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Regulation: Basel’s big exam

Proposals from Basel to reform the bank capital adequacy framework have triggered a wide-reaching debate on the nature of bank capital, liquidity and valuation. A hasty conclusion could waste some valuable new thinking.

If the Basel Committee on Banking Supervision's proposals for a new capital adequacy framework were applied raw tomorrow, they would be a disaster. Nearly everyone agrees about that.

But the draft of that framework, unleashed on the banking sector in June last year, has certainly stimulated active thought. Bankers, regulators and credit analysts have wrestled with the conundrum: how do you get a fair assessment of a credit portfolio, in order to apply a capital charge to it, consistent enough to encourage a level playing field?

Credit rating agencies at first expected a bonanza, with a heavy increase in demand for their services. But that was quickly followed by concern that external credit ratings are too blunt an instrument to reflect the day-to-day riskiness of a credit portfolio - and not enough companies, banks and other bank customers are rated, except in the US.

However, the use of banks' internal credit ratings instead is fraught with difficulty too, since that is like asking each bank to set its own standard. It threatens to give supervisors - or auditors hired by supervisors - a huge amount of extra work.

The Basel committee's three pillar concept - 1) a numerical charge for credit and other risks; 2) continuous supervisory review; 3) the use of market discipline to promote transparency - has thrown the debate wide open, even to the level of philosophy or religion.

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