"As U.S. supervisors have previously stated, in this country we expect to apply, for regulatory capital purposes, only the advanced internal-ratings-based (A-IRB) approach for credit risk and the advanced measurement approach (AMA) for operational risk. In line with our additional goal of improving risk-management techniques, the authorities believe that the largest, most complex, internationally active banking organizations in the United States--those that our screening criteria determine to be core banks--should be subject to the most sophisticated version of Basel II. To be clear, we are not proposing to implement either the standardized or the foundation internal-ratings-based (F-IRB) approaches within the United States."
Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework Bank of International Settlements (BIS)
Unraveling the Basel Capital Accord
By Smithy
from http://www.wizardsofmoney.org
(this site is no longer active, but this article
and much
more can be found at http://www.bilderberg.org/bis.htm)
Table of Contents
- Introduction
- Background to Development of Basel Capital Accord
- Overview of the Basel Capital Accord (BCA)
-
Problems with the new BCA from Public Interest Perspective
- Trends in Bank Supervision (esp. Gramm-Leach-Blily)
- Global Financial Consolidation and "Too-Big-to-Fail" Risks
- Addressing Causes of Financial Crises
- Credit Creation for Low/Middle Income Groups and Predatory Lending
- Non-Bank Financial Institutions - Need for Public Input
The Basel Committee on Banking Supervision (BCBS) is a committee of bank supervisory authorities from the G10 (i.e. the wealthiest 10 nations). They meet regularly at the Bank for International Settlements in Switzerland and are in the process of putting together the international agreement known as the Basel Capital Accord (BCA). This sets bank supervision, risk-based capital and disclosure requirements for banks operating internationally. These concepts are described more fully in Sections 2 and 3. The new BCA will effect the activities of all large international banks, and will probably be adopted by more than 100 countries.
While such an Accord might seem rather obscure and irrelevant to the general public, this is perhaps more a feature of the general ignorance, secrecy and complexity surrounding the operations of the international banking and monetary systems than anything else. The purpose of this paper is to act as a discussion document to start gathering concerns from various NGOs working on monetary/finance system issues so that more comments representing public interest issues can be submitted to the BCBS for its next comment period in 2002.
This Accord is of particular interest because of:
- Increasing Power of International Creditors over Debtors. International banks affected by BCA create the bulk of the money we all use in day-to-day living, especially the US currency which is the backbone of the international monetary system. The power of international creditors, particularly those responsible for money creation in the US Dollar, over debtors is increasing. This, in combination with the collapse of the gold standard and the original Bretton Woods structure in 1971, as well as the trend for western corporations to seek financing outside the banking sector, has lead to increasingly reckless behavior of these bank creditors. This is especially true where they can exercise their "powers" to access "collateral" (real assets) crucial to less powerful debtors - e.g. through IMF Structural Adjustment Programs internationally, and through predatory lending and foreclosures domestically. Such activities are increasing income and wealth gaps globally. Good supervision of, and appropriate capital standards for, powerful creditors can help curtail this recklessness.
- Increasing Financial Consolidation: Both domestic and cross-border consolidation of financial services companies is continuing to escalate in the wake of global financial deregulation and the collapse of banks in various countries after financial crises. This is leading to the emergence of huge global "financial empires" domiciled in the same G10 countries that create the "hard currency", dominate institutions such as the IMF and set the rules for international banking. Also, the bigger a financial corporation becomes the more it becomes "too-big-to- fail". Big creditors at the heart of the international financial system are very likely to get bailed out no matter what they do, for their collapse could collapse the entire global financial system. This creates a tremendous "moral hazard" proportional to size and global reach. This further increases the powers of large western creditors over sovereign nations.
- Trends in Bank Supervision and Financial Convergence. The new BCA comes at a time of significant changes in the supervision of large banking operations. In the Western nations, over the past decade or so, we have seen insurance, banking and brokerage operations all merge together. One of the last countries to jump on this bandwagon was the United States with the Gramm-Leach-Bliley act of 1999. This made the Federal Reserve, the central bank of the United States, the new umbrella supervisor of financial conglomerates. The potential for conflicts of interest arising from the driver of monetary policy for the linchpin currency also regulating and supervising large financial players are enormous. Most other countries employ a fully separate government body for this regulatory role and one under democratic control. This strange move in the US could have significant worldwide impacts.
