One Basel leads to another

The difficult business of drawing up new international banking rules

AS BANKS get bigger, they also become smarter. That, at any rate, is the theory underpinning a new set of rules on risks and capital for banks around the world, formally called the "International Convergence of Capital Measures and Capital Standards" and informally "Basel 2". The code has been drafted by the Basel Committee on Banking Supervision, an offshoot of the Bank for International Settlements (BIS), which supports and co-ordinates the work of leading central banks around the world. It is a gentlemen's agreement among leading regulators which all countries with international banks are encouraged to adopt, but which relies on national law for its implementation.

One striking feature of Basel 2 is its principle that banks should have the option to decide for themselves where they think their big and their little risks lie, and then to allocate their capital accordingly, subject to national regulators' rules and national laws. Another feature is that it will probably allow many big banks to reduce the capital needed for their current balance sheet, in some cases quite sharply.

Europeans, by and large, are keen to get on with it. The European Union has passed legislation to implement Basel 2 next year. Americans, by contrast, are worried on three counts. First, they think the rules are too slack, allowing banks to reduce capital too far. Second, they reckon that American banks will not be able to implement the rules reliably without at least another four years' practice, if ever. Third, they fear that the rules will give the biggest banks too much of an advantage over small banks.

Those worries have persuaded America to adopt Basel 2 later and more gradually. International banks with headquarters in America and subsidiaries in Europe, and vice versa, can only guess how they will reconcile European and American regulatory requirements when the EU works to Basel 2 rules and America does not.

The Basel rules have their origin in the failure of Germany's Herstatt Bank in 1974. Herstatt defaulted on contracts with banks overseas, highlighting the need for more international co-operation among banking regulators. The Basel Committee published its first "Basel Capital Accord", now known as Basel 1, in 1988.

Recognising that some loans and investments were less risky than others, the Basel rules "weighted" them accordingly. For example, all loans to companies were assigned a weighting of 100%, but loans to banks in rich Western countries had a risk weighting of just 20%. A bank which had $8m in capital and lent $100m to companies was at the limit of its lending capacity if it observed the minimum capital requirement of 8% recommended by the Basel Committee. But a bank which lent only to other banks could lend $500m before reaching its limit.

A bigger, better rule book

These Basel 1 rules soon came to be seen as much too crude in the way they weighted risks, with one category for all corporate loans, another for all sovereign loans and so on. Work on a new and more flexible framework, Basel 2, started in 1996, and a draft was published in June 2004. The new code was designed for internationally active banks. In America, this may mean only ten to 20 banks. In the European Union all banks will have to implement Basel 2, so that they can be treated equally, as European law requires.

Basel 2 invites banks to choose between two approaches when calculating credit risk and capital allocation. The simpler method, the so-called "standardised approach", is designed for smaller banks with less sophisticated risk-modelling and risk-management systems. It requires banks to use the risk assessments provided by accredited credit-rating agencies when giving a risk weighting to their loans and investments.

Bigger banks with more sophisticated risk-modelling and risk-management systems can opt for what Basel 2 calls the "internal ratings-based approach", or IRB. The IRB allows a bank to use its own internal historic data to calculate the riskiness of its loans and investments. To do this calculation, the bank needs to be able to estimate the probability of default within one year for each borrower; the bank's potential exposure at a default; the bank's potential loss from a default; and, in the absence of a default, when the borrower will repay.

In addition to these risks of default, Basel 2 requires banks to provide capital against what it calls "operational risk", meaning the risk of losses from crashing computer systems, natural disasters or rogue traders. But here calculation shades into guesswork.

In allowing banks to do more of their own risk assessment under IRB, the Basel rules rely on national regulators to ensure that banks are up to the job and are doing it diligently. That is a tall order, at least initially. National regulators also need to look out for problems which may not be easily caught by assessment of default risk alone. A bank with a very large portfolio of fixed-interest securities and derivatives, for example, would lose a bundle if interest rates went the wrong way.

The Basel 2 rules count on "market discipline" to do some of the work of keeping banks in line. Banks must publish details of their assets and liabilities and of the models they use to calculate credit and operational risk. As George Kaufman, professor of finance at Loyola University in Chicago, has pointed out, this is not really market discipline, but transparency and disclosure. If regulators wanted to increase market discipline, they could do so by abolishing deposit insurance, which would make depositors think more about their choice of bank, or by requiring all banks to issue publicly traded subordinated debt.

America's hesitations over Basel 2 were increased by a study last year of how its banks might calculate current risks and capital requirements using Basel 2 rules. On average, the banks thought that applying Basel 2 rules would allow them to decrease their regulatory capital by 15%. They reached that conclusion using calculations of risk falling "well short of the level of reliability that will be necessary to allow supervisors to accept those estimates for risk-based capital purposes", said John Dugan, America's Comptroller of the Currency, whose job includes bank regulation. Different banks gave weightings ranging from 5% to 80% for seemingly identical risks.

And even if banks manage to standardise their calculations, the Basel 2 rules will still be a cause for concern, according to Donald Powell, the FDIC's chairman. Its formulas for regulatory capital, he told the Senate, "are inherently calibrated to produce large reductions in risk-based capital requirements", implying "a far lower standard of capital adequacy than we have in the US today".

A third concern among America's thousands of small banks has been that Basel 2 would give big banks an unfair advantage. Big banks using the IRB approach would be updating their risk calculations second by second, laying off assets that tied up a lot of capital and adding ones that tied up much less. Small banks without the same information systems, and without the same scale and diversity of assets in which to trade, might end up with a concentration of the worst-priced risks without even knowing it.

To allow more time to deal with these concerns, America plans to implement Basel 2 only from 2008, and with a three-year transition period. No American bank will be allowed to use Basel 2 as a reason for reducing its risk capital by a total of more than 5% before 2009, 10% by 2010 and 15% by 2011. Small banks will get a new set of rules more flexible than those of Basel 1 but much less complicated than those of Basel 2, including more categories of risk, more use of external credit ratings and more scope for using collateral and guarantees to reduce risk weightings.

American regulators will also reserve the right to keep a basic minimum equity capital ratio for all banks, currently set at 4% of assets regardless of risk weighting, and they will go on prodding banks to keep their capital levels well above any statutory minimum. Most banks do that already in order to impress customers and shareholders as well as regulators. The argument here is that capital signals the trustworthiness of a bank. Having lots of it on the balance sheet keeps down the bank's cost of funds. Certainly, international comparisons suggest that high capital ratios have done no harm to American banks' profits in recent years (see chart 5).

America returned to strict capital requirements for all banks in 1984, after Continental Illinois, the country's seventh-biggest bank, lost half its funds overnight. Until then, the biggest banks had not been subject to any minimum capital requirement, in the belief that they could be trusted to manage their own balance sheets. Times have changed, and banks too. But Americans can be forgiven if they worry that banks, at any rate, have not changed enough.

Artcile forms part of a special survey of international banking.

Bank for International Settlements: Monetary & financial stability: Basel II http://www.bis.org/publ/bcbsca.htm

---