXERA Research for EAMA, January 2001
2
‘Operational risk and capital requirements in the European investment fund industry’, a report by the
University of Toulouse for FEFSI, January 2003
3
The OXERA study covered 39 asset managers with a bias towards the UK, the Toulouse study covered
46 companies biased towards Continental Europe.
Appendix 10 – Issues for ISD firms Page 1 of 7

CONFIDENTIAL
Figure 2: Frequency of operational risks
Figure 3: Frequency and impact of operational risks
Source: Toulouse
We do not consider that there is sufficient evidence to show that income or expenditure
alone necessarily constitute reliable indicators of risk for investment firms. Income in
asset management is subject to major swings caused by markets and unrelated to
changes in risk. Alternatives include a volume/transaction-based approach (as offered
by Basel for retail and commercial banking) or funds under management (as proposed
by the Toulouse study).
Compared with many other activities, overall losses in the asset management industry
resulting from operational risk have been small. The two studies quoted, Oxera and
Toulouse, show similar results. Exceptionally large losses have occurred from time to
time, but no firm would hold sufficient capital to meet them. These losses are better

CONFIDENTIAL
dealt with by insurance as they tend not to be driven by cross-industry events and are in-
frequent but with a large impact on the particular firm.
Table 1: Ratios of observed losses to various factors
There is a lack of coherent loss data for investment firms in Europe. We recommend
that consideration be given to collecting such data for use in developing future legisla-
tion. We understand that the Bundesverband Investment und Asset Management e.V. is
starting to collect such data in Germany and recommend that this should be done on a
consistent basis throughout the EU. The results should be shared with investment firms
and insurance companies to allow more effective operational risk management and the
development of insurance cover.
2. The treatment of operational risk in limited license firms
We have noted above that, for the majority of investment firms, i.e. limited licence
firms, the predominant determinant of regulatory capital will continue to be the EBR.
The EBR has the effect of ensuring that firms maintain sufficient liquid resources to al-
low their business to run for a period after it has closed for new business, allowing time
to make new arrangements for existing customers. The amount has not been designed to
be sufficient to liquidate the business. The operational risk requirement, however, is de-
signed to ensure that firms have adequate resources on a going concern basis. To date,
the EBR has generally been shown to be an effective, if crude, prudential tool. By its
nature (relating to orderly reorganisation rather than going concern), it is to be expected
that the EBR would generally be higher than an operational risk requirement for in-
vestment firms.
All the evidence from the OXERA and Toulouse studies, and from ICI Mutual points to
operational risk as being the prime, if not only, risk for these firms. However, the EBR
has no sensitivity to the underlying risks of the business. Indeed, expenditure on risk-
management systems could lead to a higher capital charge. Moreover the current EBR
proposals offer no incentive for firms to improve their operational risk systems and con-
trols.

CONFIDENTIAL
3. Possible way forward for limited license firms
Because of the relatively small overlap between the risk profiles of banks and invest-
ment firms, it would be helpful if the Commission were to develop a risk-sensitive pru-
dential framework especially for limited licence investment firms. We suggest that, at a
time of its choosing, the Commission should:
define business lines and loss categories appropriate to limited licence investment
firms.
work with supervisors and the industry to capture loss data in these business lines
devise a risk sensitive proxy/proxies for limited licence investment firms
devise a capital regime that rewards improvements in risk management.
This could be a lengthy process and, until it has been completed, Pillar 2 will assume
considerable importance. If that is not, in turn, to lead to regulatory arbitrage the appli-
cation of Pillar 2 to investment firms must be characterised by cross-European collabo-
ration and transparency. It should be noted that few regulators currently apply Pillar 2
requirements to their investment firms, even those that systematically apply additional
capital requirements to banks, although some have powers to levy additional capital
through such mechanisms as a secondary requirement.
4. The use of insurance as a risk mitigant in asset management firms
In the draft Risk Based Capital Directive, insurance has been allowed to reduce capital
requirements only in respect of the AMA. This restriction seems to have been estab-
lished because of the difficulty for regulators in defining their requirements with respect
to insurance policies and their caution over the emergence of this market in relation to
the banking sector. However, the risks for investment firms are different and may be
more easily insured.
Risk capital is but one of the protections available against operational risks in asset
managers. Zurstrassen4 has characterised the possibilities as including the following:
Capital
Earnings
Internal control
Corporate governance
Asset separation
Parent support
4
P. Zurstrassen. Credit Agricole Investor Services / PwC Study 2003

