Bank capital adequacy. Basel lite

New banking rules are less precise than they look

ON JUNE 26th, the world's top central bankers put their seal of approval on Basel 2, a new capital-adequacy framework for banks, which is intended to come into force in stages from the end of 2006. The fruit of more than five years' work by a committee of leading bank supervisors, Basel 2 is supposed to relate banks' regulatory capital more closely to the perceived risks that they run. Yet the framework has become so protean that the central bankers might as well have stayed at home.

Do not despair, though: Basel 2's creators hope that this very flexibility will turn out to be its magic. Bank regulators, terrified of “regulatory capture ” - -having the wool pulled over their eyes by clever bankers - have ended up committing themselves to almost nothing. True, the number-crunching part of the framework contains lots of daunting and devilish ratios for credit risk (the chance that a debt might not be repaid or recovered) and operational risk (the chance that, say, a bank is clobbered with a large regulatory penalty). But these are less exact than they look: there is almost unlimited scope for these to be adjusted over the next few years.

Moreover, regulators are still haggling with bankers over many details, such as “double default”, the extra weight to be given to the risk that a provider of credit insurance might go bust as well as a borrower. Bankers claim this is negligible: regulators are not convinced.

To make matters less precise still, during negotiations with bank associations, regulators have been placing less weight on “pillar 1” and more on “pillar 2 ” - -Basel-speak for supervisors' discretion - in order to overcome anomalies produced by the formulas in pillar 1. Each national banking system and each class of bank within it has a different track record of default and of recovering loan losses, and faces different operational and legal risks. The only way to deal with these inconsistencies is to allow regulators to adjust the rules. The framework allows for exactly that.

There is also a “pillar 3”: reliance on disclosure by banks and market reaction to it as a means of discipline. This too is already bearing an increasing weight. Banks have been under more pressure from rating agencies and from threats to their sources of funding than they have been from regulators to show that they are aligning themselves with Basel 2. A prime example is Germany's Landesbanks, wholesale, state-sector banks which in a year's time will lose their state guarantee for any new funds they raise. That deadline, and the anticipation of it by rating agencies and buyers of their bonds, has convinced them faster than any regulator that they needed to improve their capital ratios.

If there were no implicit or explicit guarantee, such as deposit insurance or a lender of last resort, the bank supervisors could let pillar 3, market discipline, do their job entirely. That is, or should be, the ultimate goal towards which this framework is moving.

However, there is a snag. Basel 2 is being translated into European law, to be applied to investment firms as well as banks throughout the European Union. Amendments to the Codified Banking Directive and the Capital Adequacy Directive should be drafted some time this month. It remains to be seen how much room will be given for flexible negotiation. The European Commission is trying to reduce the amount of discretion that each national supervisor is permitted under the Basel 2 framework. It will be a pity if the commission does not change its mind.

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