"The
financial world changes all the time and those who supervise and
regulate the financial world have to be prepared to change too. So I
do not have any doubt that soon after Basel II is in place, we will
have to start to think about Basel III.
I
do not like to say this to my colleagues in the Basel Committee
because they say “oh no, I have been up all night for years doing
Basel II”. But there is no doubt that the task will have to be
engaged"
Andrew
Crockett, Former
general manager of the Bank of International Settlements
(BIS)
|
The
Basel iii Accord is near...
Shortcomings
in Basel ii
"Supervisors should, at a minimum, be aware of
the increasing sophistication with which banks are responding
to the existing regulatory
framework"
Alan
Greenspan, October 1998 (Alan Greenspan
was the chairman of the Board of Governors of the US Federal
Reserve System)
Basel II
is much better than Basel I. But, it does not mean that it is
good enough.
There are some very serious
shortcomings
and has so many loose
ends.
Basel II
is more risk sensitive than Basel
I but it is NOT really risk sensitive.
We do have
a new risk, operational risk, but...
-
Reputational risk is not an operational
risk
-
Systemic risk (disruption at a firm or a
market segment causes difficulties to other firms or market
segments) is not an operational risk
-
Strategic risk (the risk of losses or reduced
earnings due to failures in implementing strategy) is not an
operational risk
Basel I:
-
A $100,000 commercial loan with a AAA credit
rating would necessitate $100,000 x 100% x 8% = $8,000
capital charge
-
A $100,000 commercial loan with a B credit
rating would necessitate $100,000 x 100% x 8% = $8,000 – the
same capital charge
Basel
II:
-
A $100,000 commercial loan with a AAA credit
rating would necessitate less capital charge, even $370
(Advanced IRB)
-
A $100,000 commercial loan with a B credit
rating would necessitate more capital charge, even $42,000!
(Advanced IRB)
The logic behind Basel
II:
Capital requirements should
increase for banks that hold risky assets and decrease
significantly for banks that hold safer
portfolios
What is really
happening:
-
Basel II has become an
international competition for consultants: How to help banks
allocate less capital.
-
Basel II creates incentives for banks to move risky
assets to unregulated parts of the holding company.
-
Banks
take advantage of the opportunity to transfer risk to
investors - use securitization.
-
We
have important opportunities for regulatory
arbitrage
It is interesting to follow the thoughts of Alan
Greenspan. This is what he said in
1998
"Despite
the attempt to make capital requirements at least somewhat
risk-based, the main criticisms of the (Basel I) Accord—at
least as applied to the activities of our
largest, most
complex banking organizations—appear to be
warranted.
In
particular, I would note three:
First,
the formal capital ratio requirements, because they do not
flow from any particular insolvency probability standard, are
for the most part arbitrary. All corporate loans, for example,
are placed into a single, 8 percent
bucket
Second,
the requirements account for credit risk and market risk but
not explicitly for operating and other forms of risk that may
also be important
Third,
except for trading account activities, the capital standards
do not take account of hedging,
diversification, and differences in risk management
techniques, especially portfolio
management.
These
deficiencies were understood even as the Accord was being
crafted. "
"The
Basle standard lumps all corporate loans into the 8 percent
capital bucket, but the banks’
internal capital allocations for individual loans vary
considerably—from less than 1 percent to well over 30 percent—
depending on the estimated riskiness of the
position in
question.
In
the case in which a group of loans attracts an internal
capital charge that is very
low
compared with the Basle 8 percent standard, the bank has a
strong incentive to undertake regulatory capital
arbitrage to
structure the risk position in a manner that allows it to be
reclassified into a lower regulatory risk
category
At
present, securitization
is, without a doubt, the major tool used by large U.S. banks
to engage in such arbitrage.
Regulatory
capital arbitrage, I should emphasize, is not necessarily
undesirable. In many cases, regulatory capital arbitrage acts
as a safety valve for attenuating the adverse effects of those
regulatory capital requirements that activity’s underlying
economic risk.
Absent
such arbitrage, a regulatory capital requirement that is
inappropriately high for
the economic risk of a particular activity could cause a bank
to exit that relatively low-risk business by preventing the
bank from earning an acceptable rate of return on its capital.
That
is, arbitrage may appropriately lower the effective capital
requirements against some safe activities that banks would
otherwise be forced to drop by the effects of
regulation.
It
is clear that our major banks have become quite efficient at
engaging in such desirable forms of regulatory capital
arbitrage, through securitization and other
devices.
However,
such
arbitrage is not costless and therefore not without
implications
for resource allocation. Interestingly, one reason that the
formal capital standards do not include very
many risk buckets is that regulators did not want to influence
how banks make resource allocation
decisions.
Ironically,
the “one-size-fits-all” standard does just that, by forcing
the bank into expending effort to negate the capital standard,
or to exploit it, whenever there is a
significant disparity
between the relatively arbitrary standard and internal,
economic capital requirements.
The
inconsistencies between internally required economic capital
and the regulatory capital standard create another type of
problem:
Nominally
high regulatory capital ratios can be used to mask the true
level of insolvency probability. For
example, consider
the case in which the bank’s own risk analysis calls for a 15
percent internal economic capital assessment against its
portfolio.
If
the bank actually holds 12 percent capital, it would, in all
likelihood, be deemed to be well capitalized in a regulatory
sense, even though it might be undercapitalized in
the economic
sense.
The
possibility that regulatory capital ratios may mask true
insolvency probability becomes more acute as banks arbitrage
away inappropriately high capital requirements on their safest
assets by removing these assets from the balance sheet via
securitization.
The
issue is not solely whether capital requirements on the bank’s
residual risk in the securitized assets are appropriate.
We
should also be concerned with the sufficiency of regulatory
capital requirements on the assets remaining on the book.
In
the extreme, such
“cherry picking” would leave on the balance sheet only those
assets for which economic capital allocations are greater than
the 8 percent regulatory standard.
Given
these difficulties with the one-size-fits-all nature of our
current capital regulations, it is understandable that calls
have arisen for reform of the Basle
standard.
It
is, however, premature to try to predict exactly how the next
generation of prudential standards will evolve. One set of
possibilities revolves around market-based tools and
incentives. Indeed, as banks’ internal risk measurement and management technologies improve, and as the depth and
sophistication of financial markets increase,
bank supervisors
should continually find ways to incorporate market advances
into their prudential policies, when appropriate.
"
Question: This is
what Alan Greenspan had said many years before the Basel
ii Accord.
Could Alan Greenspan say the same
things today, after the (third version, 2006) of the Basel
ii paper?
|
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