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Capital Standards for Banks: the Evolving Basel Accord

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Capital Standards for Banks: the Evolving Basel Accord Capital Standards for Banks: The Evolving Basel Accord The business of banking involves taking and manag- U.S. banking agencies established specific standards ing risks. Lending, for example, involves the risk that for capital in relation to the risk of loss rather than the borrower will not pay back the loan as promised, simply commenting on institutions' capital adequacy and paying a fixed rate of interest on term deposits to managers and boards of directors on a case-by- involves the risk that rates will drop, leaving the bank case basis, often in qualitative terms. earning less on its investments than it is paying out Specific standards were first imposed in 1981, fol- on deposits. Risk is not unique to banking, of course; lowing a period in which already low capital ratios at all types of companies engaged in international large U.S. banks continued to decline in the face of activities, for example, face the risk of unfavorable a substantial deterioration in the quality of loan port- movements in exchange rates. But changes in bank- folios due primarily to exposures to emerging econo- ing and financial markets have increased the com- mies. Prompted by the slow response of banks to plexity of banking risks. And the position of banks these growing risks, the Federal Reserve and the in modern economies has made the management of other U.S. banking agencies adopted the "primary banking risks ever more important to financial stabil- capital'' standard requiring that banks maintain a ity and economic growth. ratio of capital (essentially equity and loan-loss In the United States, banks, in addition to their reserves) to total assets of 5.5 percent. economic role in funding households and businesses, Later, coordinated international efforts led to the are central to the credit intermediation and payments more elaborate, though still relatively simple, Basel process and to the conduct of monetary policy. More- Capital Accord, which sets forth a framework for over, they have privileged access to borrowing from capital adequacy standards for large, internationally the Federal Reserve (via the discount window) and active banks and serves as the basis for the risk-based to federally supported payment systems; in addition, capital adequacy standards currently in place for all the deposits they accept from the public are federally U.S. banks and bank holding companies. Now pro- insured. posals are being considered to refine the current Because of banks' multiple functions, the great framework to take account of changes in banking and degree of leverage they employ in carrying out their the banking system over the fifteen years since the economic role, and their access to the safety net, Basel Capital Accord was adopted. society has a keen interest in the health and well- being of the banking system. The level of govern- ment regulation and supervision, unique to insured THE BASEL CAPITAL ACCORD. depository institutions, has evolved over the years. As part of the supervisory process, examiners have The Basel Capital Accord, the current international routinely evaluated the overall health of the institu- framework on capital adequacy, was adopted in tion as well as its risk-management capabilities. In 1988 by a group of central banks and other national the process, they have also assessed bank loan port- supervisory authorities, working through the Basel folios and the general integrity of bank financial Committee on Banking Supervision. statements. Only in recent decades, however, have [note: 1]. The Basel Committee on Banking Supervision, established in 1974, is made up of representatives of the central banks or other This article is adapted from testimony presented by Federal Reserve supervisory authorities of Belgium, Canada, France, Germany, Italy, Board Vice Chairman Roger W. Ferguson, Jr., on June 18, 2003, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the before the U.S. Senate Committee on Banking, Housing, and Urban United Kingdom, and the United States. The committee, which meets, Affairs and on June 19, 2003, before the U.S. House of Representa- and has its secretariat, at the Bank for International Settlements in tives Committee on Financial Services, Subcommittee on Financial Basel, Switzerland, has no formal authority. Rather, it works to Institutions and Consumer Credit. The full testimony is available on develop broad supervisory standards and promote best practices, in the Board's web site, at www.federalreserve.gov/generalinfo/basel2/ the expectation that each country will implement the standards in speeches.htm. ways most appropriate to its circumstances. Agreements are devel- The accord's fundamental objectives are to promote thaddrese s financial innovation, both on and off balance soundness sheet. Although the anframeword stabilityk osetf ths e fortinternationah many l banking system and details, it allows national supervisortso provida degree