1. Future Banking Supervision under the New Basel Capital Accord (Basel II)
1.1 The Basel Capital Accord of 1988
1.1.1 Historical Development
The period between the end of Bretton Woods and the mid eighties saw a general reduction of protection and regulatory restrictions. Many banks were not ready for the increasing international competition and reacted by an enlargement of their credit volumes and more aggressive credit pricing. Credit granting also increased outside the OECD countries where especially developing countries profited from new sources for debt rising. However, the debt situation worsened rapidly and reached a high with the 1982 Mexico crisis. During the subsequent crisis of the US savings & loans in the mid eighties the number of banking failures increased rapidly and reached a record level. As a reaction the US Congress created the FDIC Improvement Act (FDICIA), a framework enabling the supervisory bodies to intervene or even close a financial institution at an early stage.[1] This measure should help to guarantee a minimum capital, reduce the number of bank failures and the economic cost of such events. Outside the USA similar measures had to be taken. In 1975 the Bank of England had to prevent over 20 institutions from defaulting.
The general reduction of banks’ equity ratios and the threatened existence of large banks needed corrective measures by the international supervisory bodies. As a consequence the 1988 Basel Capital Accord[2] was issued forming an universal ground for the capital adequacy of credit risk. Since then minimum capital requirements became one of the primary instruments of the bank supervision even if high equity rations cannot prevent banks from failing.[3]
1.1.2 Subject of the 1988 Basel Capital Accord
After the consultative period within the G10 countries the Basel Committee on Banking Supervision published the framework „International Convergence of Capital Measurement and Capital Standards“ that formed the basis for capital requirements. The standard had to be adopted by the central banks of the G10 countries into national law by the end of 1992. Even though there was no legal enforcement the adoption was morally binding.
The Basel Capital Accord of 1988 was thought to guarantee the stability of the international banking system on a harmonized equity basis and to reduce the global systematic risk (same risk, same rules). Despite all critics the Accord marked the beginning of the risk sensitive treatment of risk and differentiated between the major balance and off-balance sheet positions. The risk weighting was and is transaction based depending of the nature of the counterparty:[4]
The Accord states that banks hold at least 8% as capital in terms of their risk-weighted assets. Four risk weights (risk buckets) were defined. The first bucket consists of claims on OECD governments and has a zero weight. The second bucket, consisting of claims on banks incorporated in OECD countries, receives a 20% weight. The third bucket, consisting of asset-backed claims, is weighted 50%, and the fourth bucket, consisting of claims on consumers and corporations, has a 100% weight.[5]
Several amendments were added to the Accord in relation to capital adequacy. Most importantly, in the 1996 Market Risk Amendment[6] minimum capital requirements were defined for market risk of banks' trading positions (accounts that contain assets held for short-term trading purposes).[7] However, the treatment of credit risk has remained the same since 1988.
1.1.3 Limitations of the Capital Accord of 1988
Following the adoption of the Accord, the amount of capital held by banks increased substantially. However, over time several important limitations of the current framework have become apparent, particularly that the regulatory measure of bank risk (risk-weighted assets) can differ substantially from actual bank risk. One example of such a difference stems from the growth in loan securitisation. By selling loans to a third party while retaining some exposure via credit enhancements, a bank can effectively remove loans from its portfolio and decrease its required capital without a commensurate reduction in its overall credit risk.[8]
The existing risk weights also generate incentives to shift banks’ portfolio compositions towards lower quality claims within a risk bucket.[9] For example, claims on corporations receive a 100% risk weight, regardless of their rating and riskiness. A bank would generally prefer the riskier claims to generate greater returns on investment. Clearly, shifting to riskier assets could keep a bank's required regulatory capital constant, even though its overall riskiness has increased. Since the current framework provides only a crude measure of bank risk, minimum capital requirements do not necessarily reflect a bank's true economic risks and thus are inappropriate for regulatory purposes.
1.2 Revision of the 1988 Basel Capital Accord (‚Basel II‘)
Although some modifications have been realized over the years, especially the 1996 amendment to add the market-risk aspect[10], the Basel Accord has been criticized by the banking industry as well as by academics. They primarily complain about the one-size-fits-all approach to capital adequacy. It is argued that as an unintended consequence of this approach banks have been given an incentive to shift up their risk exposures without being required to hold an adequate amount of capital against these risks.
