Feature

posted 30 Nov 2001 in Volume 5 Issue 3

Basel II: accord or discord?

The new Basel capital accord is an ambitious blueprint aimed at strengthening the banking industry globally by strengthening regulatory capital levels. Ernest Napier, Managing Director at Standard & Poor’s Ratings in New York, looks at its implications for the trade finance market – some of them negative.

Standard & Poor’s continues to support the Basel Committee’s efforts to strengthen banking regulation in light of recent developments in global financial markets. We believe that greater bank disclosure, a more proactive regulatory stance and more explicit capital charges for interest rate and operating risks, has the potential to improve the overall global financial system, and over time the creditworthiness of banking systems, especially those in less developed markets. Further progress has been made in the second consultative phase in terms of strengthening the three pillars on which the accord is based: minimum capital requirements, improved supervisory oversight, and the effective use of market discipline. However, as one colleague puts it, this accord represents a journey and not a destination, and hopefully someday we’ll get where we’re going.

The cornerstone of the new Basel accord is how to improve the process for calculating minimum levels of regulatory capital. Standard & Poor’s recognises both the pros and cons associated with using either the standardised approach or the internal ratings-based approach (IRB).

Let’s start with our views on the standardised approach. This method permits banks to use assessments by recognised external credit assessment institutions to help them more effectively allocate capital. It also incorporates the use of a wide range of credit mitigation techniques, including credit derivatives and securitisation. For those institutions without sufficient historical default and recovery statistics, this approach permits them to benchmark their assets against a reliable third party. Another benefit is that it allows them to convey the quality of their assets in a common language.

However, there are many aspects of this approach that in our opinion raise concerns. To begin with, we are concerned about the fact that it provides insufficient differentiation of credit risks. Clearly, the difference in risk weightings for the highest and lowest quality credits is not as substantial as it should be. This is often the case when a ‘one-size-fits-all’ treatment is used to differentiate credit risks.

Second, option 1 under the standardised approach would discount the sovereign rating of the country in which a bank is located by one full grade and apply that to all banks within the country. This method would penalise better quality banks and could benefit weaker institutions. If a sovereign were rated AA, for example, the highest any bank could get would be A, which would penalise banks with higher ratings, while weaker banks that might be rated BBB would also be treated as A rated.

Standard & Poor’s strongly prefers option 2. Use of this method might also imply that the sovereign would bail out its banks, a development that could be negative for the sovereign’s creditworthiness, and is at odds with the worldwide trend of less government support for banks. However, at least it has the merit of assessing banks individually, even though the 50% weighting for unrated banks would reward banks that would achieve lower ratings on their own.

Along the same lines, we believe that claims on public sector enterprises should be judged on their merits alone, and not on the basis of their country of incorporation or the nature of the institution. The problem is that weighting unrated assets better than high-risk assets will reduce, rather than enhance, credit transparency. In order to get around this limitation, we support a super weighting of over 150% for all unquoted equity participations, private equity participations and venture capital given the traditional risks and funding of such participations.

In short, a combination of lower than 100% weightings for investment grade exposures, and the broader acceptance of credit mitigation will provide banks with the incentive, and the tools to manage down their capital allocated for credit risk under the standardised approach.

It’s not surprising that many banks seem to be gravitating toward the internal rating-based approach (IRB). The reason is that it ultimately offers them the chance to reduce the capital allocated for credit risks.

Over the past few years, Standard & Poor’s has observed that the internal economic capital allocation models in place at large international banks generally indicate that these banks feel they are overcapitalised for their desired rating levels. The advanced IRB approach in the proposed new accord will likely produce results similar to those models, and consequently, these banks will receive capital relief for credit risk. Even worse this decline in capital could set the standard for all banks regardless of their underlying credit profiles.

Nonetheless, a major benefit of this approach is that it does provide more differentiation of credit risks. In theory the IRB approach could require risk weights of up to 600% for the lowest quality credits, compared to a maximum weighting of 150% for B-category corporate credits under the standardised approach. On the negative side, this approach may underestimate the loss coverage that capital provides at the most negative point in the economic cycle.

Capital should be able to withstand an unexpected rather than merely an expected level of credit losses. In other words, banks should be able to get through a recession of some magnitude to be considered investment grade. How severe a recession the bank is deemed able to survive will then determine what rating level it will achieve.

