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THE NEW BASEL ACCORD and DEVELOPING COUNTRIES: PROBLEMS and ALTERNATIVES Jonathan Ward

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THE NEW BASEL ACCORD and DEVELOPING COUNTRIES: PROBLEMS and ALTERNATIVES Jonathan Ward WORKING PAPER NO. 04 THE NEW BASEL ACCORD AND DEVELOPING COUNTRIES: PROBLEMS AND ALTERNATIVES Jonathan Ward The Working Paper is intended as a means whereby researchers’ thoughts and findings may be communicated to interested readers for their comments. The paper should be considered preliminary in nature and may require substantial revision. Accordingly, a Working Paper should not be quoted nor the data referred to without the written consent of the author. All rights reserved. © 2002 Jonathan Ward Comments and suggestions would be welcomed by the author: Jonathan Ward Research Fellow ESRC Centre for Business Research Cambridge University e-mail: [email protected] Version 2.0 Version 1 was presented at the Cambridge Seminar on Financial Regulation, 25-27 September 2002 2 Abstract The new Basel Accord framework relies on markets and supervisors to discipline banks. Yet both markets and supervisors fail, and more so in developing countries than in high- income countries. Therefore, the new Accord is not, as its designers claim, suitable for wide application. Nevertheless, developing country policymakers have little choice but to implement it in part or in whole. Hence there are problems of governance in international regulation. I offer seven general principles for the design of a prudential regime more robust to government and market failure. Four alternative capital regimes are evaluated in the light of these principles. Simpler and harsher regimes are likely to achieve greater safety with a given level of resources. Keywords: Basel Accord, Basel 2, international banking law, bank regulation, capital adequacy, finance and development, World Trade Organisation JEL codes: G21, G28, K33 Acknowledgements: This research was generously supported by the Ford Foundation. I am grateful to my colleagues at CERF and to bank regulators from several countries for discussions and suggestions. None of these bears responsibility either for the errors or for the opinions. 3 CONTENTS Executive Summary ........................................................................................................ 5 1. Introduction .............................................................................................................7 2. The new Basel proposals......................................................................................... 9 Basel Accords 1988 and 2003..................................................................................... 9 The weaknesses of Basel 2........................................................................................ 12 3. The new Basel Accord and developing countries ................................................. 18 The supply of external funds..................................................................................... 18 Bank regulation in developing countries................................................................... 24 Pillar 1 ....................................................................................................................... 27 Pillar 2 ....................................................................................................................... 29 Pillar 3 ....................................................................................................................... 32 Conclusion................................................................................................................. 33 4. Is the Basel Accord voluntary? ............................................................................. 33 5. Elements of a prudential regime............................................................................ 39 1. Reductionism and holism.................................................................................. 42 2. Carrot and stick ................................................................................................. 45 3. Boom and bust................................................................................................... 48 4. Rules and standards........................................................................................... 52 5. Price and quantity.............................................................................................. 53 6. Home and host................................................................................................... 56 7. Some for one and one for some......................................................................... 59 6. What are developing countries to do about capital? .............................................62 Basel 1.5.................................................................................................................... 63 Basel 1.5+.................................................................................................................. 65 Basel ‘current plus’ ................................................................................................... 66 ƒ(Basel) ..................................................................................................................... 67 7. Conclusion............................................................................................................. 70 4 Executive Summary The new Basel Accord consists of three ‘pillars’: capital requirements, supervision, and market discipline. In the sophisticated version of the capital requirements pillar, capital requirements are based on banks’ own measures of risks. The new framework is based on the premise that discipline by the markets and by supervisors is beneficial. Yet both markets and governments fail. The new framework has not been designed with developing countries in mind, and it is especially likely to fail in developing countries. First, developing countries experience greater macroeconomic volatility, and greater volatility of external flows and greater vulnerability to external shocks. Secondly, Basel 2 relies on strong institutions. In developing countries, institutions limiting rent-seeking are weaker: banker and bureaucrat have more opportunity and incentive to reap private benefits at public cost. And thirdly, skills are scarce. Supervision and market discipline require skilled supervisors and market participants. Even the more basic capital requirements rely on the skill of bankers, since any capital adequacy rule relies on the valuation of assets that have no market price. Yet developing countries are under pressure to implement the new framework. Implementing the Basel Accord is, according to the official view, voluntary. In reality it is not entirely voluntary. Countries that do not implement risk sanction in several ways. Most notably, the lending programmes of the IMF and World Bank come with conditions attached, and these conditions include compliance with international regulatory benchmarks. Bank branches from developing countries are authorised in high-income countries only if their home country supervision meets Basel standards. Although they have little chance of influencing the Accord itself, developing countries do have some choices to make. I offer seven suggestions for policymakers in developing countries. 1. Prudential regulation of banks aims to protect depositors and to protect the financial system. The two objectives are imperfectly aligned. Regulations imposed on institutions in order to reduce systemic risk should not treat systemic risk as exogenous, because systemic risk is largely determined by the collective behaviour of banks. A prudential regime concerned with risk at the level of the system cannot focus on the constituent parts alone. Regulators and supervisors should pay more attention to the stability of the system. 2. While the incentives of regulators, accountants and market participants are of great importance, bankers’ incentives are the most important. Public intervention should be designed so that bankers fear failure. ‘Risk-sensitive’ capital requirements are neither necessary nor sufficient for incentive-compatibility. 3. The Basel 2 framework for credit risk is procyclical, the IRB approach especially so. In future, developing countries will be even more vulnerable to high-income countries’ business cycles. Rather than relying on supervisors to ensure that banks can survive recession, they should consider imposing countercyclical prudential requirements. These could include countercyclical minimum capital ratios, collateral haircuts, liquidity and currency mismatch limits. 5 4. The new Accord shifts from rules to standards. Developing countries should rely as much as possible on simple rules that are easy to write, communicate, enforce and verify. They should restrict the role of supervisory discretion to the minimum. 5. Capital requirements fail to protect against low-probability, high-impact risks, and they are sensitive to the failure of underlying assumptions. Like engineers, regulators should build in redundancy. In addition to capital requirements, they should also use a suite of simple back stop limits and stress tests. 6. In order for domestic prudential requirements to have effect in the presence of foreign banks, regulators must protect their autonomy. They should consider requiring all foreign banks to submit themselves to local regulation by incorporating locally. This would be an alternative way of counteracting competition in laxity. 7. The combination of maladaptive design and near-obligation creates a severe problem of governance in international regulation. Developing countries cannot by themselves entirely solve these
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