Although the proposed new accord is an important improvement on Basel I, it fails to create a supervisory regime that embodies a credible and strong market discipline, says Harald Benink.

John Hawke: “We have really no sound basis whatsoever for assessing capital impact”

On May 11, 2004 the Basel Committee on Banking Supervision achieved consensus on the remaining issues regarding the proposals for a new capital adequacy framework for banks to respond to deficiencies in the 1988 Capital Accord on credit risk. The proposed framework –the New Basel Capital Accord, or Basel II – contains a number of new aspects to regulation and supervision of banks, structured around three pillars.

The first pillar deals with the minimum regulatory capital requirement and contains new rules for calculating more refined risk weights for different kinds of loans. Moreover, it suggests that capital should be held against so-called operational risk.

The second pillar is the supervisory review process, which requires supervisors to ensure that each bank has sound internal processes in place to assess the adequacy of its capital based on a thorough evaluation of its risks.

The third pillar aims to bolster market discipline through enhanced disclosure by banks. Although the new framework’s focus is primarily on internationally active banks, its underlying principles are intended to be suitable for application to banks of varying levels of complexity and sophistication.

Based on the consensus reached on May 11, the Basel Committee was expected to publish the final Basel II Accord by the end of June 2004. The committee aims to implement Basel II for the standardised approach (using external ratings for calculating risk weights) and the foundation approach (using banks’ internal ratings for calculating probabilities of default and related risk weights) by the end of 2006. For the advanced approach – using banks’ internal ratings for calculating both probabilities of default and loss given default and related risk weights – the envisaged date of implementation is by the end of 2007.

Risk evaluation

Under an internal ratings standard, the proposed accord encourages the development of sound internal systems for risk evaluation since only banks complying with strict methodological and disclosure standards will be allowed to use these ratings as a basis for determining the regulatory capital requirement. Notwithstanding this positive incentive, it could be argued that at the same time it provides potentially perverse incentives for banks to develop new ways to evade the intended consequences of the proposed regulation.

As argued in a recent paper by Clas Wihlborg from Copenhagen Business School and myself, additional opportunities for risk arbitrage are created by the scope for “gaming and manipulation” of ratings. Banks generally have access to private credit risk-relevant information that can be excluded from the system for risk weighting presented to the supervisory authority. Banks might have incentives to design internal ratings systems that systematically underestimate credit risk and, hence, lower the regulatory capital requirement.

A deliberate underestimation occurs when banks decide to manipulate the internal ratings systems. A non-deliberate underestimation of credit risk occurs when banks do not develop sufficient awareness and expertise in risk evaluation, because explicit and implicit insurance schemes reduce incentives to compete by developing such expertise.

Burden of control

Under the proposed Basel II, most of the burden of controlling banks’ internal risk assessment is placed on expanded and active supervision (Pillar 2). Supervisory authorities are expected to build up their expertise substantially in both quantitative and qualitative terms. In fact, supervisors are expected to work closely with the banks when they develop and upgrade their internal risk-scoring models.

This envisioned close co-operation between banks and supervisors is intended to reduce the information (and knowledge) asymmetry between banks and supervisors. Unfortunately, there are great difficulties already for the banks to translate their own ratings into probabilities of default. This is due to the lack of data over a longer time horizon capturing the credit risk related to the full economic cycle of 10-15 years and due to the large variety of internal ratings systems.

For the same reasons, it is difficult for the supervisors to check the truthfulness of these estimates. An even more complex and substantial challenge facing banks and supervisors is to map an internal ratings method into risk weightings that are consistent across banks. In the final analysis, the intensified involvement of supervisors is unlikely to mitigate sufficiently the scope for gaming and manipulation, and could instead lead to greater “regulatory capture” in the sense that supervisors identify themselves more strongly with the banks they supervise.

This increased regulatory capture is likely to lead to greater moral hazard and stronger incentives for risk taking in the banking system. This is because it will become even more difficult for supervisors not to bail out a large problem bank due to the fact that the supervisors themselves have validated and approved of the internal ratings systems of the bank facing financial distress.

More discipline

The implication of the discussion so far is that the need for market discipline (Pillar 3) as an instrument to induce banks to hold sufficient capital is stronger under the proposed new accord. Market discipline can mitigate the potential underestimation of credit risk and limit the degree of regulatory capture, but the Basel Committee proposal does not provide a strong mechanism for such discipline. Effective market discipline requires not only that information is available to some observers, but also that the observers value the information and are able to impose a cost on the bank that releases negative information (or abstains from releasing positive information).

As long as depositors and other creditors of banks are insured, or implicitly expect to be bailed out, information about potential credit losses is not going to be a major concern to creditors. Another aspect is that the disclosed information is going to be more relevant and effective if the choice of disclosed information is based on demand for information in the market place. Information disclosure and transparency will generate strong market discipline only if there is a group of professional investors having maximum incentives to use this information. As has been proposed many times by the Shadow Financial Regulatory Committees of Europe, Japan, Latin America and the US, credibly uninsured subordinated debt-holders could play such a role.