Largely in reaction to these concerns, in June 1999 the Basel Committee released for comment a consultative paper that introduced the Committee's proposal for a new capital adequacy framework.[11] In its 1999 release, the Basel Committee said that the new framework should improve capital requirements reflecting the underlying risks. In addition, a particular focus was given to the financial innovations that have developed since the introduction of the original Basel Accord. The Basel Committee mentioned that, as a result of these innovations, the Accord has become less effective to reflect a bank's true risk profile. During the formal comment period on the 1999 proposal, which ended on March 31, 2000, the Basel Committee received more than 200 comments from industry members and supervisors around the world. The result is a comprehensive proposal that goes beyond simply setting rules for credit risk in the banking book.
On January 16, 2001, the Basel Committee on Banking Supervision released the second version for a new Basel Capital Accord.[12] The proposal modifies and substantially expands the earlier proposal of June 1999. Comments on the proposal were due by May 31, 2001, and the Committee expects to issue the definitive version of the new accord by year-end 2001. Implementation by participating supervisory jurisdictions is targeted for 2005.[13]
The full release of the Basel Committee’s proposal of January 16, 2001 includes over 500 pages and consists of the following parts:
(1) an overview paper that summarizes the proposal and describes the key components of the new framework;
(2) the new Basel Capital Accord itself, which explains the proposal in detail and forms the basis for the final rule expected to be adopted at the end of the comment period;
(3) a set of seven technical papers that serve as the supporting documentation for the proposal and contain the background information and technical details regarding the underlying analysis for the proposal.
The proposed framework builds on the three pillars to assess a financial institution's capital adequacy:
(1) minimum regulatory capital standards that are more risk sensitive;
(2) an effective supervisory review process;
(3) and more effective use of market discipline through enhanced public disclosures.
In addition, the Basel Committee will extend the new Basel Accord on a consolidated basis to holding companies of banking groups, with the avowed purpose of ensuring that the risks of the entire banking group are considered.
1.3 Pillar I: Minimum Capital Requirement
1.3.1 Overview
The new framework leaves unchanged the existing definition of capital and the minimum requirement of 8% of capital to risk-weighted assets.[14] The major changes concern the measurement of the underlying risk itself. Under the 1988 accord, uniform risk-weights are assigned according to the institution type and country of the borrower. This includes a distinction between corporates, sovereigns and banks. Within these categories risk-weights vary according to membership or not of the OECD and the definition of the claim's maturity. Under the new framework, the treatment of credit risk is more sophisticated. While the measurement of market risk remains unchanged the New Accord will require capital for operational risk.
1.3.2 Measurement of credit risk in the New Accord
The new framework includes three different approaches to the measurement of credit risk:
- The Standardised Approach (as a modified version of the existing approach)
- The Foundation Internal Ratings Based Approach and
- The Advanced Internal Ratings Based Approach.
The Basel Committee expects that in the beginning a majority of banks will operate under the standardised approach while only the most sophisticated of international banks will qualify the internal ratings based approach (IRB). Over time it is assumed that an increasing number of financial institutions will change to the IRB approach. In order to bring this process forward, the Committee has created explicit and implicit incentives in the more sophisticated approaches, especially a potential reduction of required capital. Indeed, following recent consultations, the Basel Committee has concluded that a greater number of major banks will be in a position to adopt the IRB approach when the Accord is implemented.
1.3.2.1 The Standard Approach for Credit Risk
As in the current framework, the credit equivalent and the proposed risk weights are multiplied to obtain the risk-weighted assets. Weights will still be depending upon the category of borrower (sovereign, bank or corporate). However, to create the new standard approach more risk sensitive there are some major changes from the 1988 Accord:
- The distinction between OECD/non-OECD countries is to be abandoned.
- The Creditworthiness of the debtor is given by external credit assessment institutions (ECAIs).
- The sovereign rating for claims in the specific country is abandoned. In this way, banks and corporates may be assigned a higher rating than their sovereign.
- The number of risk-buckets is increased to obtain a better differentiation of risk in corporate claims. Especially, a 50% weight is added for single A rated assets and single B rated assets now require a 150% weight.
