With prompt corrective action procedures in place, banks would be made to recapitalise themselves at a far earlier stage.

The turmoil in world financial markets, triggered by defaults on subprime mortgages in the US, raises questions about macroeconomic policy, financial stability and the design of financial regulation, including the new Basel II capital adequacy framework for banks.

The implementation of Basel II coincides with massive losses reported by some of the world’s largest banks, requiring large-scale recapitalisations. The risk models that anchor Basel II are, to a large extent, the same as the ones many of these banks have been using in recent years. Sheila Bair, chairman of the Federal Deposit Insurance Corporation in the US, has noted that these models have important weaknesses which, in the light of recent market turmoil, are a flashing yellow light to drive carefully.

Basel II aims to address weakness in the Basel I ­capital adequacy framework for banks by incorporating more detailed calibration of credit risk and by requiring the pricing of other forms of risk. Under the Basel II framework, regulators allow large banks with soph­isticated risk management systems to use risk assessment based on their own models in determining the minimum amount of capital they are required to hold by the regulators as a buffer against unexpected losses.

However, recent events challenge the usefulness of important elements in the Basel II accord. The need to recapitalise banks reveals that the internal risk models of many banks performed poorly, and greatly underestimated risk exposure, forcing banks to reassess and reprice credit risk.

The new CEO of Fortis, Herman Verwilst, gave an interview to a group of Dutch financial journalists in July in which he made some interesting remarks on Basel II. Mr Verwilst said that: “Under Basel II one thought: if we measure risks adequately, then we as banks can operate with less capital. That image has changed completely. Perhaps one should hold even more capital.”

Mr Verwilst’s remarks coincided with the publication by the Basel Committee on Banking Supervision of its proposed revisions to the Basel II market risk framework, containing stricter guidelines for computing capital for incremental risk in the trading book.

Bank capital-asset ratios are near historically low levels, typically at about 7% of total assets (on a non-risk-weighted basis). During the past five years, several so-called ‘quantitative impact studies’ (QISs) have been conducted under the auspices of the Basel Committee to explore the consequences of shifting from Basel I to Basel II for large banks. These studies show that bank capital requirements will fall further for many banks when the Basel II rules are fully implemented. In the US, the QIS results indicate potential reductions in required capital of more than 50% for some of the largest banks.

The financial crisis of the past year, forcing some of the world’s leading banks to recognise mega losses on their portfolios of subprime mortgage loans and to engage in massive recapitalisation plans, clearly demonstrates that bank capital levels have been too low. In this respect, it is encouraging to note that bankers such as Mr Verwilst, as well as the Basel Committee, now seem to acknowledge that Basel II should not be implemented in an unmodified form.

Moral hazard

However, the proposed changes to Basel II do not address sufficiently the fundamental problem of moral hazard which is all too present in banking. As is now well known from the public policy debate on banking regulation, the existence of explicit deposit insurance systems, as well as implicit guarantees associated with the perception that (large) banks will almost always be bailed out by the government, is creating moral hazard by providing banks with incentives for increased risk taking and a reduction of bank capital ratios.

Although banks are now operating on historically low capital ratios, financial markets accept such low capital levels because of the expectation of government assistance in case of financial problems (such as with Fannie Mae and Freddie Mac). The value of this expected government assistance was recently called “shadow equity” by JPMorgan Chase. Hence, total capital of a particular bank consists of the amount of capital reported on the bank’s balance sheet plus the value of the shadow equity. However, this shadow equity comes at a cost as it is a subsidy to the bank which is ultimately borne by the taxpayers.

In order to address the moral hazard problem, and to reduce the value of banks’ shadow equity, it is essential to reduce the need for government bailouts, both for small and large banks.

As the recent crisis demonstrates, even small (but politically sensitive) banks such as IKB and Northern Rock are likely to be rescued by the national authorities. This is unfortunate since these bailouts exacerbate moral hazard, thereby increasing incentives for risk taking and reduced capital in the future. The problem is that most governments fear that the failure of even a small bank could lead to a general loss of confidence in the banking system as a whole and to damaging bank runs which could force even solvent banks into liquidity crises.

In order to reduce the risk of bank runs and to enable an orderly liquidation of (small) banks, deposit insurance systems should be reformed in such a way that immediate payout of insured deposits is made possible. It is interesting to note that the legal and regulatory regime in most countries does not allow for this, as was notably illustrated by the Northern Rock case in the UK.

Premptive action

The failure of a large bank would, of course, pose much greater threats in terms of contagion and systemic risk. In order to make such a failure highly unlikely, so-called ‘prompt corrective action’ (PCA) procedures, similar to those adopted within the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in the US in 1991, could play an important role by requiring bank supervisors to take pre-specified actions when bank capital starts to decline below certain PCA threshold levels.

For example, if banks had been forced to disclose their risks and recognise losses at an earlier stage during the current crisis, supervisors would have been forced, under a PCA regime, to require banks to recapitalise themselves much more promptly. In this scenario, a reduction in bank capital ratios would have been quickly revealed. And as ratios fell below particular PCA threshold levels, a supervisory response would have been triggered.

As the Financial Stability Forum (FSF) notes in its report of last April: “During the early stages of the market turmoil, public disclosures by financial institutions did not always make clear the risks associated with their on- and off-balance sheet exposures… A lack of adequate and consistent disclosure of risk exposures and valuations continues to have a corrosive effect on confidence.”

A PCA regime, combined with the FSF’s recommendations for improved disclosure and more rigorous valuation, could resolve further crises more quickly, as pressure on banks is brought to bear both by financial markets and supervisors.HARALD BENINK FINANCE PROFESSOR

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