- Moral Hazard Created by the IMF. The larger international banks affected by BCA also seem to be the primary beneficiaries of the IMF bailouts associated with many recent financial crises. IMF bailouts are the insurance provided by the general public if the risk-management strategies of large creditors (including the holding of risk-based capital) fail. In one sense strong risk-based capital requirements can provide an antidote to the increasing "moral hazard" created by the IMF bailouts. Risk-based capital can be used to prevent crises by forcing international creditors to take more responsibility for the risks they assume and this will help prevent the need for severe "cures". It forms a "capital charge" on banking institutions, similar in effect to what the Tobin Tax would do to international speculators in general. A charge on the banking sector is most crucial because they are the most likely to get bailouts.
- Increasing Complexity of Financial Instruments. Convergence of financial players, increasing consolidation of wealth in fewer hands, hedging strategies and innovative regulatory avoidance have created whole new worlds of complex financial instruments. The regulators themselves are admitting that this makes it increasingly difficult to really understand what is going on at these financial conglomerates and, in fact, to regulate them. As we shall see, this is reflected extensively throughout the new BCA with the development that "sophisticated" banking operations will be able to set their own capital requirements to a very large extent. This may be the first step toward "self-supervision" of banks, which is especially dangerous as "too-big-to-fail" risks and dependence on IMF "cures" increase.
- Domestic Predatory Lending and Credit Access for Low/Middle Income: Within the US, in the sub-prime market, banks have been incented to assess good credit risks (that should get a prime rate) as sub-prime because they could charge a higher interest rate without having to hold higher capital. Presently in the US extensive problems have emerged with respect to bank's activities in low and middle-income groups. Bank capital requirements should address such exploitation of the poor, and supervision requirements in general should address the whole issue of credit access on reasonable terms for low/middle income groups. These issues are not presently addressed at all in the existing BCA.
In the following sections I wish to unravel some of the main features of the Basel Capital Accord and highlight what I perceive as some of the issues that the general public should be concerned about. In doing so I will attempt to relate the significance of BCA to these above-mentioned issues of global finance sector deregulation, mergers and acquisitions, IMF bailouts, low income credit access, bank supervision trends, and the general imbalance in creditor/debtor relations.
However it should be noted that I am making these observations and drawing conclusions based on public information analyzed using skills acquired in my own training as an actuary who has been primarily concerned with the insurance industry throughout my career. In looking at the banking sector extensive information about exactly what is going on underneath is not easy to find in the public domain.
Based on public information it is not easy to fully understand a bank's risk exposures and it has been widely acknowledged by many bank industry watchers that this is a key part of the success of the monetary system. For the monetary system is no more than a confidence game and this requires confidence in the banks at all times, especially those responsible for the creation of the linchpin currency - the US Dollar.
This necessary "secrecy" surrounding the monetary system in order to keep confidence in the ($US driven) financial system probably has a lot to do with the secrecy that surrounds institutions like the IMF. Public information from the IMF does not reveal how bailout sums are determined or what creditors are at the other end of the bailout packages. Nor do public bank financial statements reveal such details. It is highly likely that the main beneficiaries of IMF bailouts are large western creditors with banking licenses (and therefore those "regulated" under BCA standards) since these institutions sit closest to the heart of the international monetary system. Any large hit to their balance sheet is most likely to threaten global financial stability.
In no way do the opinions expressed herein reflect the views of my employer nor the views of the professional actuarial societies of which I am a member. In fact the International Actuarial Society, representing these organizations, has submitted public comments on BCA that do not overlap at all with the concerns expressed herein. Nevertheless I consider it the duty of any professional to consider the broader public implications of the goings on in their profession. My profession is built around the practice of financial risk management and it is my opinion that the financial and other risks to the broader public of the global financial order are unacceptable, so this is why I write this paper. I do not consider this exercise to be inconsistent with my duty as an actuary to sound alarm bells when risks are getting out of hand.
2. Background to Development of Basel Capital Accord (BCA)
The first BCA came into existence in 1988. More information about the original Accord can be found at the web site of the Bank for International Settlements (BIS) at www.bis.org . The BIS is an international bank for central bankers, whose dominant members are the central banks (NOT governments) of the G-10 + Switzerland. More recently other countries' central banks have been able to join the BIS but it is dominated by the G-10. I cannot be certain of all the things the BIS does but I think it is important to note that this is the main place for the meeting of minds of the world's most powerful central bankers. These meetings are conducted in private, as are the Federal Reserve's Open Market Committee and Federal Advisory Council meetings. No doubt, very key decisions about the international monetary system - the same monetary system we all depend on - are made behind these closed doors.
The BCA of 1988, according to the BIS web site, came out of the need to set consistent capital standards for international banks so that one country's banking sector would not have regulatory advantages over another. A "behind-the-scenes look" would reveal that in the late 1980s the US and other bank regulators saw the need to introduce better risk-based capital requirements in the wake of the emerging Savings and Loans Debacle and the Latin American Debt Crisis. In both crises the banks were holding capital way short of what the risk of default of their loans implied and this ultimately led to the need for bailouts (from US public and Latin American public).
