Bank regulation - Uphill work

From The Economist

Market turmoil raises concerns about the Basel 2 banking accord

SISYPHUS was lucky. He could have wound up on the Basel committee. Since 1999 the committee has been sweating over the Basel 2 accord, a regulatory framework that guides how much capital banks should set aside to cover the level of risk they face. An end is finally in sight. A few European Union banks have already adopted the new rules; others will follow next year. A select number of American banks will implement Basel 2 in 2009. But this summer's credit crunch has put the incoming framework under scrutiny before it has even had a chance to prove itself. "This is the first stressed situation in a long time and it's directly pertinent to many of the changes being brought in by Basel 2," says Vishal Vedi, a partner at Deloitte, an accounting firm.

One effect of the accord, for example, is to give credit-rating agencies an explicit role, particularly for less sophisticated banks, in determining how much capital is enough to cover certain risks. That looks dangerous, given fears that the agencies have over-estimated the creditworthiness of some asset-backed securities (see article). It may also encourage complacency on the part of the banks.

Defenders of Basel 2 point out that the agencies are under the cosh now, but that their record in assessing the risk of default is pretty good. What's more, ratings may set a floor under some capital requirements but banks are supposed to top up their reserves if they have other reasons to worry based on their own analysis.

That is not the only bit of the accord under scrutiny. Basel 2 positively encourages banks to use instruments such as credit derivatives. Yet the complexity and number of such instruments lie behind banks' difficulties in knowing who will bear the ultimate exposure to defaults on American subprime mortgages.

The accord also enshrines an approach called value at risk (VAR), a risk-management technique that, like a gambler's optimism, has a worrying tendency to swell the longer things are going well. In response, the accord asks banks to say if they are vulnerable to off-balance-sheet vehicles and to stress-test their business.

A few weeks of summer turmoil should not undo years of painstaking regulatory work. Basel 2 is a big improvement on the outgoing Basel 1 framework, which simply imposes a flat 8% charge on loans and assets irrespective of how risky they may be.

The new accord is more sensitive and more adaptable than its predecessor. By dangling the carrot of lower capital charges in front of the more sophisticated institutions, it encourages banks to think harder about risk. Transitional arrangements are in place to ensure that banks cannot slash their capital reserves precipitously. "Basel 2 is not perfect, but it is a lot better than what went before," says John Tattersall, a partner at PricewaterhouseCoopers, an accounting firm.

Even so, the credit crunch points the way for the next regulatory push. In particular, the accord does not have much to say about liquidity risk, largely because hoarding capital is not the best way to deal with it (access to funding facilities is better). Like other regulators, the Basel committee was already looking at liquidity risk before credit markets became strangled: a working group on the topic is to report before the end of the year. Sisyphus would have sympathised.