| Headline: It’s time to scrap the Basel system Source: Euromoney Date: August 2001 Like the unseen rule-master in the British television show Big Brother, the Basel Accord encourages infantile behaviour among its charges. Within the confines of the system, rational, intelligent adults are transformed into pouting, tantrum-throwing, devious children. Banks have spent the time they have been locked away in the unreal world of Basel devising all manner of time-consuming and ultimately pointless games. They have, for example, created hybrid tier one capital securities, a form of capital that obeys the letter of the Basel rules but flouts their spirit. On the asset side of the balance sheet, the subterfuge has been even greater. Banks have transferred hundreds of billions of dollars of their best assets to the capital markets through collateralized loan obligations while hanging on to the most poisonous stuff. They know this is illogical. But the paternalism of Basel creates a culture of rule-bending and discourages good risk management. Outside, in the real world, there are other financial services corporations – the insurance companies – that wouldn’t stand for any of this sort of nonsense. Their true regulators are the rating agencies and the equity markets. A small player such as recent UK bankrupt Independent Insurance may sail too close to the wind and come to grief. But the likes of Allianz or AIG set capital against risk in a prudent and rational manner. If they did otherwise, they would lose their all important triple-A insurer ratings. Regulators know all too well the drawbacks of the 1988 Basel Accord. That is why they have set about rewriting it. But two years’ hard labour has produced a mess. At the moment, Basel II consists of little more than half-written rules and platitudes about the need for sophisticated and proactive supervision. It is not too late to take a completely different tack. The whole concept of regulatory bank capital does little more than give managers and investors a false sense of security. It should be abandoned. Instead of micro-managing, regulators should stand back and let the market decide which banks are well capitalized and well managed and which are not. When the original Basel Accord was penned, this approach would not have worked. Then, banks could rely on captive sources of local funding and their shares were often closely held. But in an increasingly global market for capital, any large bank with lax risk management or inadequate capital will suffer a higher cost of funding and a lower share price than its peers. The Basel Committee believes that markets should play a role in bank supervision. It wants to see banks disclose more information about their positions to the market. Pushing too far on this is again a mistake. Disclosing too much information about market positions would simply invite herd-like behaviour. Economic and market cycles would be exaggerated as institutions copied each other’s investment strategies. Instead, rating agencies, analysts, bond holders and equity investors should ask probing questions about banks’ overall risk policies and their methods of allocating risk capital. And they should start asking ostensibly non-financial corporates the same questions. Companies such as telecoms equipment suppliers have become big players in the credit markets in recent years by extending credit to their customers. Some of the most unsophisticated and vulnerable players in the financial system today are not banks but corporates with large lending businesses. The Basel system is not all bad. It has probably increased the level of capital in the banking system and reduced the risk of systemic crisis. And there is no reason why the rough-and-ready rules of Basel I should not remain a yardstick of good capital adequacy – especially in emerging markets. But let us not kid ourselves that any banking system with 8% capital is necessarily safe. The disadvantages of the Basel approach to global bank regulation now outweigh the positives. Basel acts as a regulators’ cartel. It drags bank supervision down to the lowest common level. Rules have to accommodate the indulgent practices of the slackest regulators. Instead of trying to set international ground rules, regulators should strive to out-think and out-supervise each other. Capital will flow not to the softest banking jurisdictions but to those with wise, consistent regulators who live in constant fear of a disaster taking place in their bailiwick. The timetable for implementing Basel II has now slipped by a year from 2004 to 2005. It will slip again, because the rule writers have set themselves an impossible task. Agreeing rules for allocating capital against operational risk, to take just one example, will take many years. So far, the Basel Committee has barely agreed a definition of operational risk, never mind worked out rules for allocating capital against it. Basel has served a useful purpose in a particular historical era. But now it has outstayed its welcome. It should not be reformed. It should be evicted. |