The BIS web site also states that the new BCA is coming out of a need to get away from "one size fits all" requirements, and the need to better incorporate operational and market risks (to be discussed in Section 3) into capital requirements. They also state that "sophisticated" banks should be allowed to use their own internal risk management techniques to set their own capital levels. A behind-the-scenes look reveals that the financial crises of the 1990's and subsequent IMF bailouts scared the heck out of those at the helm of the financial system. They found that the old BCA did not have a sufficient capital charge for very risky cross-border loans over that for safer ones. Hence many creditors were incented to engage in very risky cross-border financing which played a large role, not only in triggering the crisis, but also in all the trouble the western creditors found themselves in once the crisis emerged.
The meetings of the Basel Committee on Banking Supervision (BCBS), responsible for the BCA, are hosted by the BIS and are also conducted behind closed doors. Public input into draft BCA documents has been welcomed, however, and this opportunity has certainly been utilized by the global finance sector. So far the major groups of NGOs opposed to the Bretton Woods institutions and the global financial order have not provided input and I am certain the BCBS is not expecting them to. Therefore it would be very nice to give them the big surprise of public input from the members of the public who are not large, powerful financial players. This makes sense especially because this public is called upon to bailout banks whose capital can't cover their risks.
The latest "public" comment period ended on May 31 st 2001. Due to the extensive complaints received from the banking sector (who, of course, wish to hold less capital and be less supervised) the BCBS is saying that they will have another round of comments for another (more bank friendly, no doubt) revised draft in 2002. It is important to note that the BCBS is currently chaired by William McDonough, the current President of the Federal Reserve Bank of New York, and who therefore sits on the Federal Open Markets Committee - THE committee that determines monetary policy for the world's linchpin currency.
As noted, the BCBS is composed of central bankers from the G-10. This is a critical observation for several reasons. First, bank supervision standards are being set only by the wealthy countries that create all the "hard currency". Second, bank supervision standards are being set by those responsible for monetary policy, not by separate national government bodies responsible for bank supervision. The domination by central bankers in this process means that most of the input will come directly out of the banking sector, rather than the general public or their elected representatives.
In a better world a large part of the role of bank supervision would be to protect some balance of power between creditors and debtors. Instead the large international banks seem to be moving into a world where they are gaining more ability to "supervise themselves" and this will become more evident as we study BCA. The structure of the BCBS and its role in producing the BCA is consistent with this observation.
In a much better world the actual process of money origination would be democratic, which it is far from today. The reality is that we are stuck with the international monetary system based on the US dollar because that is what people all over the world have placed their confidence and trust in. This is unlikely to change in any hurry, though baby steps are being taken with the emergence of local currencies. In the meantime it makes sense to focus attention on the supervision of those with credit creation powers in the dominant "trusted monetary system", regardless of how unsavory this system and its major players have become.
It is important to note that BCA covers ONLY international banking institutions. It does not cover non-bank financial institutions (NBFI). In one sense it is quite reasonable that banks should have tougher capital requirements and supervision standards on them for the following reasons:
- They have the special privilege of being able to "create money out of thin air", and must use that privilege responsibly else the safety of the whole financial system is put at risk.
- They have various guarantees or bailout mechanisms backing them up such as FDIC funds and, of course, the IMF bailouts that nobody wants to give us too much information on.
However the emergence of the NBFIs poses a problem and this is giving the banks a lot of leverage in arguing against tough capital requirements. Basically NBFIs have emerged as a result of huge accumulation of financial capital into few hands and the development of new instruments such as loan-backed securities. This means that large NBFIs without a banking license (who do not create M3 money) can compete with bank financiers, so they may have an advantage if banks have to comply with tougher capital and supervision requirements.
Hence many banks are approaching the BCBS with the complaint that the BCA unfairly penalizes them for being a bank. Rather than ignoring these arguments on the basis that the banking sector has privileged access to various bailout mechanisms that NBFIs don't, I fear that the BCBS may cave in to such arguments. Hence it is important for the concerned public to remind the BCBS of these things and this makes it even more important to get access to the list of creditors benefiting from the IMF bailouts.
If NBFIs are also benefiting from these bailouts then maybe the solution is that NBFIs also need something similar to the BCA. In any case that would be recommended from the point of view of prevention of crises for tougher capital requirements help curtail speculative activity.