ea no equitablf e basis for international compe- tition among banks. Although it was intended specifi- discretion in adopting the standard to its specific cally for internationally active banks, the accord has, institutions and markets. in practice, been applied beyond the largest institu- tions to cover most banking organizations worldwide. The accord sets forth a framework for measur- NEED FOR A NEW CAPITAL STANDARD. ing capital adequacy and a minimum standard to be achieved by international banks in adopting coun- The Basel Capital Accord, now familiarly known as tries. The original framework assessed capital mainly Basel I, is widely viewed as having achieved its in relation to credit risk (the risk of loss due to the principal objectives of promoting financial stability failure of a counterparty to meet its obligations) and and providing an equitable basis for competition addressed other risks only implicity, effectively load- among internationally active banks. At the same time, ing all regulatory capital requirements on measures it is also seen as having outlived its usefulness, at of credit risk. In 1996 it was amended to take explicit least in relation to larger banking organizations. From account of market risk in trading accounts (the risk of the perspective of U.S. supervisors, Basel I needs to loss due to a change in market prices, such as equity be replaced, at least for the largest, most complex prices or interest or exchange rates). banks, for three major reasons: It has serious short- Stated simply, the Basel Capital Accord requires comings as it applies to these large entities; the art of that a bank have available as ''regulatory capital'' risk management has evolved at the largest banks; (through combinations of equity, loan-loss reserves, and the banking system has become increasingly subordinated debt, and other accepted instruments) at concentrated. least 8 percent of the value of its risk-weighted assets (loans and securities, for example) and asset- equivalent off-balance-sheet exposures (such as loan Shortcomings of Basel I. commitments, standby letters of credit, and obliga- tions on derivatives contracts). For purposes of deter- Basel I was a major step forward in capital regula- mining a bank's assets, different types of assets are tion. Indeed, for most banks in this country Basel I, weighted according to the level of perceived risk that as it has been augmented by U.S. supervisors, is each type represents, and each off-balance-sheet now—and for the foreseeable future will be—more exposure is converted to its equivalent amount of than adequate as a capital framework. It is too simple, assets and weighted as that type of asset would however, to address the activities of the most com- be weighted. For example, commercial loans are plex banking organizations. As implemented in the weighted at 100 percent, whereas loans on residential United States, it specifies only four levels of risk, housing, considered less risky, are weighted at 50 per- even though loans assigned the same risk weight (for cent. Total risk-weighted assets are multiplied by example, 100 percent for commercial loans) can vary 8 percent to determine the bank's minimum capital greatly in credit quality. The limited differentiation requirement. among degrees of risk means that calculated capital A bank's capital ratio—its regulatory capital as a ratios are often uninformative and may provide mis- proportion of its risk-weighted assets—and whether leading information about a bank's capital adequacy that ratio meets or exceeds the 8 percent minimum relative to its risks. have become important indicators of the institution's The limited differentiation among degrees of risk financial strength. The definition of capital has also creates incentives for banks to ''game'' the sys- evolved over the years in response to financial inno- tem through regulatory capital arbitrage by selling, vation. The definition of assets has also changed to securitizing, or otherwise avoiding exposures for which the regulatory capital requirement is higher oped by consensus, but decisions about which parts of the agreements than the market requires and pursuing those for which to implement and how to implement them are left to each nation's the requirement is lower than the market would apply regulatory authorities. to that asset, say, in the economic enhancement nec- The 1988 Basel Capital Accord and its amendments are avail- able on the web site of the Bank for International Settlements, at essary to securitize the asset. Credit card loans and www.bis.org/publ/bcbs04a.htm. [end of note.] residential mortgages are types of assets that banks [note:securitiz e in large volumes because they believ2]e. As implemented in the United States, there are four risk weights—0, 20, 50, and 100 percent—applied to various risk categories. [end of note.] required regulatory capital to be more than market or economic capital. Such capital arbitrage of the regu- and these banks have markedly different product latory requirements by banks is perfectly understand- mixes.
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