| |
Contributions from
the Column
Tribune
The World Bank needs innovative theory
More accurate risk-assessment
4/2004
|
|
[ Banking / Basel 2 ]
More accurate risk-assessment
The capital adequacy rules in the international financial services industry are being reformulated under the name “Basel 2”. The code could result in capital becoming scarcer and more expensive, especially in crisis-plagued developing countries. In economically successful countries, on the other hand, the conditions for businesses might improve. Micro-credit programmes, which are especially important in the fight against poverty, are hardly affected. However, the pro-cyclical effect of the new concept seems questionable.
[ By Hans Dembowski ]
You can sense bankers’ fascination when they talk about Basel 2. They mention the “irresistible logic”, the “modernization of risk management” and the “rationalization of the credit industry”. The rules with which the Basel Committee on Banking Supervision (to which representatives of the most important industrial nations belong) wants to steer the international money market business are unwieldy and, indeed, a long way from being completed. But the core idea is clear: Banks will be under an obligation to assess exactly how risky their loans to businesses or governments are, and to put aside corresponding amounts of equity capital. Risky loans would then automatically be more expensive for the financial institutions, while less dubious lending would be cheaper.
In economic theory, the basic idea is convincing. In the long run, says Hanns Martin Hagen of German development bank KfW, Basel 2 will make financial institutions “more stable” and create “fair competition”. Sound debtors would get additional money more affordably while less trustworthy contenders would pay more for loans. On top of everything, banks would be better protected. Accordingly, improved security and greater efficiency are the stated goals for Basel 2.
However, reality often proves to be more complicated than theoretical models. Indeed, unpleasant surprises may be in store for many developing countries. This applies above all to economies which are crisis-prone and whose governments and companies are not particularly credit-worthy. On the other hand, Basel 2 may also mean more favourable access to capital in countries with successful histories of growth.
Anticipatory compliance
The details of the new rules have not yet been decided upon. Nor is it definite when the new code of practice will formally take effect. Nonetheless, Basel 2 already does have an impact on business. Many financial institutions in advanced national economies are already applying the stricter rules voluntarily. Bernhard Speyer of Deutsche Bank Research explains that they are ahead of the supervisory bodies in terms of the methods they apply. To a large extent, the reason for adopting the rules earlier than required is that markets generally react to expectations. Whatever the leading players regard as likely determines their strategies.
This applies in particular to the volatile finance industry. If it is evident that there will be a particular development, credit institutions adjust to it as early as possible. In the case of Basel 2, this is reinforced by the fact that the risk-acceptance of managers has declined following the collapse of the international stock exchange bubble and various regional crises such as those in South-East Asia, Russia and Argentina.
From a strictly legal perspective, Basel 2 should only apply to advanced nations and, in the case of the USA, perhaps only to internationally active banks. The governments of India and China have already announced that they will not adopt the recommended rules. However the credit institutions in emerging and developing countries will not be able to avoid Basel 2. “If there is a comprehensive body of legislation, then there is pressure to accept it,” says Rainer Schäfer of Dresdner Bank. Its predecessor Basel 1 was also originally intended only for advanced national economies but then became the worldwide benchmark. Ultimately every bank, which takes up international capital, must stick to the standards of the large financial centres.
The stricter equity capital rules of the Basel 2 accord could become an economic burden for those countries whose economic situation is weak. Granting them funds will be more expensive for banks. Therefore interest rates will rise. This effect, however, should not be over-rated, according to Deutsche Bank expert Speyer. He says that countries have always been assessed according to risk. Growing economies such as Costa Rica or Thailand have always obtained loans more easily than chronic crisis cases such as Haiti or Pakistan. However, if loans are risky, the Basel 2 accord puts banks under an obligation beyond the usual care to make higher or lower capital reserves.
In the mid-term a second problem could arise because financial institutions, which follow Basel 2 must also assess the creditworthiness of their own country if they underwrite its government bonds. So far, their own sovereign was deemed to be credit-worthy in principle. But the Argentina crisis has shown that this is not necessarily the case. In many poor countries, stricter assessment of government bonds could put considerable pressure on the equity position of financial institutions since such securities are typically a large part of their business. Stricter assessment of these securities requires correspondingly higher capital reserves, so they will have fewer funds for other customers. At the same time, the scope for governmental borrowing will be restricted. In these countries, capital is likely to become scarcer and more expensive. Dresdner Bank economist Schäfer therefore suggests affected countries should define clear transitional phases for the observance of the new rules. That would be good for the credibility of the financial sector without creating any shock of instant adjustment.
Market friendly concepts
Regarding development assistance, hardly anything can be done against the pressure of stricter risk assessment. Whether or not one likes market logic – its dynamics are an economic force to reckon with. Specialists from major Frankfurt banks recommend to the governments of poorer countries that they prepare for Basel 2 by using the familiar market friendly concepts consistent with World Bank and International Monetary Fund programmes. Countries become credit-worthy through solid budgeting, low inflation, good governance, economic growth and the like.
Banks which want to assess credit risks more accurately also incur new costs in terms of personnel and technology. Additional data and new knowledge, computers and software are needed. In addition, banking supervision must be professionalised. In principle all major borrowers have to be assessed as strictly as Standard & Poor’s and Moody’s assess the major players in the international capital market. Basel 2 leaves it up to the banks either to rely on such credit-rating agencies or to provide equally thorough analyses themselves. In either case, detailed operational data must be processed and analysed, and this will require corresponding professional expertise. All this adds up to making banking procedures more expensive.
For many poor countries, however, it will no doubt still be a long time before all major borrowers can operate as strictly as Basel 2 requires in principle. Frankfurt experts assume that, for the time being, “pared down and simpler” standards will be applied. In any case, KfW economist Hagen points out that the pressure to modernise is heading in the right direction. This applies above all where bank staff have so far allocated funds according to their whims rather than after careful assessment of commercial criteria: “Favouritism does not create lasting value.” In contrast, fair and productive competition flourishes where businesses can implement good ideas with support from credit institutions.
There is another reason why Hagen warns against judging Basel 2 too negatively. Small undertakings are often particularly important for fighting poverty and creating employment. However, they only need small amounts for relatively short time for their investments. Both facts mean that such loans are comparatively safe and that Basel 2 is unlikely to make them more expensive. Moreover, costly ratings do not become necessary. In any event, the code does not apply to credit unions and other institutions, which are not set up as full fledged banks. According to Hagen, the KfW does not foresee any restrictions in its international activities in support of the micro-finance sector and plans to extend them.
The main concern caused by the new framework, however, applies worldwide. Basel 2 no doubt makes sense on the level of individual businesses, but it has a pro-cyclical effect on the economy as a whole. Individual risk assessment by standardized methods implies that, in economic downturns, many companies suddenly get a worse assessment at the same time. Loans will become more expensive just when they most urgently need fresh money for their survival. Conversely, when there is an upturn, they will all suddenly be assessed more favourably – and the loans with which they finance investments will become cheaper at the same time increasing the risk of creating over-capacity. Experience suggests that exaggerated euphoria in an upturn is often followed by a particularly bad recessive hangover. That’s why Commerzbank’ s Oliver Stönner-Venkatarama believes that “after Basel 2 there will be Basel 3”.
|
