This paper will present an issue study by picking a current concern of The Bank for International Settlements and subjecting it to detailed examination. Capital standards of institutions in the global financial market are the concern of the Basel Committee on Banking Supervision, one of the most important of the Banks committees. After a brief history of BCBS and its role in developing capital standards a critical analysis is made of the new Basel II Capital Accord and the role of BCBS.
The history of the BCBS since its inception in 1974 is one of steady growth in power and reach. It is composed of central bank and regulatory agency representatives from the Group of 10. (BIS, 2004) One important objective of the committee’s work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be accurate. (BCBS, 2004) In 1988 the committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. (BIS, 2004) This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by the end of 1992. (BIS, 2004) This was replaced in 1999 by an expansion of the original Accord to include: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord; supervisory review of an institutions internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. (BCBS, 2004) These three pillars, Basel II, are to be introduced from the end of 2006. (BCBS, 2004). In the last few years the committee has moved more aggresively to promote supervisory standards worldwide by developing a set of ‘Core Principles for Effective Banking Supervision’ and ‘Core Principles Methodolgy’. (BCBS, 2004 It claims these detailed standards have been implemented by its members and other banking supervisory authorities including many non G10 countires. (BCBS, 2004)
But there are many criticisms levelled at the new Accord from these same non-G10 countries particularly relating to issues of sovereignty and economic philosophy. (Belmont, 2004 p22) Questions asked about both the theory and practice of the role BCBS proposes for itself and Basel II start with who elected them and why should they have power to dictate how national banking systems are regulated. (Belmont, 2004 p22) According to BCBS the adoption of the Accord is voluntary. (BCBS, 1999). But the major donor countries to the IMF and the World Bank are OECD, including the G10. Countries that do not implement the Accord will likely have a harder time getting support for loans unless they progress towards international regulatory benchmarks. (Belmont, 2004 p23) In practice Basel II relies on supervisory oversight and the market discipline imposed by an efficient market. (BCBS, 2004). In developing countries markets and supervisors fail more often. (Belmont, 2004 p24) Developing countries are more prone to greater macroeconomic volatility, greater volatility of external money flows and greater vulnerability to external shocks. (Belmont, 2004 p24) Basel II relies on strong governments and regulatory institutions but these tend to be weak in developing countries. (Belmont, 2004 p24) Bankers and bureaucrats have a greater ability to reap private benefits in these situations. (Belmont, 2004 p24) Skills are weaker for regulators and market players. (Belmont, 2004 p24) Why would developing countries want or need to allow foreign banks to compete on an equal footing in their home economies? (Belmont, 2004 p25) It could be argued, by promoting a level playing field Basel II provides a way for the developed world to get access to new markets for their banks. (Belmont, 2004 p25) Criticisms of the theory and practice of the Accord and BCBS are not restricted to the developing countries either.
In developed countries proponents of free markets ask why one of the goals is a level playing field. (Belmont, 2004 p14) Would competition between regulatory systems ensure market forces create the discipline and innovation necessary to attract banks whilst protecting taxpayers from financial losses? (Belmont, 2004 p14) It could be argued transparency and disclosure are not enough. (Belmont, 2004 p15) Unless investors have money at risk true market discipline is not enforced. (Belmont, 2004 p15) If BCBS is going to manage all the risk it may be the risk premium in the price of bank shares will fall. (Belmont, 2004 p15) Why should these investors enjoy preferential treatment?
There are practical problems as well. The calculation of capital adequacy is based on external and internal ratings, neither of which are proven to be accurate. (Belmont, 2004 p12. Jackson, 2001) External credit rating agencies give inconsistent and conflicting views of creditworthiness and are themselves unregulated. (Belmont, 2004 p12) These agencies can be pressured by debt issuers to get lower cost of funds and debt purchasers to get lower necessary regulated capital allocations thus overestimating creditworthiness. (Belmont, 2004 p12) If bank regulators approve the internal risk management processes of these banks moral hazard could arise because the responsibility passes to the regulator. (Belmont, 2004 p11) There is also no longer an arms length relationship between banks and regulators if the regulator relies on the bank to explain their internal risk management processes. (Belmont, 2004 p13) If the risk is systemically underestimated, Value at Risk type measures become unreliable. (Belmont, 2004 p12) Furthermore operational risk measurement is not possible with current information. (Belmont, 2004 p12) The risk models first accepted by the regulators will encourage herding as banks rush to migrate to these models. (Belmont, 2004 p13) There are no mandatory liquidity requirements. (Belmont, 2004 p13) No direct encouragement of diversification as correlation is only taken into account in a limited way. (Belmont, 2004 p13) Lower capital requirements for household lending may enhance real estate booms and cause household indebtedness to rise, threatening stability. (Belmont, 2004 p13) Basel II does not stipulate how regulators would intervene to maintain adequate capital. (Belmont, 2004 p15). Many of these potential practical problems may not eventuate and it may be others will materialize after the Accord is introduced.
There are also broader criticisms of the Accord. In particular it is too complex, detailed and prescriptive stifling innovation in risk measurement and management. (Belmont, 2004 p9). BIS, BCBS and the process of the formulating of the Accord are too centralized. (Belmont, 2004 p9). The Accord will be costly to implement. (Belmont, 2004 p9). Are national regulators trained to implement the Accord? (Belmont, 2004 p9) The Accord is more complex than Basel I and banks and domestic regulators will have more discretion which may result in an uneven playing field and increase the regulatory forebearance. (Belmont, 2004 p10). These criticisms are more theoretical and are likely to be leveled at any supranational regulatory agency.
There will always be disagreement between those who believe free markets are the most efficient allocators of resources and those who recognise the need for regulation of markets, particularly international financial markets. The increase in volatility in financial markets in the last decade has alarmed many past and present market participants, national governments and researchers. Soros, Stiglitz and Minsky spring to mind. Combined with the potential for contagion from the interconnectedness of the over the counter and exchange traded markets in derivatives and the activiites of unregulated players such as hedge funds suggests a potentail problem of un-heralded proportions. If we could asign a probability to all risk it may be possible to invent the perfect hedge against such a disaster. In the meantime it seems reasonable to support an international agency representing the best ideas on how to mitigate the risks we can identify from previous experience. Certainly BIS and BCBS needs to do more to increase transparancy and utilize techniques increasingly used by Central banks of the OECD, including using presentations to government committees, commisioning and publishing research on their websites and generally raising the profile of the work they are doing. Some thought needs to be applied to how to give real teeth to the international regulator if regulators in national jurisdictions should fall prey to short run political considerations. There are still too many central banks and regulators who are under the complete control of national governments in this writers opinion.
In this paper I have examined what is now a key issue for the Bank for International Settlements through its BCBS – capital standards. A number of criticisms have been levelled at the Basel II Accord to demonstrate the difficulties in bridging the gap between the theory and practise of what they are trying to achieve. Finally some consideration is given to potential improvements
References
Bank for International Settlements (2004) http://www.bis.org/index.htm Website accessed 14 April 2004
Basel Committee on Banking Supervision (2004) Home page. Website accessed
21/03/2004 http://www.bis.org/bcbs/aboutbcbs.htm/
BCBS (1988) ‘International Convergence of Capital Measurement and Capital Standards’. in BCBS, Compendium of documents produced by the Basel Committee of Banking Supervision, Vol. 1. Basel.
BCBS (1999) ‘A New Capital Adequacy Framework’ Basel.
Derivative Strategy.com (2004) BIS Capital Adequacy, version 2001
Website accessed May 25 2004 http://www.
