Vol. 2001-5&6
Dan
Krabill, a former colleague and long-time friend (now a managing director at the
Secura Group) is a highly respected financial analyst, and shares with me a
strong interest in public policy issues affecting banking.
Our views on capital regulation reform, while not identical in all
respects, are quite similar. Accordingly,
I was delighted when Dan agreed to work with me on this report and, in effect,
to be its co-author. The real
beneficiaries, I am convinced, will be our readers.
Carter H. Golembe
There is now underway a powerful, expertly staffed, and well-funded
effort to reform the present system of capital regulation.
The project is international in scope, conducted under the aegis of the
Basel Committee on Banking Supervision (the Committee).
Representatives of the principal regulatory agencies or central banks
from 12 nations comprise the Committee, of which the United States is a
prominent member. Indeed, the
Committee’s Chairman is William J. McDonough, the President of the Federal
Reserve Bank of New York. Planning
for capital regulation reform has been underway for three or four years.
The Committee has substantially completed its research-and-discussion
phase and is about to begin the implementation process, which it plans to have
in place by 2004. This report, therefore, deals with a proposal that has now
taken on recognizable form, but one that is not yet final.
There is nothing secret about the reform effort; it has been widely
reported and discussed in the financial press, in articles by experienced
commentators, and at financial industry conferences.
The reform objective is to replace the Basel Committee’s 1988 Capital
Accord (1988 Accord), which sought to deal with a perceived problem of bank
under-capitalization, particularly among major banking organizations often
characterized as “internationally active.”
However, in some countries the regulatory framework was made applicable
to additional banks or (as in the United States) to all banks.
The 1988 Accord was recognized as a groundbreaking step in capital regulation
but its shortcomings soon became apparent as banks developed increasingly
sophisticated techniques for managing risk and for determining thereby the
needed amount of capital. The editors of The Economist put the problem bluntly,
saying that it has become “glaringly
clear” that the “regulatory capital demanded of a bank often bears scant
relation to what a prudent bank manager would choose to hold in reserve”
(The Economist, January 20, 2001).
The Chairman of the Basel Committee was almost as critical.
In a speech before the Foreign Policy Association in New York, he emphasized
what he viewed as the Accord’s mischievous consequences:
.
. . the 1988 Accord does not adequately differentiate among degrees of credit
risk. As a result, banks have had
incentives to take on higher risk exposures within each of the Accord’s broad
risk categories. Banks have also tended to engage in transactions that lower
capital requirements without reducing economic risk. The effect of these developments has been to erode the
significance of the Basel ratios as an indicator of a financial institution’s
capital adequacy . . . (William McDonough, New York, November 17, 1999)
In June 1999 the Committee released its first proposal for reform.
After receiving a large number of comments it came forth, on January 16,
2001, with The New Basel Accord (2001 Accord), on which, interestingly, it has
again sought industry and other comment. Apparently
it is now intended to wrap-up the work by issuing a final document at the end of
2001 and then to begin implementation, scheduled for completion in 2004.
The current version of the 2001 Accord differs greatly from the 1988
Accord, although it retains certain key elements of the earlier document, such
as the definition of capital and the minimum requirement of 8 percent of capital
to risk-weighted assets. Obviously,
it seeks to bring more sensitivity to risk analysis than was done by the 1988
version. Moreover, it is no longer one-dimensional; it now includes
what has been referred to as three “mutually reinforcing pillars”: a minimum
capital requirement, supervisory review process, and market discipline.
The new proposal is complex and quite detailed (it is described by the
Committee in more than 500 single-spaced pages).
What some critics have already described as “mind numbing complexity”
may be reflected in the summary prepared by the three federal banking agencies
in the U.S. (FDIC, Office of the Comptroller of the Currency, and the Federal
Reserve), which we have attached as an appendix.
Readers will have to decide for themselves.
We do not plan in this report (or, for that matter, in later reports) to
analyze in detail the many elements of capital regulation.
This has already been done by others (the Shadow Financial Regulatory
Committee, for example) and the number of such analyses will doubtless swell,
now that the deadline for submitting comments on the current version (May 31,
2001) has passed. Instead, this
report will focus on key public policy implications for banking in the United
States, beginning in Section I with an historical background sketch of how we
got to where we now are.
Section II focuses on the first of the “Pillars,” namely, the minimum
capital requirement, which accounts for the largest portion of the material
provided by the Committee as well as, almost certainly, the greatest amount of
debate. Our focus in this section
is not so much on the specifics of what is being proposed or on whether or not
particular elements of the proposal are reasonable.
Instead, the focus in this section is on the implications of establishing
minimum capital requirements by rules having the force of law.
In this connection, we may look to individual items for illustrative
purposes, and will give particular attention to U.S. banking.
Section III will focus on the other two Pillars: the supervisory review
process and market discipline. Neither
is a new or unfamiliar element in capital supervision and regulation, but the
Committee places a new emphasis on, and suggests some new procedures for, these
areas.
Section IV, as usual, will attempt to tie the loose threads together, and
will offer some conclusions.
Special
Note: On the same day that this report was ready to be sent to the printer
for publication and mailing, we received news of the Basel Committee’s
announcement that because of the large number of comments received thus far it
was moving back the target date for final implementation from 2004 to some date
in 2005, and that it was “tweaking” a few controversial operational items (American
Banker, June 26, 2001). Because
our focus has been on the key public policy issues posed by the 2001 Accord,
rather than on operational matters, we saw no reason to delay or alter the
current report. We are confident
that it addresses the basic public policy thrust of the Basel Committee’s
work, but how well is for readers to decide.