Basel Accord 1 & 2 comments from Harvard Law School Forum

Full Article at

http://blogs.law.harvard.edu/corpgov/2009/02/04/the-financial-crisis-and-the-future-of-financial-regulation/#more-841

New approaches to capital adequacy

The first is new approaches to the regulation of the capital adequacy of banks. These have of course been extensively revised by the introduction of Basel 2, which has aimed to achieve greater sensitivity of capital levels to the different risks which banks are running, and there are certainly benefits to the Basel 2 approach on which the future system should build. It is important to realize that the crisis developed under the Basel 1 regime not Basel 2, and that Basel 2 would have addressed some of the problems which led to it – for instance the failure to distinguish between the capital required to support mortgages of different credit quality. But it is also clear that we will need to adjust Basel 2 in a number of ways. The general direction of travel will be towards higher levels of bank capital than have been required in the past, and in particular capital which moves more appropriately with the economic cycle and more capital required against trading books and the taking of market risk.

• On the economic cycle, there has been considerable commentary on the procyclical nature of Basel 2 risk-sensitive capital measures, and it is inevitable that any system which is risk sensitive, unless deliberate countervailing adjustments are made, will be to a degree procyclical i.e. capital requirements will rise as we head into a recession and credit quality declines. But it is important to note that the degree to which Basel 2 is procyclical in relation to the banking books – credit extension on balance sheet – depends crucially on how it is implemented and can be significantly reduced if banks use appropriate through-the-cycle approaches to estimation of probability of default and loss given default. It is therefore important to ensure that the detailed implementation of Basel 2 does not introduce unnecessary and unintended procyclicality, and the FSA on Monday issued a clarification of our approach designed to ensure this.

Looking forward, however, we need to go beyond the avoidance of unnecessary procyclicality and to create a system which introduces significant counter cyclicality, requiring banks to build up substantial capital buffers in good economic times – ratios well above absolute minimum levels – so that they can run them down in bad. Such an approach makes sense from a micro-prudential point of view, reducing the risk of bank failure. But it is also desirable from a macro-prudential and macro-economic perspective: it will tend to place at least some restraint on over-rapid expansion in the boom, and it will reduce the danger that impaired capital makes it more difficult for banks to lend in recessionary times, thus making the recession worse. Ideally, such a regime must be agreed at international level, and the FSA is working closely within the Basel Committee on Banking Supervision and the Financial Stability Forum to design the details. There are many of those details to be worked out; whether the buffer requirements will be defined in formulaic terms, as in the Spanish dynamic provisioning system, or by regulator discretion; and how to deal with the complexity of different economic cycles in the different countries in which a cross-border bank may operate. But the principle is clear.

Conclusion

To conclude, let me return to my opening thought. We are in the middle of an economic downturn which, to a far greater extent than any since the 1930s, is the result of developments which were to a degree internal to the global financial system. Developments in the banking and the near-bank system, which had been lauded as improving allocative efficiency and financial stability, have in fact caused serious harm to the real economy. The changes which we need to make to create a sounder system for the future will be profound. Their guiding principle should be that they should create a banking system focused on the delivery of the value-added functions of banking which are so essential to a market economy.

[1] Even the banks which were largely doing “originate and distribute” would often however have to warehouse significant quantities on balance sheet before packaging and distributing, and could be left with liquidity strains and future potential losses if liquidity suddenly dried up (e.g. Northern Rock)
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[2] This assumption seems also at time to have been based on a misunderstanding of the inference that could be drawn from a credit rating, with high ratings treated as carrying the inference of liquidity, rather than simply lower credit default.
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[3] Loan to deposit ratios limits continue however to be used in some emerging economies. A number of emerging economies e.g. India, also continue to use reserve asset ratios as monetary policy instruments, with significantly liquid balance sheets a resulting byproduct.
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