derivativesstrategy.com/magazine/archive/2001/030
The history of the BCBS since its inception in 1974 is one of steady growth in power and reach. It is composed of central bank and regulatory agency representatives from the Group of 10. (BIS, 2004) One important objective of the committee’s work has been to close gaps in international supervisory coverage in pursuit of two basic principles: that no foreign banking establishment should escape supervision; and that supervision should be accurate. (BCBS, 2004) In 1988 the committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accord. (BIS, 2004) This system provided for the implementation of a credit risk measurement framework with a minimum capital standard of 8% by the end of 1992. (BIS, 2004) This was replaced in 1999 by an expansion of the original Accord to include: minimum capital requirements, which seek to refine the standardised rules set forth in the 1988 Accord; supervisory review of an institutions internal assessment process and capital adequacy; and effective use of disclosure to strengthen market discipline as a complement to supervisory efforts. (BCBS, 2004) These three pillars, Basel II, are to be introduced from the end of 2006. (BCBS, 2004). In the last few years the committee has moved more aggresively to promote supervisory standards worldwide by developing a set of ‘Core Principles for Effective Banking Supervision’ and ‘Core Principles Methodolgy’. (BCBS, 2004 It claims these detailed standards have been implemented by its members and other banking supervisory authorities including many non G10 countires. (BCBS, 2004)
But there are many criticisms levelled at the new Accord from these same non-G10 countries particularly relating to issues of sovereignty and economic philosophy. (Belmont, 2004 p22) Questions asked about both the theory and practice of the role BCBS proposes for itself and Basel II start with who elected them and why should they have power to dictate how national banking systems are regulated. (Belmont, 2004 p22) According to BCBS the adoption of the Accord is voluntary. (BCBS, 1999). But the major donor countries to the IMF and the World Bank are OECD, including the G10. Countries that do not implement the Accord will likely have a harder time getting support for loans unless they progress towards international regulatory benchmarks. (Belmont, 2004 p23) In practice Basel II relies on supervisory oversight and the market discipline imposed by an efficient market. (BCBS, 2004). In developing countries markets and supervisors fail more often. (Belmont, 2004 p24) Developing countries are more prone to greater macroeconomic volatility, greater volatility of external money flows and greater vulnerability to external shocks. (Belmont, 2004 p24) Basel II relies on strong governments and regulatory institutions but these tend to be weak in developing countries. (Belmont, 2004 p24) Bankers and bureaucrats have a greater ability to reap private benefits in these situations. (Belmont, 2004 p24) Skills are weaker for regulators and market players. (Belmont, 2004 p24) Why would developing countries want or need to allow foreign banks to compete on an equal footing in their home economies? (Belmont, 2004 p25) It could be argued, by promoting a level playing field Basel II provides a way for the developed world to get access to new markets for their banks. (Belmont, 2004 p25) Criticisms of the theory and practice of the Accord and BCBS are not restricted to the developing countries either.
In developed countries proponents of free markets ask why one of the goals is a level playing field. (Belmont, 2004 p14) Would competition between regulatory systems ensure market forces create the discipline and innovation necessary to attract banks whilst protecting taxpayers from financial losses? (Belmont, 2004 p14) It could be argued transparency and disclosure are not enough. (Belmont, 2004 p15) Unless investors have money at risk true market discipline is not enforced. (Belmont, 2004 p15) If BCBS is going to manage all the risk it may be the risk premium in the price of bank shares will fall. (Belmont, 2004 p15) Why should these investors enjoy preferential treatment?
There are practical problems as well. The calculation of capital adequacy is based on external and internal ratings, neither of which are proven to be accurate. (Belmont, 2004 p12. Jackson, 2001) External credit rating agencies give inconsistent and conflicting views of creditworthiness and are themselves unregulated. (Belmont, 2004 p12) These agencies can be pressured by debt issuers to get lower cost of funds and debt purchasers to get lower necessary regulated capital allocations thus overestimating creditworthiness. (Belmont, 2004 p12) If bank regulators approve the internal risk management processes of these banks moral hazard could arise because the responsibility passes to the regulator. (Belmont, 2004 p11) There is also no longer an arms length relationship between banks and regulators if the regulator relies on the bank to explain their internal risk management processes. (Belmont, 2004 p13) If the risk is systemically underestimated, Value at Risk type measures become unreliable. (Belmont, 2004 p12) Furthermore operational risk measurement is not possible with current information. (Belmont, 2004 p12) The risk models first accepted by the regulators will encourage herding as banks rush to migrate to these models. (Belmont, 2004 p13) There are no mandatory liquidity requirements. (Belmont, 2004 p13) No direct encouragement of diversification as correlation is only taken into account in a limited way. (Belmont, 2004 p13) Lower capital requirements for household lending may enhance real estate booms and cause household indebtedness to rise, threatening stability. (Belmont, 2004 p13) Basel II does not stipulate how regulators would intervene to maintain adequate capital. (Belmont, 2004 p15). Many of these potential practical problems may not eventuate and it may be others will materialize after the Accord is introduced.
