Basel II? Track

What is... Basel II? Track

Basel II is an international agreement that reserve requirements is thus one of the most sets minimum requirements for the capital important tools of prudential supervision, since it reserves held by creditor banks. It was drafted helps to prevent excessive lending by banks and by the Basel Committee on Banking Supervision, thus reduces the risk of bankruptcies. which is comprised of central bankers from the 13 The basic principles of the Basel Capital Accord of biggest industrialised economies.. With the official 1988 (Basel I) are: name “International Convergence of Capital Measurement and Capital Standards: a Revised l Banks must put aside 8% of the amount of a Framework,” “Basel 2” is a follow-up to the first loan in reserve when there is a 100% risk Basel accord established in 1988. associated with that loan, as defined by the Basel Accord framework's risk assessment. If The Basel Committee assessed risk is lower, reserve requirements can The Basel Committee on Banking Supervision (Basel be lowered accordingly. Committee) was established in 1974, by the Bank of l Banks must make assessments of the potential International Settlements (BIS), an international for loan default for government, bank and organisation founded in Basel (Switzerland) in 1930 corporate borrowers. For instance, a bank that to serve as a bank for central banks. The BIS gives a loan to a government in an OECD- currently has 55 member central banks, only 13 of country does not have to put any money in which are represented on the Basel Committee. It reserve since according to the Basel principles, started as a forum for regular cooperation between the risks of non-repayment are none. In banking supervisors of 10 Western countries (G-10) contrast, Basel I stipulates banks have to put and currently consists of supervisory authorities and aside 8% of all loans provided to corporations. central banks of 13 developed countries. l Banks that give loans to other banks have to The Basel Committee has gradually developed distinguish between short-term (up to 12 common international standards of banking months) and long term loans. According to Basel supervision that are supposed to be implemented I, the risk of providing short term loans to banks through national legislation, although the is much less (only 20% risk) than providing long Committee has no international means of term loans (up to 100% risk for developing enforcement. The main instruments developed by country borrowers). the Basel Committee are: The Basel Committee's Concordat, The Basel Committee's 25 Core By 1994, Basel I was being implemented in over Principles for Effective Banking Supervision, and 100 countries, and the Basel Committee established most importantly, the Basel Capital Accords. the Accord Implementation Group to share experiences and promote implementation. Basel I: a major international standard Basel II: a revision of the framework of banking supervision By the late 1990s, the Basel Committee began In 1988, the supervisors of the Basel Committee discussions to update Basel I. A revision was agreed on how much financial reserves banks must needed to reflect current risk measurement put aside when providing loans. For banks, it is techniques that were more sophisticated than the costly to leave capital idle and they prefer to keep 1988 “one size fits all” approach. Big banks were as little capital in reserve as possible. But this already increasingly using their own more detailed temptation could threaten financial stability if the risk assessment mechanisms, and the 1988 loans are not (entirely) paid back, or when standard approach thus increasingly was regarded depositors suddenly collect their money. The use of as a burden. private finance : a public interest In addition, a new framework was needed to aside. Also, banks themselves hold securities account for developments in financial markets, such such as bonds and this presents a credit risk in as the common practice of “credit risk transfer”. and of itself. Again, in determining the risks Credit risk transfer (or mitigation) refers to the use associated with securities, the Accord offers a of instruments that pass credit risk onto other banks standardized approach, as well as the option of or individuals through the sale of credit derivatives using a more sophisticated internal rate based or through the securitization of credit. approach. The capital reserve requirements depend on the approach used. Finally, with the Asia financial crisis in the late 1990s, the need for better financial supervision B. Capital requirements are introduced for became very clear, further spurring the revision of operational risk, the risk associated with the internal the Capital Accord. By May 2004, the Basel member processes of the bank. Basel II offers 3 different countries reached a consensus on a new approaches, varying in complexity, to assess these agreement, Basel II. risks.