3. (Very Brief) Overview of BCA Standards (see www.bis.org/ )
The BCA contains what are known as the three pillars of bank supervision. These are:
- Pillar 1: Risk-Based Capital Requirements
- Pillar 2: Supervisory Review Process
- Pillar 3: Market Discipline = Reporting and Disclosure Requirements
Each of these are now discussed in turn: Pillar 1: Risk-Based Capital Requirements
Capital is the excess of a bank's assets (mostly loans to the non-bank public, including security holdings) over its liabilities (primarily deposits of the non-bank public).
Risk-based capital requirements demand that a bank's capital (or equity) be at least as large as something specified as minimum capital.
Minimum capital requirements act like a safety net and are set based on the riskiness of a bank's assets. If a bank makes lots of risky loans or holds risky securities, then it must hold more capital -more of a safety net - than a bank that takes less risks. Thus capital requirements act like sort of a charge on risky speculations. This helps to curtail risky speculation (which can often serve to destabilize markets) and provides institutions with a capital buffer big enough to absorb the higher expected losses on the asset. In turn this helps reduce the need for publicly funded bailouts of the banking industry such as what happened with the S&L Debacle and what seems to happen with IMF bailouts.
Advocates of the so-called Tobin Tax should be rather fond of well-crafted capital requirements for banks and also other non-bank speculators. Therefore it would be appropriate for such advocates to have some input into BCA.
To see how banks view capital requirements and to see why they like this charge to be as low as possible (especially since handy public bailouts are often available anyway) it is useful to look at an example.
Example of the "Cost of Capital" Charge:
- Suppose shareholders have 10 units of equity capital to invest in a bank.
- Let's suppose the bank's assets will earn 5% and its liabilities will costs 3%.
- If capital requirements are at 10% assets, then the bank can create a total of 100 units in assets by lending with 90 in liabilities and 10 in capital. Then shareholders Return on Equity (ROE) is:
(100 * 5% - 90 * 3%) / 10 = 23%
- If capital requirements are at 5% assets, then the bank can create a total of 200 units in assets by lending with 190 in liabilities and 10 in capital. Then shareholders Return on Equity (ROE) is:
(200 * 5% - 190 * 3%) / 10 = 43%
Banks refer to the "cost of capital" as the earnings that are given up by holding capital earning whatever the assets are invested in (usually a low risk bond rate) versus the required shareholder return rate, which for banks is normally around 20% after tax. In the case of the example above we might like to calculate the cost of capital of the extra 5 units of capital that had to be held as capital in the 10% requirement, but got to be released and invested in banking business (making loans) for another 100 in loans in the 5% requirement.
The costs of capital of these 5 units is:
Earnings on 5 units in 5% Capital Requirement - Earnings on 5 Units in 10% Capital Requirement
= (100 * 5% - 95 *3%) - 5% * 5 = 1.9
This equates to an ROE cost of 1.9/5 = 38% = 43% - 5%.
So you can see why banks like lower capital requirements on the same set of assets and why good risk-based capital requirements help deter certain risky or speculative activities.
Minimum capital is defined in BCA as:
8% * Risk Weighted Asset Base
The risk weighted asset base brings assets into capital requirements commensurate with the risks associated with them. These risks are:
- Credit Risk = Default risk.
- Market Risk = Risk of loss on market positions in the "Trading Book" (defined later).
- (Note that Interest Rate Risk is NOT explicitly addressed here but rather is addressed under Pillar 2).
- Operational Risk = other risks such as computer failure, mistiming trades, fraud.
In what follows I will focus primarily on Credit Risk requirements because this is the primary risk for banks and is the main culprit in financial crises. Explanation of how this risk is being treated under the new BCA will serve to illustrate the direction things are headed in and will sound most of the necessary alarm bells.
Credit Risk Assessment
The contribution of bank assets (loans or securities) to the risk weighted asset base for credit risk can be calculated using one of these methods:
- Standardized Approach to Credit Risk: Each bank asset is assigned one of the following weights to enter into the Risk Weighted Asset Base;
0%, 20%, 50%, 100% or 150%
The factor will be selected based on the claim counter-party type (sovereign, bank, corporate) and their rating from an independent body such as Standard and Poors, or the Export Credit Agencies. For claims such as retail mortgages a blanket 50% is used and for unrated entities a blanket 100% is used. Interestingly a risk weighting of 100% for commercial real estate is being proposed because this area has been so much of the cause of recent financial crises.
Though a passing statement is made about higher risk weights for higher risk loans, no explicit mention is made of certain types of loans that caused great shocks to the financial system in the late 1990s. Specifically I am talking about the loans underlying the Long Term Capital Management (LTCM) crisis whereby major US banks lent heavily to this high-risk, highly leveraged hedge fund whose losses almost collapsed the global financial system. Given the growth in these hedge funds and similar vehicles, their tendency to get debt capital from banks on favorable terms, and the fact that they are NOT REGULATED because they involve "sophisticated investors" the BCA should address this explicitly. The unnamed high risk activities with discretion for setting capital requirements is an area wide open for abuse.
BCA also sets out the capital relief that will be given for various credit mitigation techniques, such as collateral against loans, guarantees, and credit derivatives. This is based on the amount of the asset covered by such risk mitigation techniques.
- The Internal Ratings Based (IRB) Approach
- First bank assets are categorized into one of the six categories of corporates, banks, sovereigns, retail, project finance, and equity.
Under the IRB approach banks will use their own internal measures and techniques for setting the Probability of Default associated with each borrower grade. Either the regulators (under the Foundation Approach) or the banks themselves (under the Advanced Approach) will set the other variables for assigning a risk weighting - these include Loss Given Default, Exposure at Default and treatment of guarantees and credits.
The risk weights for each asset are derived using a continuous formula specified by the BCA which assumes a normal default distribution, and is function of both the probability of default, the loss given default and the maturity of the loan under the advanced approach. Another adjustment is made to the group of assets for concentrated risk exposure to single borrowers. No adjustment appears to be made for single groups of related borrowers, which might be a problem, and has certainly been a problem in recent financial crises.
Under these approaches capital relief is also given for credit risk mitigation such as collateral, guarantees, and credit derivatives based on the amount of the asset covered.
There are very detailed sets of rules for the circumstances under which banks may be able to set capital requirements under the Standardized, IRB - Foundation and IRB - Advanced techniques.
Without going into this detail here I think it suffices to use the terminology that the BCA uses - that sophisticated banks with sophisticated risk management techniques will be the ones that get to set their own capital requirements, which are then to be reviewed by the Bank Regulators under Pillar 2. This means that, generally, the self-setting of capital requirements will be done by the largest international banks who also suffer most from the "too-big-to-fail" moral hazard risk.
These are the same banks that tend to exercise power over their regulators rather than the other way around. Furthermore the complexity of both the methodology for the subjective approaches and the complexity of the underlying financial instruments will make it very difficult for the regulators to adequately monitor capital requirements. For example, instruments like credit derivatives are very new, and will often be used for purely speculative, as opposed to risk-mitigation, purposes. Self-setting of capital requirements for such new, complex and speculative investments is wide open for abuse. It is very interesting that the insurance industry regulators do not yet allow such capital relief on credit derivatives.
Market Risk, Interest Rate Risk and Operational Risk
- Market Risk is now referred to as "trading book" risk and covers those positions in financial instruments and commodities held with trading intent or to hedge other risks in the trading book. Trading intent includes benefiting from short term price movements and locking in arbitrage profits. Evidence of trading intent must be available.
- The BCA specifies asset valuation techniques for trading book risks and specific risk capital charges as a percentage of these asset values and capital relief for various hedging strategies. Without having assessed the impact or implications of these separate requirements I will just note that these types of distinctions between trading book and non-trading book assets can create regulatory arbitrage opportunities from the decision of where to place assets based on where they have the least capital requirement.
- Interest Rate Risk arises from duration mismatch between assets and liabilities which is a major profit source for all financial operations. It is interesting to note that capital requirements for this are being dealt with under Pillar 2, to be assessed on a case-by-case basis in the supervisory review, rather than having any minimal capital requirements or basic tests specified under Pillar 1.
- It is also interesting to note that the insurance industry, for many years, has had specified minimum capital requirements for mismatch risk based on the nature of liabilities as well as mandated asset adequacy tests whereby interest rate shocks are applied to asset/liability portfolios to test the adequacy of assets. The subjectivity of the banking industry's approach could leave this need for capital open for abuse.
- Operational Risk arises from all other major sources of risk - such as systems failure, mistiming of trades, fraud and so forth. It is extremely difficult to assess and, like with other risk measures, a range of options are available from specified % income to highly subjective requirements for the "sophisticated" banks.
Pillar 2: Supervisory Review Process
This section of the BCA describes the role of bank supervisors in making sure that banks are managing their risks appropriately. This involves review of banks' risk monitoring techniques and ensuring that banks comply with minimum capital requirements. Obviously this role of the supervisor will become many times more complicated than it has been for those classified as sophisticated banks. This is because of the level of subjectivity and complexity involved in these banks being able to set their own capital requirements.
In my view an adequate supervisory effort in the context of increasingly complex and subjective capital setting methodologies, in conjunction with the convergence of financial services, the increasing cross-border acquisitions, and the growing complexity of financial instruments is becoming almost impossible for the largest financial players. As noted earlier this is also where the "too-big-to-fail" moral hazard and associated risk is also greatest.