Table 11 shows the weights for claims against sovereigns. As a major changes the distinction between OECD members and other countries is replaced by an external credit assessment of the sovereign. It was widely argued that the membership criterion is insufficient since the creditworthiness within the OECD is not homogenous.[15]
Table 11: Sovereign Weights
Sovereign creditworthiness / AAA to AA- / A+ to A- / BBB+ to BBB- / BB+ to B- / Below B- / UnratedRisk-Weights / 0% / 20% / 50% / 100% / 150% / 100%
Source: Basel Committee on Banking Supervision [2000d] 3.
As far as risk weights for banks are concerned supervisors will have to choose between two options. The first option assigns a weight that is one category lower than the sovereign’s weight. There is a cap at 100%, except for banks in countries with a rating below B- where a 150% weight is applied. The second option considers the bank’s rating of ECAIs. In addition to the higher differentiated risk buckets, there is a special treatment for short-term debt. In the current regulation a risk weight of 20% is assigned for banks outside the OECD if the maturity of the claim is less than one year. A 100% weighting is applied for claims of greater duration. This distinction has created an incentive for financial institutions to prefer short-term debt. In opposite to the 1999 proposal, the Committee decided to lower the maturity bound to three months. However, negative incentives are not totally removed for banks with an external rating between A1 and B-. Table 12 shows the proposed weights for banks under the two options.
Table 12: Bank Weights
External credit assessment of banks / AAA to AA- / A+ to A- / BBB+ to BBB- / BB+ to B- / Below B- / UnratedRisk Weights / 20% / 50% / 50% / 100% / 150% / 50%
Risk Weights for Short-term claims / 20% / 20% / 20% / 50% / 150% / 20%
Source: Basel Committee on Banking Supervision [2000d] 6.
In the corporate sector risk weights are applied in a similar way. In opposition to the bank’s scheme there is broader distinction between rating classes. Despite the fact that an unrated debtor of low credit quality receives a 100% weight, the Committee believes that negative incentives and adverse selection will be limited. Table 13 describes the weighting scheme for corporates and the private sector.
Table 13: Corporates Weights
Credit Assessment / AAA to AA- / A+ to A- / BBB+ to BB- / Below BB- / UnratedRisk Weights / 20% / 50% / 100% / 150% / 100%
Source: Basel Committee on Banking Supervision [2000d] 7.
The decision to remove the OECD criterion is seen as one of the major improvements in the proposed Standard Approach. However, this will have negative effects on low rated OECD countries. In addition, by the removal of the sovereign floor highly rated debtors in less highly rated countries will benefit. It is expected that the new Capital Accord will in sum create more risk sensitivity. One crucial aspect, however, could be the introduction of external credit assessment by private sector agencies.[16] Many comments received by the Committee have highlighted that the historical performance of such external ratings has proved to be poor in stressed market situations. In this context external ratings are said to be inherently pro-cyclical.[17] Therefore, the Basel Committee proposes that the external ratings be supplemented by national export credit agencies (ECAs). The ECAs need to be recognized by national supervisors and therefore fulfill certain criteria.[18] The seven categories used by ECAs are mapped to the risk weights as described in Table 14.
Table 14: Weights According to ECA Risk Scores
Risk Weights / 0% / 20% / 50% / 100% / 150%
Source: Basel Committee on Banking Supervision [2000d] 4.
1.3.2.2 The Internal-Ratings-Based (IRB) Approach for Credit Risk
The second and more sophisticated approach for the treatment of credit risk is the internal-ratings-based (IRB) approach.[19] It represents a "fundamental shift in the Committee's thinking on regulatory capital."[20] In order to use the IRB approach, there is a comprehensive set of minimum requirements that need to be met. Depending on its methods used to evaluate credit quality, banks may choose between two proposed IRB approaches. The first one, the foundation approach, gives more weight to supervisory parameters that are taken over from the standardized approach and less weight to the bank’s own parameters. While the probability of default (PD) is estimated by the bank’s rating unit, other inputs will be provided by the national supervisor. If a bank chooses the second approach, called advanced IRB, it needs to determine the input data. In addition, the required standards regarding assessment competency and process control are more strict. In both cases the following input figures are needed for risk assessment and capital determination: