The Hindu Business Line : Is it time for ‘Basel III’?

Many banks already face so many risks that implementing Basel II as written will put them in a capital squeeze. They will either have to reduce risk by cutting back on lending, or sell more shares to give themselves a bigger capital buffer, or both.

Sunil Kewalramani

The changing role of central banks from ‘lenders of last resort’ to ‘buyers of first resort’ was clearly visible in the rescue act played by the US Treasury in the case of Fannie Mae and Freddie Mac. The January-March and May-June 2008 turmoil in the world financial markets underscores the importance of strongly capitalised banking systems. The intellectual foundations of financial regulation today rest on three pillars: greater transparency, inc reased disclosure and more rigorous risk management by firms.

Japanese banks implemented Basel II in 2007, and European banks at the start of 2008. US regulators are scheduled to switch over in 2009.

According to ace investor George Soros, Basel II is totally misconceived. It will have to be reworked and we need Basel III for a new order.

Even as the world is tiring of the saga of Basel II, it would be pertinent to evaluate what went wrong.

First, the internal risk measurement systems used to compute Basel II ratios were developed in benign environments. They rely extensively on banks’ internal models that remain relatively untested during a downturn.

Second, Basel II is being applied inconsistently around the world, and even within individual markets, leading to very different risk weights and capital charges for identical assets.

Third, Basel II is too accommodating on certain risk categories, especially trading risk and sub-prime mortgage.

Finally, there is an in-built pro-cyclicality in how it will be applied that is likely to lead to volatile capital measures during the cycle, with many cases of inadequate provisioning during boom times.

Risk-weights should be similar for Basel II compliant banks.

It is essential to adjust the Basel risk-weights to ensure that similar assets and similar banks are treated the same regardless of where a bank is located, the Basel methodology or accounting standard it uses, and what its own risk assessments may be.

Basel II fails to recognise that the enforcement of a common approach to risk management enhances the homogeneity of the behaviour of market participants and hence exacerbates financial crisis.

The Basel committee has worked hard to introduce many safeguards across the three pillars of the framework to achieve a reasonable balance between risk sensitivity at banks and the stability of industrial capital over various business cycles. This includes the requirement that banks perform stress tests and demonstrate that they hold adequate cushions above the minimum during good economic conditions, in order to weather such stress.

Effect of Basel II

Both the options have their flaws. The first one — shrinking the loan book — would be economically destructive, since cutting off credit in today’s weak environment could send businesses and households into bankruptcy.

The second possibility — raising more money from shareholders — is better for the economy but extremely difficult in a downturn because no one wants to buy. So some banks will simply be swallowed up by other banks or vulture investors. Or to put it differently, the bureaucratic machinery of Basel II could become a classic case of the “law of unintended consequences”.

At a wrong time

The new rules kick in at a time of major credit-market problems, which will mean a sharp spike in US bank regulatory capital. Unlike Europe, the US will retain a crude “leverage ratio” that takes precedence over Basel II if the two measures give different results.

Significant amounts of risk-based capital will need to be raised in a hurry, driving a new wave of industry mergers and acquisitions. Some believe that the very concept of risk-weight assets is wrong, and that a basic leverage ratio that compares unweighted assets with tangible book equity is preferable.

But this approach is insensitive to the risk profile of a bank’s portfolio, and fails to capture off-balance-sheet risk such as un-drawn commitment to SIVs (structured investment vehicles) and is heavily reliant on accounting standards.

For example, Deutsche Bank had trading assets under US accounting principles of 448 billion euros in January 2006 but 1010 billion euros under IFRS.

Comparing a leverage ratio based on IFRS with one based on US GAAP and another on German GAAP will not help investors compare banks on an apples-to-apples basis internationally.

The best approach is to adjust the Basel risk-weights to ensure that similar assets and similar banks are treated the same regardless of where a bank is located, the Basel methodology or accounting standards it follows, and what its own risk assessments may be.

Fundamental rethink

The idea is to have a set of capital measures that are much less volatile than regulatory or economic capital ratios, less model-dependent and less affected by economic cycles. An independent risk-based measure, based on a methodology consistently employed across the sector, represents a more appropriate way of assessing solvency than a crude leverage ratio.

Basel II needs a fundamental rethink. That rethink must address the systemic issues that individual firms cannot, and recognise the homogenising, pro-cyclical failings of consensus thinking.

It may just be time for a Basel III to address each of these concerns, which will help in mitigating risk and formulating a robust financial regulatory environment conducive to non-volatile growth of the banking and financial services sector.

(The author is CEO, Sunil Kewalramani Global Capital Advisors. blfeedback@thehindu.co.in)