In a recent article, The Economist observed that capital requirements may sound arcane and achingly dull, but are nonetheless hugely important. The magazine is undoubtedly correct on both accounts, although international bank capital regulation is arguably not as tedious nor as esoteric at it seems.
In January 2001, the Basel Committee of Banking Supervision issued its final proposed revisions to the existing capital accord of 1988. The new proposals, which substantially modify a June 1999 draft amendment that had attracted considerable controversy from a variety of quarters, are likely to be accepted without fundamental changes by the end of the year and will be implemented by 2004.
The impact of the new capital regime is still uncertain, but some preliminary conclusions may be drawn. To understand the repercussions it is likely to have, it may be helpful to take a step back to review the reasons for replacing the existing accord and why the standards of bank of capital are so important.
The existing guidelines, that regulators in more than 100 countries have implemented into law, are widely acknowledged to be deficient and obsolete. While the 1988 accord certainly had some positive aspects it had the virtue of simplicity and encouraged a more uniform approach to the calculation of minimum bank capital requirements these very characteristics were also limitations.
While the rules were simple, they lacked refinement, and instead of discouraging imprudent practices, they often perversely encouraged them, while exalting form over substance. In Asia, they arguably contributed to the 1997-98 crisis by stimulating banks, notably in Korea and Japan, to engage in high-risk lending and investing, and also provided incentives for multinational banks to engage in short-term lending to financial institutions in Thailand and other crisis-affected countries.
Defining bank capital
What is bank capital and why is its definition a critical concern? Financial institutions are unlike most ordinary corporations in that their functioning is practically a prerequisite to economic growth. Banks provide finance, backup lines of credit, run payments mechanisms, and act as a transmission belt for central bank monetary policy through their ability to expand the money supply. In addition, because the margins on dealing in money - the ultimate commodity - are so thin, banks typically operate with extremely high levels of gearing or leverage.
To put it another way, their customary debt to equity ratio is in the range of 10:1, and can even be much higher. Even conservative banks have leverage far exceeding that of the ordinary industrial or service corporation. As a result, banks are highly prone to cyclical ups and downs, and in the down cycles are vulnerable to collapse if they are not managed prudently.
The function of bank capital is to provide a cushion against such ups and downs and to ensure that the shareholders of the bank have sufficient funds at risk so that they are less likely to take a casual attitude toward operations that could place depositors' funds (which comprise most of the bank's debt) in jeopardy. It is crucial to be aware, however, that to a bank, capital is not synonymous with shareholders' equity (contributed capital, retained earnings and miscellaneous equity reserves) as it is with most corporations.
Prior to 1988, many bank regulators allowed some rather unusual definitions of capital in order to make their country's banks appear as solid as the edifices in which they were housed. Regulatory capital began to diverge more and more from simple shareholders' equity, the traditional measure of capital strength.
The main thing to understand is that regulatory capital, whether defined by the Basel Committee on Banking Supervision or local bank supervisory authorities, is an entirely artificial construct that bears no necessary relationship to risk capital (sometimes referred to in the credit context as economic capital ), which is embodied in shareholders' equity and which represents the shareholders' claims on the banking corporation.
Refining the concept
Indeed, a major impetus for the 1988 accord was to level the playing field by establishing standard rules for defining regulatory capital. The concept of regulatory capital was not abandoned, however; instead it was enshrined and standardized into the first Basel accord. It legitimized the concept of risk-adjusted capital requirements. The current proposals merely refine the way in which these risk requirements are measured and calculated.
In the original 1988 scheme, the basic formula of capital (originally shareholders' equity) divided by assets was deconstructed, adjusted and an arbitrary ratio of 8% (i.e. 12.5:1) was chosen as the minimum level of capital adequacy.
Capital, the numerator of the ratio, was divided into two components, Tier 1 and Tier 2 capital. Tier 1 capital was roughly synonymous with shareholders' equity, while Tier 2 capital was mainly comprised of subordinated debt. Similarly, instead of nominal total assets in the denominator, under the 1988 accord, assets were risk-weighted.
Certain assets such as loans to corporations (to a bank, the money it lends is an asset which generates revenue) were weighted at 100%, while others, for instance, short-term loans to banks in non-OECD countries, were weighted a mere 20%. These risk weightings were again basically arbitrary, having no empirical correlation to actual risk.
For this reason and because there were only four asset categories, the 1988 accord could be said to have taken a meat-axe approach which did not sufficiently discriminate between different levels of risk. A loan to Microsoft was deemed just as risky as a loan to Joe's Bar, or to the Steady Safe Taxi Company, to use a more regional example.