CONFIDENTIAL
Custodian
Insurance
Market discipline
Audit
The Toulouse study found that operational losses would be financial first from internal
profits and then from capital.
In the USA, the prudential regime for investment managers is different from that for
banks. Investment advisers, the equivalent of a European asset managers, have no regu-
latory capital requirements but the mutual funds they advise are required to take out in-
surance against a wide range of operational risks. Investment companies must be
bonded by a reputable fidelity insurance company against larceny and embezzlement by
any officer or employee of the company. Other types of coverage are also sought by
funds. This arrangement appears to operate effectively and we are not aware of any
cases where a significant insured loss has not been met. Thus an effective market in op-
eration risk insurance can be developed, at least for investment firms.
ICI Mutual is an insurance company, which underwrites a significant part of the market
for risks in the mutual funds industry. Their experience is that most losses fall into a se-
ries of readily identifiable categories, of which very few are found in banking.
Figure 4: Types of D&O/E&O Claims (% of amount paid since inception)
Other
7.4% Investigations
Breach of Fid. 18.9%
Duty
17.0%
Corporate Action
6.5%
Pricing Error
11.8%
False Prosp./Filing
23.8%
Failure to Follow
Investment
Guidelines 14.8%
Source: ICI Mutual Insurance Company
The concentration in the USA on mutual funds, where there is the greatest need for in-
vestor protection (as with UCITS in Europe), means that their experience cannot be
transposed directly into European asset management terms. Nonetheless their experi-
ence is suggestive. ICI Mutual comments that the problem is rarely the frequency of

CONFIDENTIAL
losses (most firms encounter a continuing series of low-value operational losses), but
more the severity of a small number of losses. From time to time large losses do occur,
but these are rarely the result of a single event. Large losses tend to occur where a group
of mistakes escalate and are not detected quickly, i.e. where the systems and control en-
vironment is poor. US regulators have found that a suitable way of covering such losses,
and creating incentives for good risk management, is insurance rather than capital re-
quirements. The underwriters perform a role akin to regulators’ envisaged ‘Pillar 2’ in-
tervention. Where they find poor controls, they increase the premium. The system is,
therefore, risk sensitive.
It is also significant that large losses in this market are rarely driven by pan-industry
events, as can happen in the banking industry, making insurance a suitable prudential
mechanism for at least part of the operational risk encountered.
5. The problem of borderline €730k firms
The limited licence regime is not available to €730k firms. They are regarded as com-
peting in the same markets and facing the same risks as banks, so they will be subject to
the same capital requirements.
We believe that this problem may not be as large as at first appears. In some jurisdic-
tions, €730k treatment is imposed on all ISD firms regardless of the business conducted.
In others, firms have applied for €730k treatment as a precaution, again on occasions
encouraged by the local supervisors. A more rigorous approach to the nature of the busi-
ness being undertaken from both firms and supervisors is likely to remove a number of
currently problematic cases. We are aware that certain jurisdictions are currently con-
ducting such a re-consideration.
The original classification of firms (€50k, €125k and €730k) did not have such signifi-
cant implications for capital requirements.
Nonetheless, a real problem will remain for a significant number of firms in several
countries. To help resolve their problems, where there is no indication that a substantial
increase in capital is justified by the underlying risks, a number of actions are open to
the Commission.
Regardless of other actions, it would be helpful if the Commission revisited a number of

key definitions.
‘principal trading’, ‘dealing on own account’, ‘acting as principal’.
Annex A of the draft Directive refers to “trading book”: Annex H-1, in a key
definition, refers to “dealing on own account”. A distinction needs to be found be-
tween the business of holding oneself out continually as a market maker and
committing capital to the business (trading), and a broker acting primarily for
non-market customers who deals occasionally in its own name (acting as princi-
pal) solely to complete a customer order.
‘underwriting/placing’.

