FRBSF Economic Letter

1999-23 | July 30, 1999

The Basel Proposal for a New Capital Adequacy Framework

Jose A. Lopez

Western Banking Quarterly is a review of banking developments in the Twelfth Federal Reserve District, and includes FRBSF’s Regional Banking Tables. It is published in the Economic Letter on the fourth Friday of January, April, July, and October.


In 1988, the Basel Committee on Banking Supervision, an international organization of bank supervisory agencies, adopted a capital adequacy framework for internationally active commercial banks based in the G-10 countries. However, after ten years, the limitations of that framework have become increasingly apparent. Last month, the Committee released for comment a proposal for a new framework that would replace the current one. This Letter briefly describes the increasingly important limitations of the current framework and the new proposal’s main features.

The 1988 Basel Capital Accord

The capital held by any firm helps to absorb possible business losses and thus protect its creditors. For banks, capital also provides this protection to government agencies that insure depositors, such as the FDIC. Consequently, bank supervisory agencies have an interest in maintaining adequate capital in the banking system and have used their authority to impose minimum capital requirements. Regulatory capital typically consists of equity and long-term subordinated debt.

A major development in bank capital regulation occurred in 1988 when the Basel Committee on Banking Supervision (the Committee) adopted the Basel Capital Accord. The Accord explicitly linked capital regulations to a bank’s degree of risk. Furthermore, the Accord established minimum capital requirements that were internationally comparable, paving the way for more uniform capital requirements across countries.

The Accord specifically created capital requirements for the credit risk in banking assets. (Credit risk is defined as the possibility of losses due to borrowers’ defaults or decreased ability to repay their debts.) The Accord requires that banks hold as capital at least 8% of their risk-weighted assets. Four risk weights or “risk buckets” were created. The first bucket, generally consisting of claims on OECD governments (which includes the U.S.), has a zero weight. The second bucket, generally consisting of claims on banks incorporated in OECD countries, has a 20% weight. The third bucket, consisting of residential mortgage claims, has a 50% weight, and the fourth bucket, generally consisting of claims on consumers and corporations, has a 100% weight. Following the adoption and phasing in of the Accord, the amount of capital held by banks increased substantially.

Subsequent amendments to the Accord have addressed other issues regarding bank capital. Most importantly, the 1996 Market Risk Amendment set minimum capital requirements for the financial market risks inherent in banks’ trading accounts (accounts that contain assets held for short-term trading purposes). However, the treatment of credit risk has remained the same.

Limitations of the current framework

Over time, several important limitations of the current framework have become apparent, particularly that the regulatory measure of bank risk (risk-weighted assets) can differ substantially from actual bank risk. One example of such a difference stems from the growth in loan securitization. By selling loans to a third party while retaining some exposure via credit enhancements, a bank can effectively remove loans from its portfolio and decrease its required capital without a commensurate reduction in its overall credit risk.

The existing risk weights also can lead banks to shift their portfolio compositions toward lower quality claims within a risk bucket. For example, claims on corporations receive the same 100% risk weight, regardless of whether the corporations are highly rated or lower rated and, therefore, riskier. Since the full 8% capital requirement applies to these claims, a bank would generally favor the riskier claims, which could provide greater returns on investment. Clearly, shifting to riskier assets could keep a bank’s required regulatory capital constant, even though its overall riskiness has increased. Since the current framework provides only a crude measure of bank risk, it sets minimum capital requirements that do not necessarily reflect a bank’s true economic risks and thus are inappropriate for regulatory purposes.

The 1999 Basel proposal

In order to address such shortcomings and respond more directly to recent financial developments, the Committee released for comment a proposal for a new capital adequacy framework. While maintaining minimum capital requirements that are comparable across countries, the framework hopes to provide a more comprehensive approach to addressing actual bank risk. The framework is built on three pillars: minimum regulatory capital requirements that expand upon those in the 1988 Accord, direct supervisory review of a bank’s capital adequacy, and the increased use of market discipline to encourage sound risk management practices.

Minimum capital requirements. The new proposal contains several revisions that should better align capital requirements with actual bank risk. The new risk weights are 0%, 20%, 50%, 100% and 150%. For the so-called standardized approach, the weights on banking assets will now depend on external credit ratings provided by commercial rating agencies, such as Moody’s or Standard & Poor’s. For example, the current zero weight applied to claims on sovereigns would be replaced by a zero weight for highly rated sovereigns and up to a 150% weight for low rated sovereigns. Similarly, highly rated corporate claims would receive a 20% weight, while low rated corporate claims would receive a 150% weight. Generally, unrated claims would receive a 100% risk. Residential mortgages and unsecured consumer loans would continue to receive a 50% and a 100% weight, respectively. By reducing the risk weights for high quality borrowers and increasing them for low quality borrowers, the capital requirements will reflect a bank’s actual risk better and distort its lending decisions less.

The Committee recognizes that banks’ internal rating systems for banking assets also could provide a basis for regulatory capital requirements in certain cases. Risk weights could be assigned according to a bank’s own credit ratings, as long as they meet certain criteria for accuracy and consistency. The Committee hopes to develop such an internal ratings approach in parallel with the standardized approach. Furthermore, the Committee is willing to consider using banks’ own capital allocation models for setting regulatory capital requirements. Such models are used by bank management to measure possible credit losses and to assist in internal capital decisions. However, many difficulties, such as data availability and model validation, must be dealt with before regulators can follow this approach.

The Committee also is seeking to expand capital requirements beyond credit and market risk. Capital charges for interest rate risk in the banking book and for operational risk (risks due to systems failures) are being considered. Specific proposals related to these areas are being developed by the Committee.

Supervisory review. The Committee argues that banks’ own capital positions should be consistent with their overall risk profiles. Thus, the internal process by which bank management assesses and sets capital should be subject to supervisory review. Such oversight would encourage supervisory intervention if existing capital levels do not provide sufficient protection against bank default. Furthermore, supervisors should be able to require banks to hold capital beyond the regulatory minimum under certain circumstances.

Market discipline. The Committee plans to issue more detailed guidance on the public disclosure of banks’ capital requirements and risk exposures. The Committee’s guiding principle is that increased transparency regarding banks’ actual risks should permit better monitoring by private investors, which in turn should encourage better bank risk management and capital allocation.

Conclusion

The Basel Committee’s proposal represents an evolutionary step in refining regulatory capital requirements. By creating capital requirements that are more closely aligned with actual bank risks, the proposal should mitigate many of the shortcomings of the current Accord. However, the proposal will not be the last step in this process. Bank capital regulation will need to adapt as the tools for measuring and managing bank risks continue to improve.

Jose A. Lopez
Economist

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