1 Questions and Answers on Basel 2 and the agenda for regulatory reform Remarks of Andrew Cornford, Observatoire de la Finance XXIX Technical Group of the Group of Twenty-Four Geneva, 7-8 September 2009
2 1. What are the principal revisions of Basel 2 currently planned for or recently introduced? During the corresponding Geneva meeting of the Technical Group last year I forecast that an initiative to start work on a Basel 3 to replace Basel 2 was unlikely in the near future, though a process of incremental revision and expansion of Basel 2 starting shortly could reasonably be anticipated. On nomenclature I was correct since no initiative entitled Basel 3 is currently in the works. Nevertheless the changes whose introduction has been under way since the start of 2009 arguably entail a major overhaul of the agreement. The changes cover the following areas 1 : better coverage of banks risk exposures by minimum regulatory capital. The principal risks targeted by these changes are those of securitisations and of market risk in the trading book. improvement in the quality of the regulatory capital corresponding to banks risks; countercyclical capital buffers and provisions; and introduction of a non-risk-based measure of regulatory capital designed to help to contain the degree of leverage in the banking system. Closely related to the proposed changes in Basel 2 will be work by the Basel committee on Banking Supervision in the areas of liquidity buffers; risk management and the corporate governance of banks; macroprudential supervision, and transparency concerning banks exposures to different risks. Changes to Basel 2 under risks of securitisation and in the trading book are covered in the paper available to you, The Basel 2 Agenda for 2009: Progress So Far. Revision of the definiton of capital for the purpose of Basel 2 is likely to reinforce the role of common equity and reserves, the components of capital most obviously trusted during the crisis by banks counterparties in financial markets other banks and investors. Procyclicality is a longstanding feature of banks lending behaviour and has been a notable feature of the recent crisis. Basel 2 as currently drafted is widely regarded as doing nothing to mitigate procyclicality indeed as perhaps even accentuating it in certain circumstances. Leverage concerns the risks of a bank s portfolio in relation to its ability to absorb these risks. Historically leverage increases during booms. The commonest measures of leverage involve assets in relation to equity, and the supplementary regulatory standard to control leverage which the Basel Committee is currently considering is likely to be an aggregate leverage ratio. Introducing changes to Basel 2 to deal with the definition of capital and procyclicality is complicated by definitional issues variations in definitions among countries - and, in the case of procyclicality, by accounting standards. As part of accounting standards provisions have typically been identified as liabilities related to actions of current or earlier years. They are thus not forward-looking in the sense which one would want in design of countercyclical capital buffers and reserves. 2 However, the appropriateness of international accounting standards for financial instruments and firms is itself 1 See Bank for International Settlements, Initiatives in response to the crisis by the Basel Committee, March 2009, and, Basel Committee initiatives in response to the financial crisis, remarks by Dr Nout Wellink, President of the Netherlands Bank and Chairman of the Basel Committee on Banking Supervision, before the Committee on Economic and Monetary Affairs of the European Parliament, Brussels, 30 March 2009. 2 C.Nobes and R.Parker, Comparative International Accounting, tenth edition, Harlow, England, Pearson Education, 2008, pp. 348 and 351.
3 being re-examined in the light of the experience of the current crisis. In a recent short paper related to this re-examination the Basel Committee has expressed the view that Loan loss provisioning should be robust and based on sound methodologies that reflect expected credit losses in the banks existing portfolios over the life of the portfolio...for the purpose of these principles, expected credit losses are estimated losses on a loan portfolio over the life of the loans and considering the loss experience over the complete economic cycle. 3 2. How important are indications that Basel 2 is having adverse effects on the availability of trade finance and on bank lending to SMEs, and what would be an appropriate policy response? (a) SMEs Evidence from various sources points to a major tightening of credit conditions for SMEs since the outbreak of the credit crisis. 4 The systematic evidence concerns primarily OECD countries. But there are indications also of a similar tightening in several developing countries. The tightening is partly a response to the worsening of macroeconomic conditions. It also reflects developments within the banking sector such as the stagnation of interbank lending, increased cost of capital, and banks efforts to rebuild their balance sheets. Moreover the tightening is taking place even in countries where governments have intervened to strengthen banks balance sheets and to guarantee their lending. Evidence concerning a possible role of Basel 2 in this tightening is hearsay but should not for this reason be dismissed out of hand. During the drafting process for Basel 2 since 2001 several of the revisions were intended to make the rules more flexible, and beneficiaries of this greater flexibility have included SMEs. Under the simple Standardised Approach of Basel 2 loans to SMEs which meet the requirements for classification as retail benefit from a reduction of their weighting for credit risk in estimating their capital requirements. 5 Under the Internal Ratings-Based Approach of Basel 2 SMEs benefit from a downward adjustment in the formula for estimating their credit risk and from other adjustments in the curve relating probability of default to regulatory capital requirements. 6 Estimates of the quantitative impact of Basel 2 have indicated that the rules for SMEs should be successful in reducing risk weights for lending to them and thus regulatory capital requirements for such lending. 7 3 Basel Committee on Banking Supervision, Guiding principles for the replacement of IAS 39, Bank for International Settlements, 27 August 2009. 4 See, for example, OECD Centre for Entrepreneurship, SMEs and Local Development, The impact of the global crisis on SME and entrepreneurship financing and policy responses, CFE/SME82209)3/Rev1. 5 Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards A Revised Framework Comprehensive Version (henceforward Revised Framework), Bank for International Settlements, June 2006, paras. 69-71. 6 Revised Framework, paras. 273-274. 7 For a summary of such estimates see A.Cornford, The global implementation of Basel II: prospects and outstanding problems, UNCTAD Policy Issues in International Trade and Commodities Study Series No 34, New York and Geneva, 2006, section D.
4 Nevertheless, concerns remain. These are partly due to the likelihood that in the absence of further revisions Basel 2 rules will be procyclical in their effects on lending. Moreover the impact of the rules in practice will reflect the changes in national supervisory frameworks for banking which accompany its introduction and the changes in banks risk management and internal controls which are capable of leading to higher interest-rate margins and more restrictive conditions for their lending. (b) Trade Finance Difficulties in obtaining trade financing have been attributed a significant role in the collapse of international trade. A modelling exercise reported in the June edition of the OECD Economic Outlook suggests that approximately one-third of the fall in world trade in the fourth quarter of 2008 and the first quarter of 2009 was due to contraction in the availability of trade finance. 8 Another estimate - provided by market participants - of a mismatch of USD 25 billion between supply and demand for trade finance was cited at a March meeting of the WTO Working Group on Trade, Debt and Finance. In a letter to G20 finance ministers of March 2009 9 the Banking Commission of the International Chamber of Commerce (ICC) claimed that a factor contributing to the contraction of trade financing was an erosion of banks incentive to provide trade finance due to Basel 2. 10 Regrettably the intervention of the ICC is not very clear about how the rules of Basel 2 have exerted this effect. Under the Standardised Approach of Basel 2 to estimating regulatory capital requirements for credit risk the rules relating to off-balance-sheet exposures follow lines similar to those of the Basel Capital Accord of 1988 (Basel 1). Self-liquidating commitments (which would include letters of credit) with an original maturity of up one year are attributed a credit conversion factor of 20 per cent of that for the corresponding on-balance-sheet exposure such as a loan, and commitments with an original maturity of over one year a credit conversion factor of 50 per cent. 11 The rules for estimating regulatory capital requirements for collateralised loans and loans guaranteed by third parties also follow lines similar to those of Basel 1. 12 Under the Internal Ratings-Based Approach of Basel 2 off-balance-sheet exposures are also the subject of credit conversion factors which reduce the weight for credit risk in comparison with the corresponding weight for on-balance-sheet exposures. These factors are estimated either as in the Standardised Approach or, in the case of banks using the advanced version of the Internal Ratings 8 The proxy for the availability of trade finance is the product of a measure of United States credit standards and the spread on high-yield debt. See OECD, Economic Outlook, no. 85, June 2009, pp. 23-24. 9 World Trade Organization Working Group on Trade, Debt and Finance, Expert group meeting on trade finance 18 March 2009, Note by the Secretariat, 23 March 2009. 10 See International Chamber of Commerce, ICC Banking Recommendations Impact of Basel II on Trade Finance, Document 470/1119, 25 March 2009. 11 Revised Framework, paras. 82-89 12 Revised Framework, paras. 119-144.