Interestingly the current BCA draft states, in its section on Pillar 2 that "Bank management clearly bears primary responsibility for ensuring that the bank has adequate capital to support its risks". This sounds very nice. If only it were true! Then we might have avoided so many nasty financial crises whose costs were ultimately borne by the public and generally by those who could least afford it. In this statement I would have to say that the BCBS is wrong, and that this view they have is leading bank supervisors down a very dangerous path. Because banks sit at the heart of credit (money) creation - at the heart of the international monetary system that we all depend on - it is the PUBLIC in general, not bank management, who bear ultimate responsibility for whether or not the banks have adequate capital and risk management techniques. The BCBS, and bank supervisors in general, clearly need to be reminded of this as they seem to have forgotten that they have any responsibility to the public at all.
Pillar 3: Market Discipline or Public Disclosure
This includes disclosure of risk exposures and calculations of risk-based capital, risk mitigation techniques, and comparison of minimum capital to actual capital. Without seeing an example or explicit list of reporting requirements it is difficult to know how detailed this will be. Nevertheless it sounds like it has potential for the general public to understand just what kind of risks the banking industry is getting us into.
What already has become clear is that the major banks are complaining about the amount of detail of disclosure required under this Pillar. However, given the statements above about who ultimately bears responsibility for bank risks, the public should prefer very detailed disclosure, and maybe even add some additional requirements - such as details of loans rescued by the IMF.
4. Problems with the new BCA from Public Interest Perspective
Bank supervision and the setting of risk-based capital requirements are very complex issues. Mandating risk-sensitive capital requirements for banking book assets is very complex because of the diverse range of complex assets and loan structures banks can invest in (or really, create money for). The mandating of quantitative capital requirements tends to lump together assets with different risk profiles into the same minimum capital requirement class. This then leads to problems with banks investing predominantly in the most risky of this class where the returns are higher, but capital requirements the same, as for a lower risk asset.
This reality played a major role in laying the foundations for the Asian financial crisis whereby so many loans made by large creditors were related to overpriced real-estate that didn't carry a capital charge over safer loans. There is no question this was also a primary cause of the Latin American Debt crisis, the aftermath of which helped create the first round of Basel Accords. There is also little doubt that this facilitated the Long Term Capital Management Crisis, heavily funded by large US banks.
It is highly likely that this problem of mandated % capital requirements for broad asset groups and the extensive "regulatory arbitrage" it generates is a large part of the rational behind the BCA recommendations of Internal Ratings Approaches. Here banks largely set their own capital requirements based on their internal assessments of risk for the specific assets they hold. It is then thought that the supervisory role of regulators and various disclosure requirements will ensure that banks' capital levels and risk management techniques are adequate.
In a world where bank regulators truly represented the interests of the public, and the public had extensive oversight and input into banking system operations and risk management, this would sound like a pretty good idea. It would also require that bank regulators actually have the resources and ability to properly monitor bank risk exposures and capital levels, as well as the necessary authority to make banks improve their practices where needed. Unfortunately none of these conditions hold today and this is discussed in more detail in the following points.
As noted earlier bank supervision has undergone radical shifts in recent decades in part due to the worldwide convergence of financial services - banking, brokerage and insurance - operations. This has created large conglomerates involved in all aspects of financial services and resulted in new regulatory structures in the form of "umbrella supervision" of the new conglomerates. This has complicated financial supervision and also may create a shift towards more uniform supervision across financial operations (though we are not there yet, or even close).
The last major industrialized nation to merge financial services was the United States in 1999. Under such changes the Federal Reserve became the US Umbrella Supervisor of Financial Services Conglomerates, in addition to retaining its previous powers as bank holding company and state-chartered bank supervisor. While the US Government body known as the Office of the Comptroller of the Currency still retains some powers as supervisor of national banks, today the Federal Reserve is the "king of regulators". It seems that the Federal Reserve will have the ultimate responsibility for the supervision of all big financial operators based in the United States. It is the Federal Reserve in the United States who will ultimately oversee the standards set by BCA, because BCA applies to the international players that will be supervised by the Fed.
This reality is potentially fraught with peril for a number of reasons. First, although the Federal Reserve has some government oversight its operations are disproportionately controlled by the private banking sector itself, the very same group supervised by the Fed. This domination by the banking sector comes partly from the role of the Federal Advisory Council, who are the primary Federal Reserve Board advisors and are 100% bankers. It also comes from the fact that most (67%) of the directors of the 12 Federal Reserve Banks are appointed by the banks, and that the Federal Reserve Board is generally dominated by Wall Street choices.
