Academic journal article The McKinsey Quarterly

Getting International Banking Rules Right

Academic journal article The McKinsey Quarterly

Getting International Banking Rules Right

Article excerpt

Significant changes in the proposed new Basel Capital Accord are needed to avoid placing unintended burdens on banks and discouraging them from embracing the sophisticated risk-management practices it was intended to promote.

This past June, the bank regulators on the Basel Committee on Banking Supervision postponed the deadline for finalizing a new version of the 1988 Capital Accord, which serves as the basis of the minimum-capital requirements for banks around the world. [1] Although the regulators affirmed their commitment to the broad outline of their proposal--Basel II--they conceded that many of its details were incomplete. The Basel committee now plans to issue a new draft in early 2002 and to finalize it during that year.

The regulators were wise to delay. Far from being an esoteric banking issue, the new rules will have far-reaching implications for banks and borrowers everywhere. Although the current draft of Basel II clearly improves on the 1988 Capital Accord, it does not live up to two of the Basel committee's main goals: aligning minimum-capital requirements with risk more satisfactorily and encouraging banks to adopt better risk-management practices. Indeed, Basel II as currently written threatens to put an undue and unintended capital burden on banks and to discourage them from embracing more sophisticated credit-risk-management practices.

As the committee drafts a revised version of Basel II, it should add four key modifications to its list of planned changes. [2] It should reconcile the disparate treatment of loans to the least creditworthy borrowers under different credit-risk-measurement approaches, change the framework for assessing the risk posed by unsecured retail assets such as credit cards, reconsider its approach to operational risk, and give banks sufficient time to collect the data they need to prepare for the new accord.

The Basel committee has now given itself enough time to craft a better Capital Accord. It is in everyone's interest that it do so.

Basel I

Regulators from the G-10 countries [3] developed the 1988 Basel Capital Accord after several notable bank failures in Europe, Japan, and the United States. Before the accord, many banks were woefully undercapitalized, and capital levels varied significantly among countries. In response, the G-10 formed the Basel Committee on Banking Supervision, which operates under the auspices of the Bank for International Settlements, and in 1988 introduced uniform minimum-capital requirements for all internationally active banks. The 1988 accord requires banks to hold capital equal to 8 percent of their risk-weighted assets, and half of it ("Tier 1" capital) must be common equity or disclosed reserves. Although the Basel committee has no supranational authority, more than 100 countries (including the United States, Japan, and most European countries) have adopted the standards set forth in the 1988 accord.

The main shortcoming of Basel I is that its risk-weighting of bank assets is very crude: a loan to a top-rated corporation such as GE, for instance, carries the same 100 percent risk weight (requiring banks to hold 8 cents of capital for each dollar lent) as a loan to a risky start-up or the purchase of high-yield bonds. Loans to governments in the Organisation for Economic Co-operation and Development (OECD) have risk weights of zero--even loans to sovereign states, such as Turkey, whose bonds are rated at less than investment grade.

Since 1988, advances in the banks' own risk-management systems have underscored the large discrepancy between the capital required by the Basel accord (regulatory capital) and the capital prudent bank managers would choose to hold (economic capital). Exploiting this discrepancy, banks have engaged in "regulatory arbitrage" to boost their bottom lines by shifting origination toward low-grade loans (which have higher yields and require no more regulatory capital than higher-rated loans), by trading secondary loans (selling high-grade loans to nonbanks and then purchasing riskier loans), and by securitizing assets and retaining the riskiest securities, which are the first to absorb any losses. …

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