Our fear is that basing capital on an average level of probabilities of default will dilute the picture of what could happen in years of recession, when the probabilities of default can become a multiple of the average level.

Our own data on default portrays this phenomenon. During the last recession, in the 1990-92 period, the average probabilities of default for a three-year time horizon rose dramatically, to 1.6 to 15 times the average levels, depending on the rating level.

We can only presume that bank corporate loan defaults follow similar patterns. That said, the last recession was a fairly mild one, so there is reason to believe that the default experience would be worse in more severe recessions. Because recessions cannot be predicted very far in advance, we believe that capital should be maintained in expectation of a possible recession at all times.

Many banks will not be permitted to use the foundation and advanced internal ratings based (IRB) approaches for credit because they lack the necessary systems and controls to measure risks. In our opinion, banks need to have historical default and correlations data going back at least five years. At the moment, a five-year period would reflect a sustained period of robust economic growth, yielding no indication of what a recession might bring. Even if some of the larger international capital were able to demonstrate the need for less capital to support credit risk this does not necessarily mean that total capital would need to decline. This is because other types of risk, including operational risk, must be taken into account.

Implications for emerging markets

When it comes to banks in emerging markets, critics of the new accord argue that they end up getting the worst of both worlds, and this ultimately may cause the failure of the entire initiative. According to one observer, emerging market banks will probably end up with the same, or slightly higher, capital weightings as under the first accord in 1988. The only difference is that a few sovereigns, such as Greece and Turkey, will have higher risk weightings this time around, reflecting their public ratings as opposed to their OECD status.

While Basel is primarily an accord among G-10 countries, there is a lot of peer pressure for other countries to follow suit, or at least give the appearance of doing so. As the argument goes, any proposal that imposes higher capital allocations based on borrower quality works to the disadvantage of emerging market banks. This reflects the composition of their loan portfolios and the nature of the markets in which they operate. Of course these are legitimate reasons why emerging market banks should allocate a greater amount of capital for credit risk. Nevertheless, many believe it puts them at a competitive disadvantage vis-à-vis banks in mature markets.

So what redress do emerging market banks have to combat any competitive disadvantages they feel the new accord may create? The most obvious would be to shop around for external credit assessments that give them the most favourable capital charge. This could reduce capital from current levels without changing the risk profiles of banks in emerging markets. Even worse it could weaken the level of capital in the global banking system, if regulators in mature markets are forced or allowed to accept the decisions of local regulators, when determining the risk weightings for claims in that country.

Another way for emerging market banks to beat the system is to encourage some of their clients not to get rated. If a bank is rated below BBB-, a corporate is rated below BB-, and a sovereign is rated below B- there is a disincentive for such entities to get rated. Clearly this type of behaviour would undermine the new accord’s goal of promoting greater financial market transparency. In fact, I think most people would agree that such a development could reduce the global capital available to borrowers in emerging markets.

Practically speaking, the Basel Committee had little choice but to allow some flexibility in dealing with unrated companies. This reflects the reality that a large percentage of corporate entities in many markets are not rated. Any attempt to discourage banks from lending to this sector of the economy, particularly small and medium-sized companies in emerging markets, would have certainly evoked harsh criticism from national interest groups.

However, the problem with compromises is they often serve to weaken the effectiveness of an accord. This is basically what happened in the original accord in determining the risk weightings for some assets, particularly mortgages. For this reason, a great deal of vigilance is needed by regulators in order for the new accord to be as successful as possible in light of the need to make compromises.

Under the current proposal, national supervisors are responsible for determining whether an external credit assessment institution (ECAI) meets the prescribed eligibility requirements. Standard & Poor’s believes that regulators should ensure as transparent a mapping process of agency ratings to ratings default performance as possible, over as long a time frame as possible. We also believe that the treatment of multiple ratings on an obligor warrants revision if regulators wish to discourage banks from selecting ECAIs according to the highest rating instead of the most accurate.

With respect to trade finance, the general consensus is that Basel II is less accommodating, compared to the existing framework. While there is no specific mentioning of how trade debt should be treated in the proposal, there are important implications included throughout. For many, the concern is there will no longer be any favourable capital weighting based upon whether the sovereign is an OECD member. Others believe that any accord that potentially reduces trade flows cannot be a positive development for the global economy.