Basel II, the new framework C. A final paragraph introduces a new definition of the trading book. Banks keep both a banking book The text of the new accord (Basel II) is a complex and a trading book. With banks' increased document of 250 pages. It is based on three pillars: engagement in security trading, the importance of Pillar 1 the trading book has increased, so more specific New risk assessment mechanisms and definitions and rules are introduced as to how the resulting capital requirements: book-keeping should be done. A. New methods are introduced to measure credit Pillar 2 risk, the risk of non-payment associated with bank Changes in the supervisory processes: lending. The new capital requirements depend on l Banking supervisors get more power and scope the approach used. to intervene and monitor risk assessment l a "standardised approach" measures the risks of systems of banks. a borrower by using private or public rating l Banking supervisors of the home and host agencies that assess borrower solvency; for countries of banks are required to make concrete government borrowers, banks can rely on the plans to improve cooperation and information assessment of Export Credit Agencies. exchange, and decrease the burden of banks to l an “internal rate based approach” (IRB) allows a implement supervisory requirements. bank to use its own risk estimation systems as Pillar 3 long as they comply with certain criteria and Market discipline through better disclosure of information disclosure requirements, e.g. information by banks: sufficient auditing. Banks have to publicise more differentiated data. l a “securitization framework” provided by Basel II The assumption is that when data indicate bad also helps measure of credit risk. Although banking behaviour, e.g. too many risky loans, the securitization aims to mitigate credit risk, there banks' clients and investors will react and put often still remains a 'securitization exposure' that pressure on the bank to correct the situation. could result in credit loss. For example, if a bank securitizes home loans, so that investors buy Status and Implementation bonds based on homeowners' mortgage According to the Basel Committee, the new Accord payments, it passes much of the risk onto these should be implemented by the end of the year 2006 bondholders. However, the bank still would not and like the Basel I Accord, it is to be introduced want massive defaults on its home loans, so it worldwide. It must be noted that the exact would give implicit support to the these implementation process is unclear. Before the text of mortgage-backed securities. Therefore, the bank Basel II had even been agreed upon, the US and still faces a risk and should keep some capital

This fact sheet was produced by SOMO, centre for research on multinational corporations -www.somo.nl- for BankTrack, the campaigners network tracking the private financial sector. T: +31-30-2334343, F: +31-30-2381112, E: [email protected], www.banktrack.org China already announced that they would pursue international banks. Consequently, the banks other regulations for most of their (national) banks that operate in a particular developing country so that not all banks would apply Basel II as might each use different risk assessment originally conceived. The US House Financial approaches with different capital reserve Services Committee feared that Basel II would requirements. Those international banks that use disadvantage smaller US banks that have no their own risk assessment system ('Internal rate capacity to apply it, and that it would increase the based' approach - IRB) which require less capital concentration in the banking industry. As for the requirements would be given a competitive European Union, the EC is planning to implement advantage over domestic banks that use a the entire accord into the third European 'Capital standardised approach requiring higher loan Adequacy Directive' (CAD3), which will make the reserves. Basel II principles applicable to all European credit l Loans to developing countries more institutions. As for less developed countries, the expensive? Governments, banks and Basel Committee acknowledged that the adoption of corporations in developing countries will Basel II might not be the first priority of supervisors probably face higher costs for loans due to Basel and banks in those countries. Thus, developing II. First of all, developing country entities countries should focus more on the implementation generally receive low ratings by rating agencies, of pillar 2 and 3 of the Accord (supervisory process Export Credit Agencies, and by the banks' own and market discipline), rather than on the complex risks assessment systems; many companies or reserve requirements of pillar 1. governments from developing countries have no Some critical issues rating at all. These lower or non-existing ratings do not always reflect actual creditworthiness of In drafting the new accord, the Basel Committee the corporations or governments and can reflect had already requested, and received, comments on some bias in capital markets. According to the its three consultative papers. Numerous articles “internal ratings based” (IRB) approach in Basel written by experts have criticised the Basel II II, banks need to put more capital aside for such proposals, but many have not analysedt final lowly or non-rated lenders, meaning banks will definitive version of the Accord. In the end, it seems charge relatively higher interest rates for many that the major aim of Basel II is to prevent Western loans to developing countries. Secondly, it is governments from having to bail out the large argued that interest rates charged to the consolidated Western private banks in case they fail. developing world as a whole could be too high Also, the Basel Committee, which negotiated and because Basel II has chosen not to include designed the Basel II Accord, did not have diversification in its risk assessment mechanism. representatives of developing countries among its For banks, the concept of diversification (among members. The Committee held regular consultations regions, sectors, etc.) is an important way to with a group of 13 non-member countries, including spread and manage risks throughout their credit Russia and China, but Basel II ultimately failed to portfolios. Loans to developing economies are take into account the interests of developing relatively risky, but banks can partially offset countries, who have no decision-making power in these risks with high-quality loans to developed the design. countries. Although tools exist to assess the l International banks get competitive impact of diversification on credit portfolio risks, advantage in developing countries Banks Basel II does not take them into account. As a that use their own risk assessment system must result, the estimated credit risk for developing apply it to all the loans they provide in all country loans could be as much as 20% too high countries. The costs of introducing and operating and, consequently, the interest rates charged to one's own risk assessment systems are developing countries could be much too high as expensive and only feasible for the top well.

