k November 2006 o o A Bridge Too Far: The Basel II Bank Capital Accord l t By Peter J. Wallison u The international bank capital accord proposal known as Basel II is a statistical and probabilistic effort to replicate O what the market would do if government regulation had not interfered with market discipline. The proposal has many flaws, and a recent test suggested that it would reduce bank capital requirements substantially below s current U.S. levels. In other areas, formulas and mathematical models have failed to represent the real world accurately; there is little reason to believe that a model of how the market might assess bank risk would be any more e successful. A leverage ratio seems essential, at least as a stopgap measure, but a better idea would be to use a c special kind of subordinated debt to discover the market’s perception of a bank’s risk position. i v If banks were not backed by the government in and the regulation together distort the market’s r various ways, their required capital would be set by perception of banks. Unlike ordinary business entities, the market, as is the case for every other business. subject to the vicissitudes of economic conditions e The capital of any business serves many purposes, and bad management, banks are perceived to be safer S but for bank depositors and other creditors it pro- and less likely to default because of their connection vides a cushion against default. In the absence of to and regulation by the government. The result is a l government support, depositors and other creditors weakening of market discipline—the wariness that a would assess the risks associated with a bank’s port- creditors generally show when providing financial i folio, management, policies, and operations, and resources to borrowers. In practical terms, this means establish a price—an interest rate—at which the that bank depositors demand lower-capital cushions c bank would be able to attract deposits and other from banks than they would if banks were not n credit. If the interest rate were too high for the government-supported and regulated. bank to compete with other banks, it would be In the absence of effective market discipline, the a required to increase its capital to a level that would government must protect itself from the conditions n provide a sufficient cushion against default to it has created through its support of banks. In par- i assure creditors and lower the risk premium ticular, it must require banks to hold more capital embedded in the interest rate they are demanding. than the market—now relying on the government’s F Government support changes all this. In the regulation—may demand. The government’s inter- United States, government support for banks est in keeping bank capital strong comes from its includes the administration of a deposit insurance desire to reduce the likelihood of bank failure, system,1 bank access to the Federal Reserve’s which may cause economic disruption, losses to the resources as lender of last resort, and the exclusive Fed through its market stabilization activities, and right of banks to participate in the Fed-subsidized the weakening of other banks when the government payment system. These government-granted privi- raises bank insurance premiums because of losses to leges bring government regulation, and the privileges the deposit insurance fund. An example of the stakes for the government in setting these capital Peter J. Wallison ([email protected]) is a resident fel- levels is the significant losses it and the economy low at AEI. suffered in the late 1980s and early 1990s, when 1150 Seventeenth Street, N.W., Washington, D.C. 20036 202.862.5800 www.aei.org - 2- both the banking and savings and loan (S&L) industries least risky of these, were assigned zero risk weight. In other suffered a huge number of failures; neither banks nor words, a bank would not have to hold any capital against S&Ls had been required by regulators to hold enough the possibility of its failure because of losses in its govern- capital to survive the high inflation period ment bond portfolio. On the other hand, of the late 1970s—a major change in No harm can come corporate debt was assigned a 100 percent economic conditions. from the deficiencies of risk weight, meaning that the bank would Without much help from market disci- have to carry the maximum amount of pline, the government’s challenge is to Basel II as long as the required capital against its holdings of com- set capital requirements at a level that mercial loans. The constituents of capital leverage ratio—at its replicates what the market would require in were also defined so that a bank’s risk- the absence of government intervention. current level—remains adjusted capital level could be determined That capital level would provide enough by dividing its capital level by its risk- cushion to minimize failures while simulta- in place. weighted assets. neously maintaining the competitiveness Basel I was an effort to improve upon of individual banks. This is a tall order, and as has been previous methods of setting capital requirements for banks, illustrated by the huge number of bank failures in years past, which relied on seemingly arbitrary capital levels intuited it is an art—not a science. This is important because it is by regulators. It reflected a recognition that if the market the belief that the setting of bank capital requirements can were setting the capital level for a bank, it would take be done scientifically—or at least according to a statistical account of the bank’s risk profile, requiring, as noted above, or probabilistic formula—that underlies some of the objec- more capital from a bank that was taking high risks than tions to Basel II. from one that was not. But Basel I had its flaws: in many ways it was just as arbitrary as the previous methods. For Basel II and Bank Capital Requirements one, the supervisors settled on 8 percent risk-based capital as adequate capitalization for all portfolios. It was still an Basel II took its name from the work of the Basel Commit- arbitrarily selected number, despite being somewhat sensi- tee on Banking Supervision—a conference of the bank tized to risk. But there were also conceptual deficiencies supervisors of most developed countries—which meets involving arbitrary choices by the Basel supervisors. under the auspices of the Bank for International All corporate debt was lumped into a single category of Settlements in Basel, Switzerland. What began in the 100 percent risk-weight, which did not take account of the 1970s as an information-sharing process developed over difference between the credit-worthiness of corporate time into consultation about how to create a level playing borrowers—some of which had AAA ratings, while field for banks that were competing globally and how others were weaker. Also, assigning a zero risk-weight to all to replicate the capital levels that the market would require government debt did not adequately distinguish among the of banks in the absence of government intervention. financial strengths of various governments, and the lower Out of this grew Basel I, the system of bank capital risk weight for mortgages than for corporate debt tended to requirements now in force globally. The distinguishing shift investment in the direction of mortgages. feature of Basel I was its adoption of the concept of risk- One element stood out. Because of the zero risk weight based capital—capital levels that are related to the risk that of government debt, it was possible for a bank that invested a bank is taking. For example, a bank investing only in U.S. only in government bonds to carry no capital at all. This government securities is taking on less risk than a bank made no sense, since banks face many risks other than making commercial loans. In the absence of government credit risks. Interest rate risk, operational risk, and market regulation, the market would make a distinction between risk are some of the more prominent risks that would these two banks, requiring of the former less capital than require banks to hold capital if the market were setting the the latter. Basel I, then, sought to inject an element of risk level. Accordingly, the Federal Deposit Insurance Corpora- sensitivity into the process of estimating the appropriate tion Improvement Act of 1991 (FDICIA) required that level of bank capitalization. It did this by dividing bank U.S. banks also meet a “leverage ratio” test in addition to assets into a number of different categories—including gov- Basel I. The leverage ratio—equity capital divided by total ernment bonds, mortgages, and commercial loans—and assets—was simple, did not rely on risk-weighting of assets, assigning risk weights to each. Government bonds, the and assured that all banks held at least some capital. - 3- But the deficiencies of Basel I were so obvious that revi- By means of a stochastic credit portfolio model, it sions were necessary, and in 1999 the Basel Committee is possible to estimate the amount of loss which proposed a different method of linking bank risk with will be exceeded with a small pre-defined proba- bank capital requirements. This proposal, bility. This probability can be con- which became known as Basel II, relied A better approach sidered the probability of bank on a more nuanced method for assessing insolvency. Capital is set to ensure would be to create a risk—again in an effort to replicate what that unexpected losses will exceed the market would do without the distort- class of at-risk claimants this level of capital with only this ing influence of government regulation.