The Future of International
Banking Regulation: A New
Beginning or Business as Usual?
Presentation at DIIS by Ranjitt Lall
18th of May 2010
Basel Accords
• Set minimum capital requirements for banks
• Capital (mainly equity) absorbs unexpected losses, but is costly for
banks as a source of funding
Basel I (1988)
• Minimum capital requirements based on ratio of capital to riskweighted assets of 8%
• Risk weights depend on riskiness of borrower e.g. government bonds
(safe) 0% risk weight; corporate loans (riskier) 100% risk weight
• Provided opportunities for regulatory arbitrage, causing capital levels
in the banking system to decline
Objectives for Basel II
1.To promote safety and soundness in the
financial system
2.To continue to enhance competitive equality
3.To constitute a more comprehensive
approach to addressing risks
Objective
Regulation required to
meet objective
1
More refined risk-weights
linked
to external ratings
for all
Link risk-weights
to external
ratingsbanks
for all banks
Regulation of trading book
risks
Regulation of trading book
Regulationrisks
of market risk
2
2
3
3
Regulation of market risk
Regulation of securitization
risks
Regulation of securitization
risks
Basel II
?
No regulation
?
Use of VaR models
underestimating
?
market risk
Use of excessively
low risk weights
?
Objective
1
2
3
Regulation required to
meet objective
Basel II
Internal ratings for
Link risk-weights to external large banks; modified
the accord would have to introduce rules to
ratings for all banks
version of Basel I for
capture three previously unregulated types of
other banks
risks: trading book risks, in particular
counterparty credit risk and risks related to
Regulation (OTC)
of trading
book market No regulation
over-the-counter
derivatives;
risksto on- and off-balance
risk, the risk of losses
sheet assets arising from movements in market
Use of models known
prices; and securitization risks.
Regulation of market risk
to underestimate
market risk
Regulation of securitization
risks
Use of excessively
low risk weights
Impact of Basel II on capital levels
• Large banks under A-IRB approach experience
26.7% decline in capital levels
• Small banks under standardized approach
experience 1.7% increase in capital levels
• Consequence: overall capital levels fall (contra
objective 1); large banks increase profits at
expense of small banks (contra objective 2)
Mattli and Woods (2009): Regulatory Outcomes
Institutional Supply
Demand
Narrow/
Limited
Broad/
Sustained
Limited
(Closed and exclusive
forums, minimal
transparency)
Extensive
(Proper due
process, multiple
access points)
Pure Capture
Regulation
De facto Capture
Regulation
Capture but with
Concessions and
Compromises
Common interest
regulation
My ‘dynamic’ analytical framework
• Mattli and Woods flawed: regulatory process takes place
over time; some actors arrive before others
• This is significant because of first-mover advantage:
decisions made at an early stage are self-reinforcing
• Who will arrive first? Those with the best information
about the regulatory agenda; usually through personal
contacts with regulators
• Qualification: timing only important when agreements
not subject to ‘ratification phase’
Applying my framework to Basel II
• First-movers: large international banks
represented by IIF
• Second-movers: smaller banks and emerging
market banks
• Theoretical prediction: large banks will secure
their preferred regulatory outcomes in Basel II
Objective
Initial proposal
Industry
Recommendation
Final proposal
(Basel II)
Incorporate external
credit ratings into new
framework
Recognize internal credit
risk models of large banks
?
Introduce capital
charge for derivatives
risk (‘w factor’);
capture counterparty
credit risk
Drop ‘w factor’; do not
apply credit risk capital
requirements to trading
book
1
2
?
3
Standardized
Substitute standardized
methodology based on methodology for market risk
fixed risk parameters
(VaR) models
Link risk weights to
external credit ratings
Lower risk weights for rated
tranches
?
?
Objective
Initial proposal
Industry
Recommendation
1
2
Incorporate external
credit ratings into new
framework
Recognize internal credit
risk models of large banks
Introduce capital
charge for derivatives
risk (‘w factor’);
capture counterparty
credit risk
Drop ‘w factor’; do not
apply credit risk capital
requirements to trading
book
Final proposal
(Basel II)
Recognition of
internal ratings for
large banks;
modified Basel I for
other banks
‘W factor’
abolished in 2001;
no regulation of
trading book
3
Standardized
Substitute standardized
methodology based on methodology for market risk
fixed risk parameters
(VaR) models
Link risk weights to
external credit ratings
Lower risk weights for rated
tranches
Recognition of VaR
models in 1996
Reduced risk
weights for rated
tranches
The G-20’s demands for capital adequacy reform
• Washington Summit (Nov 2008): raise capital requirements for
structured credit and securitization activities
• BCBS response: trading book enhancements approved in July 2009
• Pittsburgh Summit (Sept 2009): introduce international leverage
ratio, more restrictive definitions of capital, countercyclical capital
buffers, capital surcharges for ‘systemically important’ institutions
• BCBS response: preliminary proposals (‘Basel III’) released in
December 2009; to be finalized by end-2010
Why Basel III will fail
• Public attention to banking regulation decreases
• Rule-making returns to BCBS, whose agreements do
not require ratification by domestic stakeholders i.e.
timing regains its significance
• Large banks gain first-mover advantage through
personal contacts with regulators
Strategies for first-movers in Basel III process
1. Using close personal networks to conduct private
meetings with regulators: IIF Annual Conference
(Oct 2009); World Economic Forum (Jan 2010)
2. Informational ‘scare tactics’: JP Morgan (Feb 2010);
Project Oak (Apr 2010); BNP Paribas (Apr 2010)
Initial Proposal
Industry
recommendation
Likely outcome
(Basel III)
Introduce international
leverage ratio in Pillar 1 (i.e.
binding)
Move ratio to Pillar 2
(i.e. non-binding)
Adoption in Pillar 2
Create capital surcharge for
‘systemically important’
institutions in Pillar 1
Drop surcharge or move
it to Pillar 2
Removal or adoption in
Pillar 2
Introduce ‘forward-looking
provisioning’ (to mitigate
pro-cyclicality)
Adopt in Pillar 1
Adoption in Pillar 1
Move buffers to pillar 2
Adoption in Pillar 2
Introduce countercyclical
capital buffers linked to
credit-to-GDP ratio in Pillar 1