FRBSF Economic Letter
99-23; July 30, 1999
 Economic
Letter Index
The Basel Proposal for a New Capital Adequacy Framework
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
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
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