Source: www.breakingviews.com is Europe’s leading financial commentary service
Date: June 2003
By Jonathan Ford
When the world’s richest countries decided 15 years ago to coordinate national banking regulation in response to the upsurge in cross-border lending, their purpose was two-fold. They wanted to prevent a blow-up occurring in a big international bank that could hurt all of them. They also wanted to create a level playing field between banks with tough regulation and those in more easy-going jurisdictions.
The resulting treaty – the Basle accord of 1988 – has been successful in creating a level playing field. Most national regulators have since adopted it. But it has been less effective at regulating the credit risk taken on by banks.
Its planned successor – known as Basle II – risks going the other way. The US has just announced that it will only require a handful of banks to adhere to it when it is introduced in four years’ time.
A replacement for Basle is needed. The continued globalization of banking means the requirement for cross-border regulation has grown since 1988.
The accord’s shortcomings are well known. Because it dumps credit risks into big crude “buckets”, banks can end up setting more capital aside for a safe loan than for a risky one. To give one example, under Basle, countries enjoy lower risk weighting than companies. But few would say that Turkey is a safer credit than Procter & Gamble.
The crudity of Basle matters because it leaves the door wide open for regulatory arbitrage. It also encourages banks to take on riskier business. As they aren’t forced to take an economic charge against it, they benefit by getting a higher return on capital. This in turn drives up the share price to which the remuneration of most managers is linked. The fate of UK mortgage bank Abbey National is a grim warning of what happens when banks take on risks that they inadequately understand.
Basle II is a step forward in that it attempts to require banks to take more of a real economic charge against the risks they take.
Under the new treaty, banks will be required to create their own risk models, agree them with the regulator, and set aside capital accordingly. In theory, this creates a more intellectually satisfactory mechanism. Equal risks should bear equal capital charges. This should reduce arbitrage, and loan pricing should become more transparent, because it will be easier to compare loans with different risk characteristics.
But there are big practical snags. Basle II requires banks to capture and sift vast amounts of data about default risk. Few banks are adequately set up for this and the cost of equipping themselves is high.
The new accord is also difficult for regulators to operate. It makes them reliant on banks for qualitative information about their loan books. It may be hard for them to determine whether banks are telling the truth. And the enhanced collaboration that is required between supervisors and those supervised may lead to regulatory capture.
Things would be easier if there was an objective standard for regulators to cling to. To be fair, Basle II does try to impose market discipline on banks by requiring them to disclose more about the risks they are running to investors. But this will be hard to police, and may be unenlightening even if enforced. It is difficult to deduce a bank’s cost of capital if it has only equity securities or small tranches of bonds outstanding. And the overall presumption – that the market will have sufficient transparency to provide an accurate pricing signal – is unproven.
These technical deficiencies may not be sufficient to kill Basle II. But they may deter countries from signing up. The US has already taken an à la carte approach, saying it will oblige only its 10 largest banks to adhere to the accord. The rest will stick to the old rules. Other countries may follow suit, or even opt out entirely. After all the accord is a political hot potato as it may raise the cost of risky small-business lending, a sensitive subject in such countries as Germany.
Basle II isn’t a bad thing. Even if the regulatory mechanism doesn’t work that well, just implementing it should make banks sharper about risk management. That said, the cost and difficulty of implementation may ensure that only a subset of banks actually adopt it in full. Greater transparency will have been achieved among a few large banks, but only by sacrificing the objective of a level playing field.
breakingviews is Europe’s premier English-language online subscription commentary service, supplying the top investment banks, hedge funds, asset managers and corporations with timely insight into markets, economics, companies and business.
In addition to its online service, breakingviews supplies its market-moving commentary to a handful of prestigious daily newspapers. These print partners include the Wall Street Journal Europe, Gaceta de los Negocios, la Repubblica, NRC Handelsblad, l’Agefi, Kauppalehti and others.