There are also broader criticisms of the Accord. In particular it is too complex, detailed and prescriptive stifling innovation in risk measurement and management. (Belmont, 2004 p9). BIS, BCBS and the process of the formulating of the Accord are too centralized. (Belmont, 2004 p9). The Accord will be costly to implement. (Belmont, 2004 p9). Are national regulators trained to implement the Accord? (Belmont, 2004 p9) The Accord is more complex than Basel I and banks and domestic regulators will have more discretion which may result in an uneven playing field and increase the regulatory forebearance. (Belmont, 2004 p10). These criticisms are more theoretical and are likely to be leveled at any supranational regulatory agency.
There will always be disagreement between those who believe free markets are the most efficient allocators of resources and those who recognise the need for regulation of markets, particularly international financial markets. The increase in volatility in financial markets in the last decade has alarmed many past and present market participants, national governments and researchers. Soros, Stiglitz and Minsky spring to mind. Combined with the potential for contagion from the interconnectedness of the over the counter and exchange traded markets in derivatives and the activiites of unregulated players such as hedge funds suggests a potentail problem of un-heralded proportions. If we could asign a probability to all risk it may be possible to invent the perfect hedge against such a disaster. In the meantime it seems reasonable to support an international agency representing the best ideas on how to mitigate the risks we can identify from previous experience. Certainly BIS and BCBS needs to do more to increase transparancy and utilize techniques increasingly used by Central banks of the OECD, including using presentations to government committees, commisioning and publishing research on their websites and generally raising the profile of the work they are doing. Some thought needs to be applied to how to give real teeth to the international regulator if regulators in national jurisdictions should fall prey to short run political considerations. There are still too many central banks and regulators who are under the complete control of national governments in this writers opinion.
In this paper I have examined what is now a key issue for the Bank for International Settlements through its BCBS – capital standards. A number of criticisms have been levelled at the Basel II Accord to demonstrate the difficulties in bridging the gap between the theory and practise of what they are trying to achieve. Finally some consideration is given to potential improvements
References
Bank for International Settlements (2004) http://www.bis.org/index.htm Website accessed 14 April 2004
Basel Committee on Banking Supervision (2004) Home page. Website accessed
21/03/2004 http://www.bis.org/bcbs/aboutbcbs.htm/
BCBS (1988) ‘International Convergence of Capital Measurement and Capital Standards’. in BCBS, Compendium of documents produced by the Basel Committee of Banking Supervision, Vol. 1. Basel.
BCBS (1999) ‘A New Capital Adequacy Framework’ Basel.
Derivative Strategy.com (2004) BIS Capital Adequacy, version 2001
Website accessed May 25 2004 http://www.
derivativesstrategy.com/magazine/archive/2001/030
1regw.asp
Belmont, D (2004) Basel II’s Dissenting voices: Alternative voices in the global marketplace Presentation to the Asian Banking Summit May 7, 2004 Website accessed 2 June 2004 www.theasianbanker.com/.../FE0B405072B5A57548256E910012
5E31/ $File/
RiskMgt_BaselII-DavidBelmont.pdf
Fratianni, M & Pattison J (2001) ‘The Bank for International Settlements: An assessment of its Role in International Monetary and financial Policy Co-ordination’. Open Economies Review. 12: 197-222 Kluwer Academic Publishers. Netherlands.
Jackson, H.E. (2001) The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy
http://www.law
.harvard.edu/faculty/hjackson/pdfs/2001.Jackson.
Belmont, D (2004) Basel II’s Dissenting voices: Alternative voices in the global marketplace Presentation to the Asian Banking Summit May 7, 2004 Website accessed 2 June 2004 www.theasianbanker.com/.../FE0B405072B5A57548256E910012
5E31/ $File/
RiskMgt_BaselII-DavidBelmont.pdf
Fratianni, M & Pattison J (2001) ‘The Bank for International Settlements: An assessment of its Role in International Monetary and financial Policy Co-ordination’. Open Economies Review. 12: 197-222 Kluwer Academic Publishers. Netherlands.
Jackson, H.E. (2001) The Role of Credit Rating Agencies in the Establishment of Capital Standards for Financial Institutions in a Global Economy
http://www.law
.harvard.edu/faculty/hjackson/pdfs/2001.Jackson.
Credit.Rating.Agencies.pdf.
Website accessed 2 June 2004
Website accessed 2 June 2004
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