Governments in many developing countries began to deregulate in the 1990s, by ceasing direct credit, privatizing public sector banks, removing interest rate ceilings, and allowing freer entries.
Many countries also liberalised the capital account. In most cases, deregulatory initiatives were not backed up by strong regulation, severe imbalances were allowed to build up after the regime change, and crises followed some time afterwards.
Since the Mexican crisis of 1994 and the Asian crises (1997-98), the conventional wisdom has changed. The new consensus holds that while capital account and domestic liberalization are best policies in the long run, liberalization reforms should be accompanied by efforts to improve the incentives of financial agents, particularly by strengthening supervision. It is, for example, a mistake to liberalize if large parts of the system are insolvent or likely to become so.
The Basel Capital Accord (Basel Committee, 1988) is a commitment by financial authorities within the G-103 countries to apply a minimum capital requirement to internationally-active banks in the G-10.
It defines a measure of capital and a measure of risk, the latter known as 'risk-weighted assets'. The rule is that a bank's capital must be no less than 8 per cent of its risk-weighted assets.
But the proposed Basel II represents a change of approach to regulation. Banks can, and do, change their risk profiles very rapidly. Periodic examination of prudential returns has become less useful, and some banks routinely window-dress at reporting dates.
Reflecting these changes, the Basel II proposals are based on three 'pillars'. The first is capital adequacy (or solvency) regulation; the second is the 'supervisory review' process; and the third is disclosure requirements as an aid to market discipline. Pillar I now sets capital requirements against three risk classes: credit risk; market risk and operational risk.
The pillar I, establishes minimum regulatory capital requirements - the amount of capital banks must hold against various types of risk. While Basel l addressed market and credit risk, Basel II substantially enhances the regulatory capital measurement of credit risk exposure and also requires that banks have sufficient capital to cover operational risks - the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events.
Credit risk: For banks, credit risk is the most important risk category. The simplest approach to credit risk is now called the 'standardized' approach. Instead of basing the risk weight on the category of borrower (bank, sovereign, public sector entity, etc.), the risk weight is now based on the borrower's rating. There are rules determining what kind of rating agency's ratings can be used. The more sophisticated, internal ratings based, or 'IRB' approach, relies on banks' estimates of key determinants of credit risk.
It comes in two flavours. The foundation approach uses banks' estimates of a borrower's probability of default (PD), while the regulator sets other inputs. In the advanced approach, the bank may estimate other inputs, such as Loss Given Default (LGD), but the mapping from input to risk weight is still set by the Basel Committee.
The IRB approach provides a similar treatment for corporate, bank and sovereign exposures, and a separate framework for retail, project finance and equity exposures. For each exposure class, the treatment is based on three elements: risk components, where a bank may use either its own or standardized supervisory estimates; a risk weight function which converts the risk components into risk weights to be used by banks in calculating risk weighted assets; and a set of minimum requirements that a bank must meet to be eligible for IRB treatment.
Operational risk: There are three approaches to operational risk: the basic indicator approach (BIA), standardised approach, (SA) and advanced measurement (AMA) approaches. The definition of capital remains the same. The banks using BIA must hold capital for operational risk equal to a fixed percentage of average annual gross income over the previous three years.
Under the SA, bank's activities are divided into eight business lines: corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management and retail brokerage. The gross income of all these lines will be multiplied by a risk factor to arrive at the operational risk capital.
The AM approach (AMA) the regulatory capital will equal the risk measure generated by the bank's internal operational risk measurement using the qualitative and quantitative criteria.
There are certain issues addressed in respect of trading book. The new proposed definition is, "a trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book.
To be eligible for trading book capital treatment, financial instruments must either be free of any restrictive covenants on their tradability or able to be hedged completely. In addition, positions should be frequently and accurately valued, and the portfolio should be actively managed".
The pillar II which sets out supervision requirements, gives the board and senior management specific oversight responsibilities, thus reinforcing the principles of internal control and other corporate governance practices as required by local regulators worldwide.
The new framework stresses the importance of bank management developing an internal capital assessment process and setting targets for capital that are commensurate with the bank's particular risk profile and control environment. Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks. This internal process would then be subject to supervisory review and intervention, where appropriate.
The pillar III requires far greater disclosure by banks, to make market discipline more effective. One of the challenges for management will be to balance the greater transparency required by Basel II with the requirements of IFRS, to avoid duplication of effort and ensure consistency of reporting towards disintermediation.
Effective disclosure is essential to ensure that market participants can better understand banks' risk profiles and the adequacy of their capital positions. The core set of disclosure requirements and recommendations applies to all banks, with more detailed requirements for supervisory recognition of internal methodologies for credit risk, credit risk mitigation techniques and asset securitisation.