5 Based Approach, from internal models. 13 There are also new, more fleshed-out rules for collateralisation and guarantees. 14 In the case of the simpler methods of estimating weights for the credit risk of contingent commitments such as letters of credit under Basel 2 there is no reason why the weights should be higher than under Basel 1. In the case of banks using the more advanced methods available under the Internal Ratings-Based Approach it is impossible to make such a generalisation a priori since estimates of the weights are the result of banks internal measurement processes. To the extent to which trade finance takes the form of bank loans unaccompanied by credit risk mitigation in the form of guarantees or insurance or without collateral the credit risk weights used to estimate regulatory capital would be those for corporations. In the case of the Standardised Approach there is no reason why these should necessarily be higher under Basel 1. In the case of the Internal Rating-based Approach generalisation is difficult since here too the weights would be the result of banks own internal measurement processes. However, loans not benefiting from guarantees, insurance or collateralisation to lower-rated borrowers would probably be significantly more expensive than under Basel 1. Although such conclusions are necessarily speculative, they suggest that contractions in trade finance accompanying the introduction of Basel 2 are due principally to changes in banks practices regarding the pricing and other terms of their loans which are part of the more rigorous risk management that was one of Basel 2 s collateral objectives. In other words the situation appears to be similar to that for the impact of Basel 2 on lending to SMEs. (c) Regulatory Response If observed problems for lending to SMEs and trade financing associated with the introduction of Basel 2 are indeed due to way in which it is being implemented rather than to the rules themselves, the appropriate policy response in both cases would appear to lie in regulatory surveillance and the provision of advisories to banks and borrowers, especially during the period when bank lending is also under several other pressures due to the credit crisis and macroeconomic conditions. Such a response would be similar to an important part of the recommendations of the ICC to the effect that The measures we propose do not require amendments of the Basel II framework; rather the introduction of small, yet significant, changes to the way in which the existing rules are implemented making use of the discretion afforded to national regulators under the charter. 15 13 Revised Framework, paras. 310-316. 14 Revised Framework, paras. 300-307. The Internal Ratings-Based Approach of Basel 2 also covers project finance where payments of debt service are to come from revenues generated by the project. This technique is used for trade financing. However, the maturities of the financing are typically medium- or long-term and thus not the focus of the concerns currently being expressed about the impact of Basel 2 on trade finance. 15 International Chamber of Commerce, op. cit., p.4. The measures proposed by the Chamber would involve ensuring that appropriate emphasis is given to the short-term character of many trade transactions and to industry s own benchmarking of the risk associated with trade transactions.
6 The agreement of G20 countries on a large increase in trade financing should also indirectly help to control problems in this area due to the introduction of Basel 2. Such a programme will presumably include a large increase in export credit insurance and guarantees which, under the rules of Basel 2 on credit risk mitigation, will reduce banks risk weights for the credit risk of the trade finance so covered. 3. How might the expansion of the membership of the Basel Committee and the Financial Stability Forum, now renamed the Financial Stability Board be viewed? I should expect some people in this room to be dissatisfied with the recent expansion of the memberships of the Basel Committee and the Financial Stability Board (the renamed Financial Stability Forum), which now include G20 countries hitherto not members. However, there would appear to be little or no probability of further expansion in the near future. Non-members may eventually be co-opted according to the dictates of their economic weight and the importance of their financial markets. The political link to the G20 is likely to give the Financial Stability a political clout which the Financial Stability Forum lacked. Other points are worth bearing in mind under the heading of membership of bodies such as the Financial Stability Board. Formal representation does not in itself assure effectiveness of participation or proper account being taken of the views of all countries represented. Moreover, as may become clearer in a moment, there may be advantages to not participating in the development of international rules primarily designed with the problems of only a limited group of countries in mind since non-participation in the process makes it easier to justify subsequent unwillingness to accept these rules as universally applicable standards and to implement them. 4. Does the existing agenda of reform contain features likely to be harmful to developing countries? The overall reform agenda, surveillance of which is the responsibility of the Financial Stability Board, is driven principally by the weaknesses in the framework of financial regulation