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Stronger foundations New proposals for regulating banks are both a step in the right direction and evidence of how hard it is to monitor the riskiness of the banking system

America's banks have spent this week announcing disappointing results, thanks in part to losses from loans that have gone sour. The start of a downturn in the credit cycle is an interesting moment to ask whether banks have enough capital in reserve to cope with their bad loan problems - which, in a roundabout way, is what the Basle committee on banking supervision did on January 16th when it unveiled proposals for new capital-adequacy standards for internationally active banks. Reading between the lines, the answer is not completely reassuring.

The Basle committee proposes to transform the capital requirements that were introduced in 1988, when regulators from G10 countries agreed that banks were woefully under capitalised, a conclusion duly confirmed by banking crises in America, Europe and Japan. The regulators aimed to force banks to hold adequate capital, yet their notion of adequacy was simplistic. It assumed that the ratio of a bank's capital to its loans would reveal whether its capital was sufficient. Though the original 1988 Basle standards were a step towards risk-based capital, with riskier loans requiring more capital to be set in reserve, the definition of risk bore too crude a relation to the actual riskiness of banks' assets.

Basle required banks to hold capital equal to at least 8% of their risk-weighted loans to the non-bank private sector.

Government debt from OECD countries required no capital, because these supposedly bore no credit risk. Non-OECD sovereign debt had some capital requirements, but fewer than for any private-sector loans. Loans between banks also entailed modest capital requirements.

The assumption, crudely, was that a bank with less than 8% in capital reserves was under-capitalised, and one with more than 8% probably had capital to spare. Nowadays, nobody thinks about bank soundness in such a simple manner. With the use of derivatives, a bank with an 8% ratio of capital to loans can get rid of credit risk (i.e. the risk that a borrower will stop repaying the interest or the principal of a loan), and thus end up with capital to spare. Or it might increase its exposure to credit, and thus have not enough. Likewise, a bank might reduce the loans it has on its balance sheet by securitising them. Yet potentially the bank may still be exposed to much of those loans' credit risk.

Securitisation and the more active management of loans are clearly in fashion. Banks used to make loans and keep these on their books until they were repaid. Or, if things went wrong, the loans were written off. Now, banks increasingly look to pass on the credit risk of the loans they originate, preferring to book only the loan-origination fees. In theory, this should shift much of the credit risk of loans away from banks and on to investors in securitised loans. In reality, things are not so simple. Depending on how loans are securitised much of the credit risk may remain with the originating bank, and to an extent that can be fiendishly hard for anyone, regulators included, to discover.

Well-run banks do not need regulators to tell them to keep capital in reserve against credit risk: prudence in the long run plumps their profits. Those big banks leading the charge to securitisation have developed risk-management systems with the sophistication, they hope, to tell them how much capital to set aside. This has made it glaringly clear both to these banks and to their regulators that the regulatory capital demanded of a bank often bears scant relation to what a prudent bank manager would choose to hold in reserve.

Regulators have also seen how the existing Basle rules created perverse incentives that encouraged excessive risk taking by banks. For instance, Basle's crude measures of classifying risk meant that banks had to put aside less capital against a loan made to the government of a banana republic than to a blue-chip company like General Electric. Equally, lending to a company with a just less-than-top notch credit rating required no more capital to be set aside than a loan to near junk-status firm.

Pillars of the community

In June 1999 the Basle committee issued proposals for capital requirements that reflected the true credit risk of loans. These were sound on principle, but weak on detail. Since then, regulators and banks have devoted much energy to fleshing out the details.

There are to be three pillars: a minimum capital requirement, regulatory supervision and disclosure. Banks will be able to choose among different methods of measuring credit risk. At one extreme is a much-improved version of the existing approach. There are many more categories of risk, which allow for the possibility, for instance, that a loan to a company from a developing country is less risky than a loan to that country's government. Certain approved banks will be able to use their own sophisticated credit-rating systems, which attribute to each loan a default risk on historic data. There are detailed new rules on how to assess the riskiness of securitisation; and on how much the risk attached to a loan is reduced when it is backed by collateral. There is a powerful incentive, namely lower capital requirements, to use internal ratings systems, though some banks complain that the carrot is not as big as it could be. Regulators remain wary about seemingly sophisticated risk-modeling. They intend to monitor models' performance before relying too heavily upon them.

Similar, unspoken worries may lie behind a new requirement to set aside capital against "operational risk," such as the possibility of losses because of computer failure, poor documentation or fraud. Some big banks reckon this will simply allow regulators to impose unjustified capital requirements should the use of internal credit-rating models mean too sharp a reduction in the capital at a particular bank or, indeed, a reduction in the banking system as a whole. In the end, though, the fate of the new Basle rules will depend on how they are implemented. American and British regulators are likely to be vigorous enforces, while Japan and Germany, as well as plenty of less-developed countries, will lag behind. Certainly, the new proposals leave national regulators plenty of room to wiggle. Even the best regulators can be seduced by those over whom they are supposed to watch. So the third pillar of the new proposals may well be crucial: market discipline through disclosure. This is supposed to include details of how a bank's internal ratings system is working. If they live up to the Basle committee's claims, disclosure rules should allow investors to throw their weight behind regulatory efforts to keep banks safe and sound. The information now available to investors tells them little that is useful about the riskiness of a bank's lending. The burden lies with regulators, and with rating agencies such as Moody's Investors Service and Standard & Poor's. Given the poor performance of both of these in predicting banking crises in the past, any sunshine that disinfects banks' inner workings has to be welcome.

The Economist

Notes

1. Basle — Basel — Базель

Basle committee — Committee on Banking Regulation and Supervisory Practices — Базельский комитет по банковскому надзору и регулированию при Банке международных расчетов

2. G10 — Group 10 — группа 10 ведущих стран, принявших в 1962 г. обязательства по взаимному кредитованию в рамках общего соглашения, занимается проблемами координации в кредитной сфере