Capital Allocation Reform Critical to Modernization

By Martin, Pam | The Journal of Lending & Credit Risk Management, September 1998 | Go to article overview

Capital Allocation Reform Critical to Modernization


Martin, Pam, The Journal of Lending & Credit Risk Management


Stock market jitters aside, the banking industry continues to enjoy record earnings in perhaps the most favorable economic environment of this century. What better time to examine core public policy issues governing the financial services industry? Significantly, this is indeed happening.

The U.S. Congress continues its nearly two-decade struggle to cobble together legislation to reform the depression-era statutes that govern the financial services industry. Regardless of whether or not such legislation is enacted this year, the marketplace has changed in such a dramatic fashion that the banking business is not what it was 10 years ago. The lines separating the sectors of the financial services industry - banking, securities underwriting, and insurance underwriting - have long ceased to be distinct. This evolutionary development helped produce the industry's rebound from losses of the late 1980s and early 1990s by providing additional revenue-generating activities and less concentration in lending functions for most banks' balance sheets. Moreover, old geographic barriers have disappeared allowing for greater diversification of industry credit risk.

Equally important to the banking industry's continued strength is the fact that regulators worldwide are beginning to reexamine the risk-based capital guidelines. Both developments - statutory reform and capital allocation reform - are critical to the industry's future success. A more interesting fact, however, is that they also are interrelated.

On July 20, 1998, the General Accounting Office (GAO) released a study on how financial services regulators and private sector firms understand and manage the relationship between capital and risk. The report, Risk-based Capital: Regulatory and Industry Approaches to Capital and Risk, should prove useful as Congress attempts to enact legislation allowing affiliations between banks, securities firms, and insurance companies. While many of the activities of large U.S. banks, securities firms, and insurance companies have converged significantly in recent years, the activities of the firms in each sector are governed by different primary regulators with different oversight purposes and very different regulatory capital requirements.

Bank capital standards on the whole are much higher since they are designed to ensure the safety and soundness of the banking system and are calculated on a going-concern basis. Meanwhile, capital standards for securities broker-dealers and futures commission merchants are calculated on a liquidation basis and are designed to protect customers in the event of a firm failure.

The GAO report suggests three important questions that must be addressed if future capital standards reforms are to be considered:

1. What are the competitive implications for firms stemming from differences in the capital rules of difference financial regulators?

2. Do differences between regulators' and firms' measurement of risks, their views of how to manage those risks, and their estimates of needed capital, create incentives to manage risks inappropriately?

3. How will financial regulators administer capital rules when the largest firms' operations are increasingly complex and growing differences exist between large and small firms?

The current risk-based capital allocation structure for the banking system was established by the 1988 Basle Capital Accord and provides an international supervisory capital standard for the G10 countries that has become the global benchmark for regulatory credit risk capital standards. There is no similar global structure that outlines capital standards for securities and insurance underwriting firms.

Reforming the 1988 Basle Accord

Concern is growing among U.S. financial institutions and the regulatory community that the current capital allocation structure outlined in the 1988 Basle Accord is in need of review and reform.

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