This created understandable distortions in the decision whether to lend or not, with capital allocation considerations being given undue importance. It is thus easy to understand why banks were often keen to lend to other banks, and for example, why European banks might have had less qualms than otherwise about extending credit to Thai financial institutions. They could do so without allocating too much capital and depressing their capital adequacy ratio.
The June 1999 proposals sought to remedy the defects of the 1988 accord. To accomplish this, the Basel Committee effectively proposed doing away with the old risk weighting categories that treated all corporate borrowers the same and replacing them with a limited number of categories into which borrowers would be assigned based on credit ratings. While some big banks would be permitted to use a more sophisticated internal ratings system that allowed for more refinement in risk weightings, most banks would have been obliged to rely primarily on external ratings provided by independent credit rating agencies such as Moody's and Standard & Poor's.
This proposal was not well-liked by the banks nor, perhaps surprisingly, by the rating agencies, who feared that it would compromise their independence. Peculiarities in the way in which ratings were applied to adjust for risk increased those concerns.
The value of internal ratings
Taking account of the near-universal criticism of primary reliance on an external ratings-based method for adjusting for risk, the Committee re-thought its proposals and disclosed a menu-based approach in January 2001 that seemed to please most parties.
Greater emphasis was placed on internal ratings, which would be available to a broader range of banks in both a standardized and advanced scheme, while the use of external ratings was also allowed. Moreover, the new calculus considers not just credit risk and market risk, but also operational risk.
Lastly, like the 1999 proposal, the latest proposal eschews sole reliance on a capital adequacy benchmark and makes it part of a three pillar framework that explicitly recognizes the importance of supervisory review and market discipline in maintaining sound financial systems. Criticism of the January 2001 proposal consequently has been muted.
The ultimate impact of the new proposals, assuming they are implemented, is not entirely clear. There seems to be a consensus that the proposed regime will redress some of the bias that exists in the present system towards retail and consumer banking, while increasing the profitability of wholesale banking. This is because the present accord, as we can see from the hypothetical example of Microsoft versus Steady Safe Taxi, considers small- and medium- enterprise and retail lending as having the same level of risk as blue chip multinationals. Under the January 2001 revisions, this would no longer be the case.
In a detailed report entitled "Basel 2: Changing the Banking Landscape", that examines the impact of the changes on European financial institutions, Morgan Stanley Dean Witter analyst Peter Toeman sees the most momentous aspect of a new accord as being the impetus it provides to the use of internal rating systems by international banks.
The effect of utilizing internal models, of course, cannot be predicted with certainty, but based on a preliminary assessment of models presently used by two major institutions, Toeman anticipates that capital required for credit card portfolios will rise significantly, capital required for mortgage and capital markets portfolios will fall, while that for general corporate and retail lending will vary with the banking environment and institution.
Looking at Asia, the reverberations of a new accord are even harder to discern. This is first because it is not yet known to what extent the new proposals will be adopted in whole by Asian regulators. (Japan, which is a member of the G10, can be expected to adopt the proposals largely in full.) Moreover, with the exception of sophisticated major players such as HSBC, DBS and several others, the risk management capability of the region's banks is limited.
In The End of Capital as We Know It , a report by Lehman Brothers banking analysts Paul Sheehan, Grant Chan and team, the new rules are seen as putting further pressure on smaller- and medium-sized banks to consolidate, while benefiting those global and regional institutions with robust systems already in place. At the same time, they conclude that the banking system in countries with high levels of sovereign risk, where financial institutions presently have mediocre credit ratings, could be shut out of the international market .
Therefore, although the precise consequences of Basel 2 depends on variables yet unknown, it can nonetheless be argued that the impact on Asia's banking systems is likely to be significant. Over the next several years, regulators and bankers throughout the region will be wrestling with the question of how to bring their own prudential regulations and internal systems in line with the new guidelines, and considering the costs and benefits of complying with a new regulatory regime and in the case of banks, implementing an internal ratings systems that passes international muster.
Rating agencies, both local and global, may very well assume increased importance, and risk management consulting is likely to be a growth business. An understanding of risk management theory and methodology will become even more critical to all market participants, while the end result, it is hoped, will be the evolution of healthier and more resilient financial systems throughout the region.
Jonathan Golin is the author of the Bank Credit Analysis Handbook: A Guide for Analysts, Bankers and Investors, which is to be published by John Wiley & Sons in May 2001. From 1997 until its acquisition in November 2000, Jonathan was associated with Thomson Financial BankWatch, a leading specialist bank rating agency, where as vice president he covered banks in some of the region's most volatile economies. He can be reached at [email protected].