March 2002 Insights Issue #40

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Bumpy road to Basel
Banking regulation: precision versus accuracy

Banks play an important role in the economy and need to be regulated. Safe, sound banks and a stable financial system are essential. Without this, the banking system would be unable to perform its basic functions well, such as financing economic development and poverty reduction. Nor would people have the confidence to use banks.

The regulation of banks for capital adequacy purposes (ensuring that banks hold sufficient capital to cover their risks) has important implications for the safety and soundness of banks, stability, efficiency and consumer protection. Regulation may be precise, through detailed and prescriptive rules, but is it always accurate? While capital adequacy rules may specify how much capital each bank should hold, such rules may not truly reflect the risks involved and unintentionally force banks to hold either too much or not enough capital. Too little capital increases the danger of bank failure whilst too much capital imposes unnecessary costs on banks and their customers and may reduce the efficiency of the banking system.

A major new initiative from the Basel Committee on Banking Supervision is the Basel 2 Accord - the proposed new capital adequacy framework. Set to replace the Basel Accord of 1988, which has been accepted by nearly all countries as the basis for the regulation of their banks, the Basel 2 Accord stipulates how much capital banks should hold in relation to their risks. But shouldn't systemic stability and the safety and soundness of banks be considered in a wider framework than just capital adequacy rules? A 'regulatory regime' should also include official supervision, market discipline, incentive structures and corporate governance arrangements for banks, and intervention arrangements should they get into difficulty. The following twelve tests to gauge the suitability of any capital adequacy regime are suggested in the box below:

Basel 2 is more detailed and complex than its predecessor, for example applying risk weight to different classes of assets and loans. If risk weights don't reflect true risk, banks' balance sheets and lending policies will become seriously distorted. If risk weights are too high, lending will decrease with serious consequences for developing countries. Banks will be required to hold more (expensive) capital against loans to developing countries than is justified, reducing the supply of loans and increasing their costs. Increased sophistication and precision does not necessarily imply increased accuracy: the distortion of bank lending with respect to loans to developing countries is an important example. Would the same objectives be achieved with a less complex and costly system?

Regulation is a response to market failure. Regulation, however, may undermine other mechanisms in the regulatory regime: excessive reliance on detailed and prescriptive rules may weaken incentive structures and market discipline. It may also weaken corporate governance within banks and blunt the incentives of the market, other banks, depositors and so on, to monitor and control the behaviour of banks. The value of Basel 2 ultimately depends upon its accuracy:

• Is better accuracy possible at an acceptable cost to banks and regulatory and supervisory agencies?
• Are the benefits of a complex set of capital adequacy arrangements enough to offset the higher compliance and monitoring costs that they will inevitably entail?

David T. Llewellyn
Economics Department
Loughborough University
Leicestershire
UK

T +44 (0)1509 222 700

D.T.Llewellyn@lboro.ac.uk

See also

'Some regulatory lessons from recent bank crises', De Nederlandsche Bank Staff Report: Amsterdam, by D. T. Llewellyn, 2001

'Bumps on the Road to Basel: An Anthology on Basel 2' Centre for the Study of Financial Innovation: London, 2001

'Financial Regulation: Why, How and Where Now?' Routledge: London, by C. A. E. Goodhart et al, 1998