CONFIDENTIAL
The current assumption is that placing always involves underwriting. It does not,
and the risks are very different. A number of 125K firms place new issues with
clients, but they take no market or credit risk themselves.
‘clearing and settlement’.
This should distinguish between cases where some or all of the risk remains with
the broker, and those systems where the risk is clearly transferred to another, usu-
ally authorised, institution.
Once these definitions have been agreed, it should be possible to distinguish between
the two types of €730k firm. It would then be open to the Commission to consider
whether the borderline firms can be offered the status quo or could be classified as lim-
ited licence until a risk sensitive system is available.
6. Large exposures directive
The large exposure rules impact in an unintended way on the business of asset manage-
ment firms. Wherever a firm has a limited number of customers, fees due can count as a
large exposure. This can arise for newer and smaller firms or where there are a limited
number of clients, such as a parent insurance company.
Similarly firms charging performance fees can have a significant debtor or accrual in re-
spect of their fees and might breach the large exposure rules even though it is in a
stronger position that if it did not receive the fees. This is a concern because the fees are
not usually admissible as a Tier 1 asset until well after they are paid. In essence, the
more successful the firm, the larger the breach they create.
Most importantly, because of the agency nature of the business, large exposures do not
put customers investments at risk.
This is not an issue introduced by CAD3 but is of concern to ISD firms more generally
and might be addressed in any future work.

CONFIDENTIAL
Appendix 11 – Project Team
Project Direction and Overall Management
Charles Ilako Lead Partner, Financial Services Regulatory Practice
Advisory Panel
Dr. Hans Blommestein Senior Financial Economist and Head of the Capital
Market Programme, OECD
Prof. Elisabetta Gualandri Head of Department of Business and Finance and Profes-
sor of Financial Intermediaries, Università di Modena e
Reggio Emilia
Prof. Dr. Thomas Heimer Geschäftsführender Dekan, Hochschule für

Bankwirtschaft
Frederik C. Musch PricewaterhouseCoopers and former Secretary General

of the Basel Committee
Dr. Walter S.A. Schwaiger Professor of Accounting and Corporate Control, Techni-
cal University of Vienna
Prof. David Llewellyn Professor of Money and Banking, Loughborough Uni-

versity
Project Team – Financial Risk Management and Basel II Specialists

Richard Barfield, London (Leader – Section 4: Impact on banks’ behaviour
and profitability)
Stephen Burke, London
Friedemann Loch, Frankfurt
Monika Mars, Amsterdam (Project Manager and Leader – Section 3: Impact
on balance sheets and capital)
Peter Milroy, London
Richard Quinn, London (Regulatory Technical Specialist)
Roberto Setola, Rome
Philip Warland, London (Leader – Section 6: Impact on investment firms)
Project Team – Economics/Econometrics Specialists

Dr. Ray Barrell (NIESR)
Prof. E. Philip Davis (NIESR)
John Hawksworth (PwC)
Dr. Bill Robinson (PwC) (Leader – Section 7: Impact on the EU economy)
Appendix 11 – Project Team Page 1 of 2

