Fikret auevi

Basel I and problems with its implementation

A major problem regarding the capacity of powerful players on global financial markets to carry out adequate supervision is the multiple use of financial leverage, particularly by financial institutions which deal in hedging (hedge funds). The trend towards creation of financial groups which combine commercial and investment banking operations with insurance and reinsurance has also made it practically impossible to carry out real time supervision of the conglomerates which make up the global financial superstructure. Parallel to this process of integration of the major financial players has gone the multiplication of risk related to the new forms of financial instrument, further complicating the issues of monitoring, regulation, and supervision. The Basel Bank Supervisory Committees capital adequacy standards no longer apply to major financial conglomerates. The high degree of interconnection between banking, investment banking, and insurance in these conglomerates allows a single dollar of equity to be multiplied many times. This advantage of the financial mega-groups allows them to create additional liquid resources outside national government control and to manage global development in line with their own priorities. The problem with the 1998 capital adequacy standards boils down to the question of averages. Because of its general nature, the capital adequacy standard of 8% set by the Basel Bank Supervision Committee fails to take into account specific activities cofinanced by a number of financial institutions. The fundamental objections made against the 1988 capital adequacy standards, particularly in the later 1990s, relate to the nature of risk and the need for more emphasis to be placed on the risk involved in the activity (investment) and less on the definition of the supervision rules themselves. The key to risk management and setting standards lies in direction of the risk management process within a framework of financial groups, or rather in the systems and procedures used to measure and manage risk. Practical admission that the 1998 Basel standards cannot be applied to the major financial groups began in early 1998. Accepting the Basel Committees guidelines on market riskbased capital management meant admitting the state regulators and supervisory bodies rights to authorize the application of internal banking procedures and models to the assessment of market risk exposure. At the heart of the new approach to setting capital standards (internal models) are more advanced risk management techniques and new risk

insurance instruments. According to Institute for International Finance studies, the 1988 Basel standards did not stimulate banks to use new risk management techniques or the setting of capital standards grounded in modern credit portfolio management. The most important problems arising from application of the 1988 Basel capital adequacy standard were: Under the 1988 Basel rules, the high-risk asset weighting applied to short-term loans to banks from any country was 20 percent. Such a modest percentage stimulated inter-bank lending, often leading to the creation of fictitious liquid capacity and contributing to systemic risk. Funds from these sources were used to finance other activities, from margin buying to trade in derivatives to financing hedging operations. Excessive risk exposure due to inter-bank loan financed transactions is dangerous because of Central Bank inability in practice to influence the generation of new liquid resources, which is after all their basic reason for existing. Increasing the weighting would raise the cost of inter-bank lending, stimulating the securitization of short-term claims, leading to better distribution of risk. Setting a zero weighting for investment in OECD-member government securities stimulated such investment, particularly in newly industrialized OECDmembers, but de-stimulated it in non-OECD-member government securities, even though they in principle carry the same level of risk. As a result, portfolio structure became arbitrarily determined, regardless of the actual level of risk in developed, developing, or transition countries. The approach taken to determining the capital adequacy ratio was to general, given the major differences between the worlds regional financial and national markets. The standard fails to take into account business cycle phase or degree of financial market development, which have a decisive impact on the need for capital. The much reduced importance of required reserves for money supply management in developed countries, due to the sophistication of financial markets, renders this operation essentially ineffective, at least as regards preventing or moderating changes in the direction of the business cycle. These weaknesses in the 1988 Basel Accords capital management standard were cited by financial players when proposing new structures of the capital standard and asset classification into risk categories, based on banks risk levels, which influence financial innovations related to risk levels. The new regulatory framework was based on the 2

following three principles: Demands for a minimum capital adequacy level, Supervision of capital adequacy, and Market discipline. The revised standards continue to refer to a minimum 8% capital adequacy ratio, but have more groups and sub-groups of assets. The main features of the rule changes are as follows: 1. The 1988 Basel Accords assigned different risk weightings to claims arising from government bonds purchases, depending on a countrys membership of various economic groupings. For rating purposes, the revision refers to assessments carried out by approved institutions of the various countries long-term liabilities denominated in foreign currency. The 1988 Basel Accords assigned a zero weighting to OECD-member bonds, while all bonds issued by nonmembers of OECD were assigned a weighting of 100%. This provision, clearly, caused unequal treatment of government bonds on international markets, regardless of whether the bonds of a given non-member of OECD were better covered than a given OECD-members bonds by the issuing countrys macroeconomic stability. Under the new standards, the 100% risk weighting for non-members of the OECD will not be applied so long as the country agrees to a Special Standards for Data Dissemination requirement, confirmed by the IMF. 2. A 20% weighting was previously applied to all short-term claims on banks (and all long-term claims on banks within the OECD), while the weighting on long-term claims on banks from countries outside the OECD was 100%. Many financial experts considered this rule a direct source of massive global liquidity and increased risk. One of the most explicit critics of the rule was Alan Greenspan, the former President of the US Federal Reserve. The revised rules give two options. Under the first option, the weighting for claims on banks would be as for the following category, where claims based on bonds are involved, and the maximum envisaged weighting is 150%. The second case directly links the weighting to the rating of the bank the claims are on. 3. The 1988 Basel rules assigned 100% weighting to all claims on companies, regardless of their credit rating. The new rules assign a much lower weighting to claims on high quality companies (20%), while high-risk companies get a 150% risk weighting. 4. Claims on the basis of loans secured against commercial property are, under the new rules, assigned a minimum weighting of 100%, while loans secured against 3

