Reforming the Basel Accord
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Volume 4 Number 4
Editorial Reforming the Basel Accord
Journal of International Banking Regulation, Vol. 4, No. 4, 2003, pp. 298–300 Henry Stewart Publications, 1358–1988
Page 298
In its third and most recent consultation paper, published on 29th April, 2003, the Basel Committee on Banking Supervision reaffirmed the essential elements of its proposed New Capital Accord (Basel II) with the expectation that all countries with international banks would begin implementing Basel II by the end of 2003. Basel II would significantly change the way banks and regulators calculate the amount of capital they should hold against their risk-based assets. Basel II proposes to make significant changes to the original 1988 Capital Accord, which was a landmark international agreement that committed the world’s richest countries to building and maintaining capital levels in their banking sectors. Basel II consists of three pillars: minimum capital requirements; the supervisory review process; and improved disclosure to enhance market discipline. Although Basel II has attracted much positive comment for doing more to improve credit risk management, it has been criticised as being pro-cyclical, favouring big banks with sophisticated risk measurement systems and increasing financial fragility in developing countries. Indeed, the proposed Accord is premised on the beneficial effects of market discipline and supervisory discretion, but it fails to take account of market failure and regulatory capture. The 1988 Capital Accord’s original intention was to prevent a slide in international capital ratios resulting from aggressive competition for market share by the leading banks during the mid-1980s. Banks actively engaged in international transactions were required to hold capital equal to
at least 8 per cent of their risk-weighted assets. This capital adequacy standard was intended to prevent banks from increasing their exposure to credit risk by imprudently incurring greater leverage. The Accord’s use of a risk-based structure for calculating capital ratios, which assigns different capital weights to fewer asset classes (both on- and off-balance sheet), has been one of its greatest contributions. This method not only marked a significant improvement from the previously used gearing ratio method used by national regulators, but it also created less incentive for off-balance sheet activities. In the 1990s, periodic amendments to the Accord extended its capital adequacy requirements to market risk, as well as allowing banks to use value-at-risk (VaR) models. A major weakness, however, of the 1988 Accord was that its rather crude risk weightings led banks to adopt cosmetic changes to their credit risk portfolios. The Basel Committee recognised this problem in 1999 in its first consultation report on Basel II. The Committee observed that the ‘current risk weighting of assets results, at best, is a crude measure of economic risk, primarily because degrees of credit risk exposure are not sufficiently calibrated as to adequately differentiate between borrow
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