Basel II creates perverse incentives to underestimate credit risk.
Says Harald Benink and George Kaufman, Professors of Finance and chair and co-chair of the Shadow Financial Regulatory Committees in Europe and the US respectively, highlighting the weaknesses of the Basel II capital adequacy framework in today’s FT.
The credit squeeze has focused eyes on the design of financial regulation, including the new Basel II capital adequacy framework for banks.
Basel II aims to address weaknesses in the Basel I capital adequacy framework for banks by incorporating more detailed calibration of credit risk and by requiring the pricing of other forms of risk.
The Basel II accord allows large banks to determine their regulatory capital requirements based on their own risk assessment models, which is fundamentally problematic as it invites an optimistic attitude toward risk exposure if you want to maximise return on equity.
The implementation of Basel II coincides with massive losses reported by some of the world’s largest banks, requiring large-scale recapitalisations. The risk models that anchor Basel II are basically the same as the ones many of these banks have been using in recent years says Benink and Kaufman. To some extent, this reflects the difficulties of accounting for low-probability but large events.
“Bank capital-asset rations are near historically low levels, typically at about 7 per cent of total assets (on a a non risk-weighted basis).” Several quantitative impact studies show that implementation of Basel II will actually reduce bank capital requirements.
In any event given the turmoil in the financial markets, Benink and Kaufman suggest either not implementing Basel II at all or making some substantial improvements:
First, another quantitative impact study using observation from the recent turmoil before allowing banks to apply their own models for calculating regulatory capital.
Second, the additional adoption of a meaningful non risk-weighted leverage ratio requirement.
Third, disclosure is not an adequate incentive to be prudent. The banks own risk models should be complemented by a credible and effective form of market discipline. As long as everyone believes that there is always a money back guarantee there’s no need to take heed of the small print. One suggestion would be “a mandatory requirement for large banks to issue credibly uninsured subordinated debt as part of the regulatory capital requirement could enhance market discipline, thereby mitigating banks’ incentives to reduce capital.”