Second is the fact that the Federal Reserve is first and foremost responsible for the monetary policy of the world's linchpin currency, the US Dollar. The role of supervisor - concerned with safety and soundness in the banking system - can and does often directly conflict with the goals of monetary policy. This creates the potential for very harmful conflicts of interest with worldwide consequences. A classic example of this arose before the Latin Debt Crisis when the Federal Reserve, from a monetary policy point of view, wanted to raise interest rates to squash inflation. At the same time, based on earlier years' desire for credit expansion (a monetary goal), the Federal Reserve (as bank holding company supervisor) had allowed banks to expand loans well beyond what their capital levels could support. So by the end of the 1970's past credit expansion had led banks into a situation where defaults on Latin loans could not be swallowed by their low capital levels, and the Fed's desired increase in interest rates would surely trigger such defaults. The end result that solved this conflict - hike up US interest rates, trigger the Latin Debt Crisis and have the IMF and World Bank come in as lenders of last resort to bail out the US banks! And who paid for this crisis for which the conflict of interest in supervisory structure/monetary policy was largely responsible? The people of Latin America, of course!
The recognized dangers of having the umbrella financial regulator be the same entity as that responsible for monetary policy are illustrated by the fact that no other major industrialized nation has put these two, often conflicting, functions under the same body. The fact that this has been done only in the country that is responsible for credit creation in the linchpin currency could have serious global ramifications as the example of the Latin debt crisis indicates.
The situation in the United States before Gramm-Leach-Bliley was that the Federal Reserve as bank holding company supervisor would basically assign staff either from Washington and/or the local regional Fed bank to work permanently on the supervision of the larger banks. These staff work mostly on site at the big banks, sort of like permanent fixtures there, or actually like staff of the banking group itself. These close relations are likely to get even closer under the "self-regulation" approach proposed by BCA for the larger banks, and don't bode well for independent supervision of the larger banking entities.
The incredible complexities of monitoring the capital adequacy of financial conglomerates in a world of increasingly complex instruments and loan structures under the "self-regulatory" methods of the Internal Ratings Based (IRB) approach (specified by BCA) will likely make adequate bank supervision a Herculean task! Given that a potentially talented bank supervisor would makes pots more money working for the banks themselves, the job is close to impossible and therefore wide open to abuse by those banks most likely to adopt IRB. That is, the big banks, and the ones for which bailouts are most necessary.
These new rules have the potential to increase both the frequency and severity of IMF bailouts by allowing more risks to be taken and by allowing those most in need of bailout mechanisms the most leeway for "bending the rules" during their "self-regulation".
International treaties like GATT, administered by the WTO, and under which new financial services agreements have been added, are accelerating the pace of cross-border acquisitions by large Western institutions. Another contributor to this activity was the Asian financial crises, in the aftermath of which various countries and investors were forced to sell off their bankrupt financial institutions at fire-sale prices to the Western institutions who benefited from the IMF bailouts.
Domestically, within the borders of the G-10 countries, mergers and acquisitions between financial institutions have also been accelerating. This is creating huge "financial empires" that are increasingly too-big-to-fail and, as noted earlier, will also be able to set their own internally determined capital requirements. The incentives for abuse of minimal capital requirements created by the "too-big-to-fail" moral hazard are tremendous. This may also give the larger players extra competitive advantages via lower capital charges and thereby facilitate more acquisitions.
Furthermore these financial empires seem to be acquiring greater powers over their own supervisors, meaning that supervisors may not be able to control them anyway, even if they wanted to. Further compounding the problem is that these same regulators are allowing mergers and acquisitions to proceed unheeded. The best example of that recently was the Federal Reserve's speedy approval of Citigroup's acquisition of the Mexican banking giant Banamex. The Federal Reserve completely ignored all public opposition to this deal, and gave no justification for its approval or for overlooking public complaints. One can conclude from this that the Federal Reserve, now the financial regulation king, does not consider itself at all subject to the discipline of democratic accountability.
We saw earlier that some of the requirements in the new BCA are aimed at addressing some of the causes and excessive risk taking that ended in various crises such as the Latin American Debt Crisis, the Asian Financial Crises and the US Savings and Loans Debacle.
Yet other areas of concern are notably absent. The past few years have seen a rise in what are known as hedge funds which are generally high risk, highly leveraged investment funds for the extremely wealthy. They are also completely unregulated on the premise that they involve "sophisticated investors". As we saw in the case of the Long Term Capital Management fund, banks have been making significant loans to these hedge funds without any corresponding capital charge commensurate with the risks involved. Fortunately the banking industry was able to bail itself out of this crises and the public did not have to bear the costs of the associated recklessness. However the new BCA does not appear to address this increasing risk of exposure to hedge funds explicitly at all. With no extra capital charge on hedge fund financing, banks are probably taking excessive risks in this area. This also exacerbates the risks that hedge funds introduce into the markets by providing them with an easy source of financing.