residential property get a 50% weighting. 5. Also proposed is the use of external ratings for calculations of the minimum capital required for financial instruments issued on the basis of securitization of underlying securities. The risk weighting is from 20% for securitization of assets with an AA- or higher rating to 150% for assets with a BB+ or BB- rating. Securities securitized on assets with a rating below BB- result in reduction of the capital by the full amount of the securitized part of the asset. 6. The conversion factors for off-balance sheet items remain basically unchanged, with the removal of the maximum 50% weighting earlier applied to derivatives operations on OTC markets. One solution applied to the problem of risk management adequacy is the use of Value-at-Risk models to assess the placement required to reduce capital value (reducing the solvency of the banks) at a given risk level. The Basel Banking Supervision Committee instructed the main financial institutions to apply internal risk assessment models, based on loan portfolio analysis. Essentially the model involves assessment of the likelihood of losses due to changed market conditions over some future period. This future period becomes progressively shorter (a month, a week, even a day), so that financial institutions face the problem of ensuring liquidity at very short notice, to react to steep changes in the market value of the instruments in their portfolios. A typical problem with assessing credit risk on either the VAR (Value-at-Risk) or CAR (Capital-at-Risk) model is excessive reliance on historical data and the belief that the price of financial instruments will not vary significantly. For the most part, the model relies on assessment of the coefficient of correlation between the instruments making up the portfolio and the return to risk ratio, as the bases of portfolio theory. These two variables for risk management in commercial banking and financial institutions have been defined by Joel Bessis as follows:
The Value At Risk, or VAR, is the maximum loss at a given tolerance level. The tolerance level is the probability that the loss exceeds this maximum value. The VAR methodology can also be used to define risk-based capital. Then VAR becomes CAR, or Capital At Risk. CAR is the capital required to absorb potential losses at a given tolerance level. This tolerance level is the default probability of the bank. .... Both CAR and VAR measure potential losses. However, the tolerance level is not the same when the solvency of the bank is at stake, and when the risk is limited to the chances that some manager goes beyond some risk limit for a short time. If a trader exceeds the authorized VAR, corrective actions are required, but solvency is not impaired. VAR can be associated with day-to-day banking operations, and CAR is more relevant when dealing with aggregated risk-based capital and with solvency issues. Hence, CAR is indeed different from VAR for two reasons: 1. CAR is the risk-based capital at a global level, after diversification of risks, whereas VAR can be used at any other intermediate level of management.

2. CAR is based on a tolerance level higher than that of VAR since the solvency of the bank is at stake.

On the other hand, financial investors desire to increase return by favouring instruments from high-growth regions creates a conflict of interests and potentially the counter-effect of a sudden fall in market prices in a given region. As long as the financial instruments from high-growth regions in the portfolio are structured as portfolio theory recommends, distributing risk over a number of regions and using low or zero-risk loan instruments (inter-bank loans or government bonds, respectively), the likelihood increases that financial crises transfer from region to region, given full openness of capital accounts. Since, in the final analysis, the IMF should stand behind the value of risk-free securities, ensuring sufficient reserves to maintain the value of the currency in which government bonds are denominated, often based on inter-bank loans, market confidence will shift sharply if the IMF refuses to support a country whose securities (particularly bonds) are oversubscribed. The entire structure of investment by financial institutions at the national, and even more the international, level is called into question, or rather expectations change rapidly. Rapidly revised expectations cause a chain reaction, a flight to quality, i.e. rapid selling-off of securities denominated in the destabilized currency, leading to a sharp fall in the market price of the instruments that make up the portfolio. This flight to the securities of unaffected countries affects the price of short-term securities, particularly risk-free ones, putting upward pressure on the value of the major currencies, which is inconsistent with overall economic growth and so potentially creates a so-called bubbleeconomy. Analyzing capital adequacy standards in their study of banking crises in developing countries, Morris Goldstein and Philip Turner conclude that:
It is perhaps surprising that the authorities in most emerging economies have thus far chosen not to set national capital standards that are much above the Basel international standard; nor have their banks (with several important exceptions) maintained actual capital ratios much above those found in countries with more stable operating environments.

Analysis of the environments in which developing countries banks operate and their IMF arrangements, however, influences the reduction of additional sources of liquidity. Such countries Central Banks are obliged to keep fixed or near fixed exchange rates, which, alongside a very limited role as lender-of-last-resort, liberalization of foreign trade, and strict budgetary constraints, means that commercial banks represent the basic, and in countries with currency boards the only, institutions for creating additional liquidity. In 5

spite of higher risk, national regulatory institutions therefore will not decide to set the standards for minimum required capital significantly higher, as such standards would further reduce the sources of short-term and mid-term capital.