and cross-border cooperation in developed countries indicated by the financial crisis. This is evident in the coverage of subjects in the FSB s own overviews: strengthening the prudential framework for financial institutions with recommendations on capital requirements, liquidity management, supervisory oversight of risk management. enhancing transparency or financial reporting and the rules for the valuation of financial instruments. reforming the use of credit ratings and the operations of the credit rating agencies. improving cross-border cooperation and information exchange amongst regulators and ensuring better arrangements for crisis management and resolution. Improving the work of the different multilateral institutions concerned with financial stability. The institutions which will provide inputs into work on the reform agenda will mainly be from the group to which responsibility has been attributed for developing the twelve key financial codes and standards. Unsurprisingly in view of their histories the representativeness of these institutions varies. But by and large there is no reason for concern about particular likely features of the output of their work on the reform agenda. Indeed, owing to political pressures on the process, the danger
7 is rather that the outcome will avoid key issues such as concentration and excessive complexity in developed countries financial sectors or be too weak on subjects like bankers pay. Although issues to be addressed under the reform agenda involve directly the financial sectors of developed countries, their wider implications should not be lost from view. Smaller financial institutions and financial sectors under tighter public control in developed countries would probably exert less pressure for policies as well as an intellectual climate which favour financial liberalisation à outrance serving primarily the interests of financial sectors in developed countries as opposed to more broadly shared interests. 5. Are there subjects related to new international rules or a new regulatory landscape regarding which developing countries should be particularly alert? Watchfulness seems justified concerning possible incorporation of features of the outcome of work on the reform agenda in IMF conditionality and in rules or standards proposed in international negotiations elsewhere. This is because the standards may not be appropriate for countries at earlier stages of development or may place a disproportionate burden on the administrative capacity of their governments and the management of their enterprises. The point about inclusion in IMF conditionality scarcely needs elaboration from me and so I shall concentrate on WTO matters. It has been suggested that international codes and standards might be used as part of determining the scope of countries flexibility under the prudential carve-out of the GATS Annex on Financial Services regarding imposition of prudential measures with implications for international trade in banking services. 16 According to the prudential carve-out a Member shall not be prevented from taking measures for prudential reasons, including for the protection of investors, depositors, policy holders to whom a fiduciary duty is owed by a financial service supplier, or to ensure the integrity and stability of the financial system. Behind the proposal to limit countries flexibility under this provision lies a judgement as to the relative importance of prudential regulation, on the one hand, and a liberal cross-border regime for banking services, on the other. This is surely a balance which countries authorities should be able to decide for themselves. The recent crisis may lead many authorities reasonably - to attribute increased importance in this balance to prudential regulation. The context within which conditions are decided for the granting of market access and national treatment to foreign banks has changed. During the WTO negotiations on financial services which ended in 1997 the ruling assumption was that banking regulation in developed countries was not only adequate but also a model for that of developing countries. Such an assumption would no longer be generally accepted and this may and should have implications for countries future negotiating stances in the WTO. Even in the 1990s only a few countries scheduled their WTO commitments in accordance with the option of the Understanding on Financial Services. The Understanding included a commitment to 16 See, for example, Communication from Switzerland, WTO Document S/CSS/W/71, 4 May 2001..
8 permit banks to offer in the country s territory any new financial service (which would presumably be any service that the bank was permitted to supply in its home country). Experience of new financial products during the financial crisis can reasonably be expected to reduce still further acceptance of this provision. In the light of experience during the credit crisis greater wariness regarding commitments as to market access and national treatment would seem justified in the interest of prudential control. The results could include increased insistence on local incorporation as a condition for the admission of foreign banks, i.e. admission only of subsidiaries as opposed to branches. The results might also include conditions concerning the distribution of costs between home and host countries in the event of cross-border insolvencies of financial firms, a subject on which generally agree international guidelines are still lacking.