The new BCA also does little to address the issue of bank speculative activity, outside more traditional loans, and what risk this introduces into the financial system in general. For example some disincentive on speculative activity like currency attacks would go a long way towards reducing major risks in the financial system.
The fact that under both the old and new BCA there are no additional capital charges for sub-prime loans seems to have created a situation whereby banks are originating a significant amount of sub-prime loans to prime risks. This tends to happen with mortgages in the lower income markets and, in fact, in 2000 the Chairman of Fannie Mae reported that about one third of sub-prime home loans in the US actually could have received a prime loan if credit assessment had been done properly.
It seems that the lack of capital charge differential has incented a number of banks to offer higher yielding sub-prime loans which reflect a higher risk in the return but not in the capital charge. This has had tragic consequences for these borrowers with many people losing their homes in recent years. I am pretty sure that the folks who meet in Basel don't have lower income customers much on their minds, therefore it is very important for NGOs to make this point.
In general the whole area of predatory lending and credit creation powers over the poor must be addressed in bank supervision standards and is currently nowhere to be found in BCA. In the US for example, the banking industry has a long history of discrimination in providing credit to various groups and a poor record of providing credit on reasonable terms in low and middle income neighborhoods.
Part of the tremendous growth in both overseas lending and sub-prime lending by US banks has surely been driven by the fact that domestic non-bank corporations have sought financing from non-bank sources such that only 20% of their financing actually comes from banks. This has lead to banks increasingly accessing the retail and overseas markets for credit creation. In both of these markets the banks have not behaved well, and have abused their power over financially weaker debtors. Only stronger bank supervision representing the interests of these debtors can help remedy such problems.
Supervision of US financial holding companies by the Federal Reserve does not bode well for any representation of the interests of poorer and foreign creditors in bank supervision. The Federal Reserve has a long track record of ignoring the interests of these groups and indeed has been lax in enforcing standards such as the US Community Reinvestment Act. A sneak preview of how the Federal Reserve may respond to interests of these groups in the future was provided by the Fed's speedy approval of Citigroup's recent acquisition of the Mexican banking group Banamex. In this approval the Federal Reserve completely ignored all complaints from NGOs representing low income groups who have been harmed by Citigroup's widespread predatory lending abuses. The total non-response by the Fed to all complaints about the merger has lead many observers to wonder whether Citigroup actually supervises the Federal Reserve now.
BCA does not cover non-bank financial institutions. However we are seeing various countries' umbrella supervisors feeling the pressure to streamline regulation in the wake of financial services convergence.
One the surface it might not make too much sense for a non-bank lender to have different capital requirements than a lender with a banking license. However it does make more sense if one considers that banks are backed up by various bailout mechanisms including the IMF and FDIC, due to their special status of being creators of money for the (M3) money supply. Because of this central role in money creation it is more important for confidence to be maintained in banks than in non-bank institutions. This is what maintains the overall confidence in the international monetary system. Therefore the likelihood of bailout is much higher for banks, particularly the large ones, and bank capital requirements are of much greater interest to the public than those of non-bank financial institutions.
That said, there could also be a very important role for risk-based capital requirements on non-bank financial institutions to curtail the type of speculative activity often responsible for causing crises in the first place. People opposing the Bretton Woods institutions and advocates of the Tobin Tax might want to keep this in mind as risk-based capital standards develop across other financial players.
The previous sections have been prepared to present a case for public input into the Basel Capital Accord for the majority of the public who are not aligned with the interests of big financial players, but are certainly affected by such international banking agreements. Supervision of banks and their risk management practices are important public issues for reasons outlined above.
However the unfortunate reality is that, of the 200+ public comments received by the BCBS, only 1 or 2 are public concerns from outside the finance sector. These comments can be viewed at the BIS web site at www.bis.org . The majority of comments coming from the larger banks (e.g. comments from Citigroup and the American Bankers Association) are generally asking for more leeway in setting their own capital requirements, and basically requesting lower capital standards. Furthermore there have been many complaints from the big banks about the proposed disclosure requirements.
Originally the last comment period was supposed to be the one ended May 31 st , 2001 but due to the number of comments about the current draft the BCBS has stated on its web site that it will issue another draft for comments in early 2002. Hopefully this will provide opportunity for various NGOs to compile and submit a list of concerns. This document is intended as a discussion document to begin the process of collecting comments and concerns from various NGOs working on monetary system issues.