Subordinated debt

Under these proposals, large banks would be required to have a certain amount of subordinated debt as part of the regulatory capital requirement, where the minimum percentage of subordinated debt to be issued is set in line with current levels of subordinated debt. Most large banks already issue substantial amounts of subordinated debt. The requirement would have to be supplemented by an international agreement that subordinated debt is credibly uninsured. Even in the case of a bail-out of other stakeholders, the holders of this debt must not be compensated for losses in order to maximise their incentives for risk monitoring.

Another key element would be a close monitoring of the risk premium on subordinated debt of each individual bank in order to establish whether the market’s perception of increased riskiness is consistent with a bank’s internal ratings system. This information should be integrated in the supervisory review process, possibly leading to a higher regulatory capital requirement. Since banks know that their supervisor is watching the yield spread on subordinated debt and might act on it, this will mitigate their incentives to underestimate the credit risk.

As indicated on several occasions by John Hawke, Comptroller of the Currency in the US, the US will conduct a fourth quantitative impact study (QIS-4), based on the “final” Basel II Accord due to be published by the end of June 2004. In Mr Hawke’s opinion, the previous quantitative impact study (QIS-3), which was published in May 2003, had significant shortcomings and was seriously incomplete. During the preparation process of QIS-3, banks were still in the process of designing internal ratings models and collecting historical data on loan losses with respect to particular loan categories. Hence, the banks’ estimates of capital impact of Basel II were rather premature at that moment. Moreover, there was virtually nothing in the way of supervisory validation of the process by which the banks participating in QIS-3 made their estimates of capital impact.

In his speech to the American Academy in Berlin in December 2003, Mr Hawke concluded: “I do not believe that any responsible bank supervisor can or should make a judgment about the impact of Basel II on the capital level of the banks it supervises based on QIS-3. And that means that at the present we have really no sound basis whatsoever for assessing capital impact. I would hope that the [Basel] Committee itself would see the wisdom of conducting its own QIS-4, but whether it does or not, we intend to do so.”

Uneven playing field

The issue is important because of the fact that the US decided to limit the application of Basel II to a group of about 20 large banks in February 2003. These banks will have to use the advanced internal ratings models. All other banks in the US will have to stay under the old regime of Basel I. Naturally, this is likely to create an unlevel playing field between Basel II and Basel I banks, especially in the markets for residential mortgages and loans to low-risk companies, since the use of advanced internal ratings will lead to a substantially lower regulatory capital requirement for Basel II banks in these loan market segments.

Quite a few US banks that have to stay under the Basel I regime have already started lobbying against this competitive inequity. In his Berlin speech, Mr Hawke notes: “QIS-4, which will follow the [Basel] Committee’s definitive paper, will be an especially important event for us, since it would give us a far clearer picture of how Basel II is going to impact on the capital of our banks. Should QIS-4 lead us to project that there might be wide or unwarranted swings in the capital of our banks, either up or down, that will present us with a very significant decision point, and we would feel compelled to bring that concern back to the committee.”

In its May 11 consensus document, the Basel Committee confirms the need to review the calibration of the new framework further, prior to its implementation. However, it seems unlikely that the committee would be willing to mitigate substantially the reduction in regulatory capital requirement with respect to certain loan market segments for banks using advanced internal ratings to address unlevel playing field concerns inside the US. In that case, the US might want to adjust unilaterally both Basel II, limiting the scope for lower regulatory capital of banks operating under this regime, and Basel I, reducing regulatory capital for all other banks in the US.

Important improvement

Basel II is an important improvement and refinement of the measurement of credit risk and the setting of regulatory capital requirements compared with the rather crude settings of Basel I. Moreover, it creates powerful incentives for banks to invest in sophisticated risk management systems because only these sophisticated banks will be allowed to use their internal ratings systems for calculating the regulatory capital requirement. Due to the QIS-4 exercise in the US, it is still unclear to what extent US banks (and possibly those elsewhere) will be allowed to grasp fully the benefits of a substantially lower regulatory capital requirement based on their advanced internal ratings estimates.

The weak facet of Basel II is that it fails to create a supervisory regime embodying a credible and strong form of market discipline, which could mitigate the incentives of some banks to underestimate the credit risk profile when designing internal ratings systems and which could limit the extent of regulatory capture. Banks will have to wait for Basel III to incorporate a more substantial form of market discipline as a complement to the Basel II focus on pillars 1 and 2.

Harald Benink is professor of finance at the Rotterdam School of Management, Erasmus University, Rotterdam, and chairman of the European Shadow Financial Regulatory Committee

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter