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Financial Institutions Center The New Basel Capital Accord and Questions for Research by Marc Saidenberg Til Schuermann The Wharton Financial Institutions Center The Wharton Financial Institutions
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Financial Institutions Center The New Basel Capital Accord and Questions for Research by Marc Saidenberg Til Schuermann 03-14 The Wharton Financial Institutions Center The Wharton Financial Institutions Center provides a multi-disciplinary research approach to the problems and opportunities facing the financial services industry in its search for competitive excellence. The Center's research focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its research is informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest. Franklin Allen Co-Director Richard J. Herring Co-Director The Working Paper Series is made possible by a generous grant from the Alfred P. Sloan Foundation The New Basel Capital Accord and Questions for Research 1 Marc Saidenberg 2 Til Schuermann 2 Federal Reserve Bank of New York 33 Liberty St. New York, NY {marc.saidenberg, First Draft: March, 2003 This Draft: May 5, 2003 This Print: May 5, 2003 Abstract: The New Basel Accord for bank capital regulation is designed to better align regulatory capital to the underlying risks by encouraging better and more systematic risk management practices, especially in the area of credit risk. We provide an overview of the objectives, analytical foundations and main features of the Accord and then open the door to some research questions provoked by the Accord. We see these questions falling into three groups: what is the impact of the proposal on the global banking system through possible changes in bank behavior; a set of issues around risk analytics such as model validation, correlations and portfolio aggregation, operational risk metrics and relevant summary statistics of a bank s risk profile; issues brought about by Pillar 2 (supervisory review) and Pillar 3 (public disclosure). Keywords: Bank capital regulation, risk management, credit risk, operational risk JEL Codes: G21, G28 1 We would like to thank Larry Wall for his encouragement and patience and Darryll Hendricks and Beverly Hirtle for their helpful and insightful comments. All remaining errors are ours. 2 Any views expressed represent those of the authors only and not necessarily those of the Federal Reserve Bank of New York or the Federal Reserve System. 1. Introduction There are broadly two sets of reasons often given for capital regulation in financial institutions broadly and banks in particular. One is the protection of consumers from exploitation by opaque and better-informed financial institutions; for banking the objective would be depositor protection. The second is systemic risk. 3 Banks are often thought to be a source of systemic risk because of their central role in the payments system and in the allocation of financial resources, 4 combined with the fragility of their financial structure. 5 Banks are highly leveraged with relatively short-term liabilities, typically in the form of deposits, and relatively illiquid assets, usually loans to firms or households. In that sense banks are said to be special and hence subject to special regulatory oversight. There is a tight linkage between deposit insurance and capital regulation. Deposit insurance is designed to overcome the asymmetry of information in the banking system (Diamond and Dybvig (1983), Dewatripont and Tirole (1994)). The bank knows more about the riskiness of its activities than do its depositors. A depositor, therefore, is unable to tell a good bank from a bad one. Because banks are highly leveraged institutions, depositors have a strong incentive to show up at the bank first to withdraw their funds in case they doubt the financial health of a particular bank. Those at the end of the line may get nothing. In short, 3 Not all observers agree that systemic risk should be an important objective of bank capital regulation. See, for example, Benston and Kaufman (1995). 4 In many countries banks control 70%or more of the assets in the financial system. In the U.S., however, the bank share of total assets has fallen to little more than 20% (Basel Committee on Banking Supervision 1996, p. 126). 5 For an interesting cross-sectoral comparison, see Joint Forum (2001). deposit insurance is designed to prevent depositors from overreacting to bad news about banks. 6 The creation of such a safety net comes at a cost, namely moral hazard. Depositors no longer have an incentive to monitor (or pay to monitor) banks since their deposits are guaranteed up to the coverage limit (currently $100,000 per individual per institution in the U.S.). Banks have an attendant incentive to increase risk. Hence the name of the game in designing a safety net has been to balance the need to prevent bank panics (and other social costs to bank failure such as credit crunches) with the moral hazard brought on by the very presence of the safety net. The regulation of bank capital is often justified to achieve this balance. 7 The literature on the general rationale for capital regulation in financial institutions is extensive and has been the subject of several recent surveys (Santos (2001), Ball and Stoll (1998), Berger, Herring and Szegö (1995)). Bank regulators have long regarded the prevention of systemic risk as the fundamental rationale for imposing capital requirements on banks. The assumption is that shareholders will not take account of the social costs of systemic risk in their capital decisions and so will tend to hold less capital than if these spillover costs were considered. 6 Bank runs and panics were quite real and prevalent in the US in the 19 th and early 20 th centuries. In the years preceding the creation of the FDIC (i.e ), the number of bank failures averaged 2000 per year (Mishkin (1997)). 7 Santos (2001), in a survey of the bank capital regulation, points out the necessity of jointly considering the problems of deposit insurance pricing, lender of last resort and bank capital standards and regulation. In general, the optimal regulation encompasses a menu of regulatory instruments, designed to extract information from banks and minimize the cost of bribing the lower quality banks to mimic the higher quality ones. (Santos (2001) p. 59). In short, while the information asymmetry inherent in banking is a real issue, deposit insurance may not be the only solution, and if deposit insurance is chosen, its design matters in determining banking stability and efficiency. -2- Capital requirements are intended to mitigate the risks of adverse selection by ensuring that the financial firm has at least some minimal level of resources to honor its commitments to its customers. Capital requirements are intended to mitigate moral hazard by ensuring that the owners of a financial institution have a stake in ensuring that the firm does not engage in fraud and conforms to conduct of business rules, if only to avoid fines or loss of equity value. To be effective in this role, capital requirements must be sensitive to the risks to which an institution is exposed. Formal and systematic bank capital regulation is relatively new. The 1988 Basel Capital Accord, or Basel I (Basel Committee on Banking Supervision (BCBS) (1988)), which set minimum capital standards for internationally active banks, was really the first international accord of its kind. It succeeded at raising capital levels at a time when they were quite low. Aside from defining what types of capital were eligible, Basel I set a capital ratio at 8% of risk-adjusted assets. It was the risk-adjustment of the assets which became the focus of concern and current regulatory reform resulting in the New Basel Capital Accord or Basel II (BCBS (2001)). The New Basel Accord for bank capital regulation is designed to better align regulatory capital to the underlying risks by encouraging more and better systematic risk management practices, especially in the area of credit risk. Compliance with an even more risk sensitive capital ratio is only one of three pillars under the Accord. Revisions to the New Accord also introduce banks internal assessments (subject to supervisory review Pillar 2) of capital adequacy and market discipline (through enhanced transparency Pillar 3) as key components or prudential regulation. It may therefore come as no surprise that underlying the Accord is some formal economic modeling. Both the models and their implication for -3- implementation of the Accord open the door to many research questions. We see these questions falling into three groups: what is the impact of the proposal on the global banking system through possible changes in bank behavior; a set of issues around risk analytics; issues brought about by Pillar 2 (supervisory review) and Pillar 3 (public disclosure). The rest of the paper will proceed as follows. In Section 2 we expand on some of the problems that Basel I brought with it; Section 3 will provide an overview of the main objectives of Basel II, details of which are provided in Section 4. In Section 5 we will cover the questions the new accord raises for the research community. Section 6 provides some final comments. 2. Problems with Basel I To understand and appreciate the basic goals of Basel II and the strategy for achieving these goals, it is important to understand the shortcomings of the current Basel Capital Accord (Basel I). Under the current Accord, capital requirements are only moderately related to a bank s risk taking. The requirement on a credit exposure is the same whether the borrower s credit rating is triple-a or triple-c. Moreover, the requirement often hinges on the exposure s specific legal form. For example, an on-balance sheet loan generally faces a higher capital requirement that an off-balance sheet exposure to the same borrower, even though financial engineering can make such distinctions irrelevant from a risk perspective. This lack of risk sensitivity under the current Accord distorts economic decision making. Banks are encouraged to structure transactions to minimize regulatory requirements or, in some cases, to undertake transactions whose main purpose is to reduce capital requirements with no commensurate reduction in actual risk taking. As an example, no -4- capital charge is assigned to loans or loan commitments with a maturity of less than one year. Perhaps not surprisingly, 364-day facilities have risen in popularity. The corollary to this problem is that the current system fails to recognize many techniques for actually mitigating banking risks. A closely related concern is that the current Accord is static and not easily adaptable to new banking activities and risk management techniques. Lastly, some banks may have been reluctant to invest in better risk management systems because they are costly and would not provide tangible regulatory capital benefits. The lack of risk sensitivity also impedes effective supervision. Although both banks and supervisors have been working to improve their assessments of capital adequacy, these assessments continue to center on comparisons of actual capital levels against the regulatory minimums. Bank examiners continue to focus on these ratios in part because they are part of the legal basis for taking supervisory actions. Reflecting supervisors emphasis on regulatory capital ratios, financial markets and rating agencies tend focus on them as well. Consequently, in some cases supervisors and even the banks themselves may have limited information about a bank s overall risk and capital adequacy. In this setting, it is difficult to ensure that banks and supervisors will respond to emerging problems in a timely manner. 3. Objectives of the New Basel Accord Broadly speaking, the objectives of Basel II are to encourage better and more systematic risk management practices, especially in the area of credit risk, and to provide improved measures of capital adequacy for the benefit of supervisors and the marketplace more generally. At the outset of the process of developing the new Accord, the Basel Committee developed the so-called three pillars approach to capital adequacy involving (1) -5- minimum capital requirements, (2) supervisory review of internal bank assessments of capital relative to risk, and (3) increased public disclosure of risk and capital information sufficient to provide meaningful market discipline. Although the Committee s proposals have evolved considerably over the past several years, these fundamental objectives and the three-pillar approach have held constant. It is hardly necessary to emphasize the importance of banks and banking systems to financial and economic stability. 8 The ability of a sound and well-capitalized banking system to help cushion an economy from unforeseen shocks is well known, as are the negative consequences of a banking system that itself becomes a source of weakness and instability. A critical potential weakness of financial markets is that risks are in many cases under-estimated and not fully recognized until too late, with a concomitant potential for excessive consequences once they have been fully realized. This is why the Basel Committee s efforts to promote greater recognition of risks and more systematic attention to them are vitally important. The essence of Basel II is a focus on risk differentiation and the need for enhanced approaches to assessing credit risk. Some critics have argued that it is preferable to downplay differences in risk, and indeed forbearance can sometimes appear the most expedient strategy. But experience has also shown that this will not work as an overall approach because ignoring risks inevitably leads to larger problems down the road. Thus, one of the key messages of Basel II is that bankers, supervisors, and other market participants must become better attuned to risk and better able to act on those risk assessments at the appropriate time. Bank supervisors must get better at addressing issues pre-emptively rather than in crisis mode. -6- Significant attention to risk management is one of the primary mechanisms available to help banks and supervisors do that. Basel II seeks to provide incentives for greater awareness of differences in risk through more risk-sensitive minimum capital requirements. The Pillar 1 capital requirements will, by necessity, be imperfect measures of risk as any rules-based framework will be. The objective of the proposals is to increase the emphasis on assessments of credit and operational risk throughout financial institutions and across markets. Perhaps even more important in the long run is the second pillar of the new Accord. Pillar 2 requires banks to systematically assess risk relative to capital within their organization. The review of these internal assessments by supervisors should provide discipline on bank management to take the process seriously and will help supervisors to continually enhance their understanding of risk at the institutions. The third pillar of Basel II provides another set of necessary checks and balances by seeking to promote market discipline through enhanced transparency. Greater disclosure of key elements of risk and capital will provide important information to counterparties and investors who need such information to have an informed view of a bank s profile. 4. Key Elements of the Package While the way minimum regulatory capital requirements are computed has changed substantially, what actually counts towards capital has not; the numerator in the capital-asset ratio remains unchanged. 9 The new Accord outlines two new approaches to assessing credit 8 For a broad cross-country study analyzing the real economic impact of banking crises, see Caprio and Klingebiel (1996). 9 See Board of Governors of the Federal Reserve System (2002) for review of eligible capital. -7- risk and for the first time specifies a capital charge for operational risk. In this section we will provide details on both, including a description of the calibration effort that the Basel Committee has undertaken with participants in industry Pillar 1: Credit Risk In order to allow for evolution of credit risk management methods and practices the New Accord introduces a range of approaches for assessing credit risk: a standardized and an internal ratings-based (IRB) approach, the latter having two version. The standardized approach incorporates modest changes in risk sensitivities to improve risk sensitivities through readily observable risk measures such as external credit ratings. This simple rulesbased approach is designed to address to address some of the most blatant shortcomings of the current Accord. Compared to the current Accord, the IRB approach is fundamentally different in concept, design, and implementation. Consistent with the Basel Committee s objectives, it is intended to produce a capital requirement more closely linked to each bank s actual credit risks a lower-quality portfolio will face a higher capital charge, a higher-quality portfolio a lower capital charge. Such an approach is essential to creating the correct incentives for both banks and supervisors. The IRB approach is based on four key parameters used to estimate credit risks: PD The probability of default of a borrower over a one-year horizon 2. LGD The loss given default (or 1 minus recovery) as a percentage of exposure at default 3. EAD Exposure at default (an amount, not a percentage) 4. M Maturity 10 See Basel Committee on Banking Supervision (2002) for detailed descriptions of each element of the minimum capital requirements. 11 Section III.B, 23 30, of Basel Committee on Banking Supervision (2001a) -8- For a given maturity, these parameters are used to estimate two types of expected loss (EL). Expected loss as an amount: EL= PD LGD EAD and expected loss as a percentage of exposure at default: EL% = PD LGD There are two variants of IRB available to banks, the foundation approach and the advanced approach. 12 They differ principally in how the four parameters can be measured and determined internally, but an essential feature of both approaches is their use of the bank s own internal information on an asset s credit risk. For the foundation approach only PD may be assigned internally, subject to supervisory review (Pillar 2). LGD is fixed and based on supervisory values. For example, 45% for senior unsecured claims and 75% for subordinated claims. EAD is also based on supervisory values in cases where the measurement is not clear. For instance, EAD is 75% for irrevocable undrawn commitments. Finally, a single average maturity of three years is assumed for the portfolio. In the advanced approach all four parameters are determined by the bank and are subject to supervisory review. The IRB at heart provides a continuous mapping from the basic set of four input parameters (PD, LGD, EAD and M), plus some other observables such as borrower type, to a minimum capital requirement. This mapping is based on the same analytical framework as most credit portfolio models. 13 Gordy (2002) demonstrates that such a risk-bucketing approach, i.e. capital requirements which only depend on the characteristics of an individual exposure, is consistent with an asymptotic single risk factor credit portfolio model, itself based on the Merton (1974) options-based model of firm default. 12 For qualification conditions, please see Basel Committee on Banking Supervision (2001a). -9- Taking corporate exposures as an example, risk-weighted assets (RWA) i
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