CONFIDENTIAL
Project Team – Analysts

Egbert Adrichem, Amsterdam
Wikash Bhagwanbali, London
Ragna Ceder, London
Karin Hartonian Matbaeh, Amsterdam
Marcus Kennedy, London
Peter Kuelsheimer, London
Chiara Lombardi, London
Pablo Martinez-Pina, London
Frank Rabouw, Amsterdam
Henry Strouts, London
John Raven, London
Paolo Vizioli, London
PricewaterhouseCoopers country experts
AUSTRIA: Andrea Cerne-Stark
BELGIUM: Josy Steenwinckel, Bert Geukens
DENMARK: Flemming Nielsen, Gert Andersen
FINLAND: Juha Tuomala
FRANCE: Benoît Catherine, Jacques Rambosson
GERMANY: Hiltrud Thelen-Pischke
GREECE: Andreas Riris, Maria A. Tsagari
IRELAND: Alan Merriman
ITALY: Roberto Setola
LUXEMBOURG: Philippe Sergiel
NETHERLANDS: Arno Pouw
PORTUGAL: José Bernardo, Manuel Luz
SPAIN: Elias Bustillo-Borruel, Giulio Guida
SWEDEN: André Wallenberg, Karin Hjalmers
UK: John Hitchins, John Tattersall
Appendix 11 – Project Team Page 2 of 2

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Appendix 1 – Outline of Basel II proposals Page 1 of 10

Appendix 1 – Outline of Basel II proposals Page 2 of 10

1.3 Basel II - The three pillars

Supervisory review process (Pillar 2); and

Appendix 1 – Outline of Basel II proposals Page 3 of 10

Market discipline (Pillar 3).

1.3.1 Pillar 1 - Minimum capital requirements

1.3.2 Pillar 2 - Supervisory review process

a bank specific internal assessment and management of capital adequacy; and

1.3.3 Pillar 3 - Market discipline

Appendix 1 – Outline of Basel II proposals Page 4 of 10

1.4 Pillar 1 – Credit Risk

the Standardised Approach;

the Internal Ratings Based (IRB) Foundation Approach (FIRB); and

the IRB Advanced Approach (AIRB).

1.4.1 Standardised Approach

Appendix 1 – Outline of Basel II proposals Page 5 of 10

Table 1: Risk weights for Sovereigns and Banks

Sovereign 0% 20% 50% 100% 150% 100%

Table 2: Risk weights for Corporates and real estate exposures

Corporate 20% 50% 100% 150% 100%

1.4.2 IRB Approach

1 Risk components - internal or supervisory estimates of risk factors such as the

Appendix 1 – Outline of Basel II proposals Page 6 of 10

3 Minimum requirements - the minimum qualitative requirements covering issues

1.4.3 IRB Foundation Approach (FIRB)

Figure 1: Risk weight for corporate, bank and sovereign exposures

Corporate CP3 Corporate Madrid

Appendix 1 – Outline of Basel II proposals Page 7 of 10

Other Retail CP3 Other Retail Madrid

Figure 3: Risk weights for residential mortgages

Residential Mortgage CP3 Residential Mortgage Madrid

1.4.4 IRB Advanced Approach (AIRB)

Appendix 1 – Outline of Basel II proposals Page 8 of 10

1.4.5 IRB Approach for equity exposures

1.5 Pillar 1 – Operational Risk

Standardised Approach: Under the Standardised Approach, the banks’ activities

Appendix 1 – Outline of Basel II proposals Page 9 of 10

Advanced Measurement Approaches (AMA): Under the Advanced Measurement

Appendix 1 – Outline of Basel II proposals Page 10 of 10

Appendix 2 – Interview programme with regulators, finance

A number of themes emerged from these discussions:

Appendix 2 – Interview Programme Page 1 of 4

Appendix 2 – Interview Programme Page 2 of 4

There is increasing confidence on the back of detailed research by a number of

There is confidence especially among regulatory authorities that, on average, the

The smaller end-users of financial services, especially SMEs in those countries

Concern exists about the interaction of International Financial Reporting Stan-

Appendix 2 – Interview Programme Page 3 of 4

In particular, there is concern that there should be a more concerted approach to

The nature of supervision is likely to change somewhat in all territories, and in

Appendix 3 contains a full list of the interviews conducted.

Appendix 2 – Interview Programme Page 4 of 4

Appendix 3 – List of Interviews

EU Banking Advisory Committee (BAC)

European Venture Capital Association

European Banking Federation

European Association of Securities Dealers

European Asset Management Association

Fédération Européenne des Fonds et Sociétés d’Investissement

Autrian Financial Market Authority