This fact sheet was produced by SOMO, centre for research on multinational corporations -www.somo.nl- for BankTrack, the campaigners network tracking the private financial sector. T: +31-30-2334343, F: +31-30-2381112, E: [email protected], www.banktrack.org l Loans for project finance more expensive? indications that supervisors did not fully Basel II also assigns higher risk to project comprehend these private risk assessment finance loans compared with similar corporate systems. Supervising such banks will require loans. For all but the most creditworthy projects, supervisors to work closely together with them, this would make project finance lending and to invest heavily in their own expertise to prohibitively expensive for banks from a capital ensure they can actually judge the banks' adequacy perspective. The result could be a assessments. It is doubtful whether the decrease of private bank lending in the project regulatory regime is strong enough for this. finance market, and an increase in the relative Another point of concern is that short term loans are importance of export credit agencies. still treated more favourably than long term loans l What about sustainability? In the Basel because of the much lower reserve requirements Accord, there is no attention at all to attached to the former. Although the Asian financial sustainability issues. Central Bankers could crisis has shown that short term loans can be the maintain that this is not within their domain since source of major financial instability, the new Accord their core objective is financial stability. But one hasn't taken this into account. could equally argue that that credit risk A final potential danger to financial stability lies in assessment should include an analysis of the possible procyclical effects of using external sustainability risks (i.e. the environmental rating agencies for the assessment of risks. If a degradation, the social and societal impacts of country is facing adverse macroeconomic the companies and projects that receive bank circumstances, and rating agencies suddenly lower loans), and that capital reserve requirements credit ratings, this would only aggravate the should be higher for environmentally or socially situation, creating financial crisis rather than harmful loans. Currently, the Basel II accord stability. only requires banks to assess those environmental risks that undermine the value of Glossary: the collateral of the borrowing company. Bonds: promissory notes that oblige the issuer to Moreover, although reputational risk is a pay back a certain amount of money within a recognized and important type of risk in banking certain time (with or without regular payments, or (especially in cases of fraud, such as banks 'coupons'). helping companies to manipulate financial statements), Basel II similarly does not recognize Securitization: aggregating mortgages, other this as an Operational Risk. Reputation types of loans or assets in a pool and issuing new management drives many banks to support securities backed by this pool. This distributes the sustainability/ corporate social responsibility, and of risk on these assets and debt instruments to to avoid irresponsible environmental or social the new owners of the securities. behaviour. Arguably, those banks with superior Credit derivative: a contract between two environmental management systems or those parties that allows for the use of a derivative to that finance less controversial transactions, transfer credit risk from one party to another. For should have lower capital requirements on the example, the creditor that has a loan or bond basis that they are reducing their reputational outstanding has the right to sell the loan or bond, and operational risk. in case of a default. In return the creditor pays l Danger of financial instability not resolved. the other party a regular fee (like an insurance The first issue in this respect is whether premium). supervisors will be able to duly supervise the implementation of the banks' own risks assessment mechanisms (IRB approach). During Useful websites: the drafting stage of Basel 2, there were www.bis.org