Under the 1988 accord, the risk weight on exposures to banks for short-term exposure less than one year was 20% regardless of the credit quality of the underlying obligor. This will no longer be the case. Under the new guidelines, the risk weights will be determined by the creditworthiness of the borrower or guarantor. With the risk weights for emerging market banks providing trade finance guarantees likely to be quite high, this will make it more expensive for exporters to engage in certain types of refinancing activities, including forfaiting.

In particular, forfaiting could be negatively impacted because the discounting institutions will need to be compensated for the more expensive use of their balance sheets. This could increase the cost of providing such a service and open the door for greater competition from export insurance institutions. However, the potential impact on pricing may not be as large as it appears given that many forfaiting houses currently allocate more than the required level of capital for such transactions.

This brings us to two very interesting questions: how much capital is really necessary to support trade finance related activities? And second, does the new proposal sufficiently address the issue of trade finance? On the one hand, a strong argument can be made that the 20% capital charge that currently exists perhaps does not fully take into account the risks associated with relying on the guarantees of some banks in emerging markets.

In response to the first question, perhaps there is a need to close an existing loophole to promote a greater differentiation of credit risks. In debt markets, the spreads for trade finance are higher in some countries than in others, even though trade finance is usually the cheapest form of debt in any given country. This tends to suggest that an element of country risk is unavoidable, and therefore, should be reflected in the amount of capital needed to support trade finance transactions.

But things are never quite so simple. There are other mitigating factors that must be taken into consideration before reaching a final determination. To begin with, the low risk nature of trade finance may mitigate some of the accord’s concern about capital support. Most people intuitively agree that trade finance, regardless of the original maturities involved, tends to be a less risky form of financing compared to similar debt instruments. While there is not a lot of empirical data to substantiate this claim, the debt markets seem to reflect this in lower risk spreads on trade finance debt compared to other cross border debt of similar maturity.

There are several reasons why trade finance is viewed more favourably including the fact that such transactions are often less than one year in maturity, they are usually self- liquidating, and are always supported by an underlying asset of some value. The Basel Committee itself has noted that a bank only suffers loss if both the obligor and its guarantor default. This double default effect can reduce credit risk to which a bank is subject if there is a low correlation between the default of the obligor and that of the guarantor.

A strong argument can also be made that trade finance is integral to a country’s economic growth and development. The disappearance of trade finance could effectively shutdown an economy.

For this reason, most countries tend to leave trade finance unaffected to the extent that financial resources will permit. Back in the 1980s many countries in Latin America excluded trade finance with less than one year in maturity from exchange controls policies. However, there have been a few cases where this traditional wisdom has not

prevailed, and others that included new facility extensions as part of the negotiations.

Admittedly, some of the arguments used to support a lower risk weighting for trade finance debt do not apply to forfaiting, with some houses willing to accept paper with tenors up to 10 years. Nonetheless, the forfaiter still benefits from holding two-name paper, the historical performance of trade debt, and the overall importance of this activity to a country’s economic prosperity.

The Basel II capital accord is a step in the right direction for the global banking sector despite some of its limitations that hopefully will get corrected before its implementation. While the proposal aims to have a neutral impact on total capital in banking systems, with some banks needing more capital and others less, it remains to be seen whether this will prove to be the case.

In the event that banks attempt to reduce their capital levels due to more favourable treatment under the new accord, but their underlying risk profiles remain constant, this could result in rating downgrades. This reflects our view that banks in general are currently not overcapitalised, and many emerging market banks are vulnerable to even moderate levels of financial system stress.

In fact, because of recent developments in global financial markets, we believe the need for banks to be strongly capitalised has become even more critical, as credit quality of banks has slipped dramatically over the past decade.

Having expressed this opinion, Standard & Poor’s does view positively a bank that has a robust internal rating system based on meaningful historical loss and recovery data by internal rating level. Likewise, it views a bank that has allocated capital based on the inherent risk of exposures in a positive light. From this perspective, the IRB approach, combined with the accord’s emphasis on improved disclosure, represents a historic advance in international bank regulation.

Still, there are other aspects of the accord that do raise concerns from a rating agency’s perspective, especially when it comes to emerging market banks. This includes the ability of banks to manipulate the system if the regulators are not vigilant, and the rules are not clear. There is also the need to explore other peripheral but important issues more carefully.

This article is based on a speech that was delivered to the Association of Forfaiters in the Americas (AFIA) on July 18, 2001 in New York entitled ‘The New Basel Capital Accord: Implications for the Banking Industry’.