The Future of International Banking Regulation: A New

Beginning or Business as Usual?

Presentation at DIIS by Ranjitt Lall18th 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 risk-weighted 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

Basel II

1 More refined risk-weights linked to external ratings for

all banks ?2

3 Regulation of trading book risks

No regulation

Regulation of market risk Use of VaR models underestimating

market risk

Regulation of securitization risks

Use of excessively low risk weights

Objective Regulation required to meet objective

Basel II

1Link risk-weights to external

ratings for all banks ?2

3

Regulation of trading book risks

?

Regulation of market risk?

Regulation of securitization risks

?

the accord would have to introduce rules to capture three previously unregulated types of risks: trading book risks, in particular counterparty credit risk and risks related to over-the-counter (OTC) derivatives; market risk, the risk of losses to on- and off-balance sheet assets arising from movements in market prices; and securitization risks.

Objective Regulation required to meet objective

Basel II

1Link risk-weights to external

ratings for all banks

Internal ratings for large banks; modified version of Basel I for

other banks2

3

Regulation of trading book risks

No regulation

Regulation of market riskUse of models known

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

Pure Capture Regulation

De facto Capture Regulation

Capture but with Concessions and

Compromises

Common interest regulation

Institutional Supply

Limited(Closed and exclusive

forums, minimaltransparency)

Extensive(Proper due

process, multipleaccess points)

Dem

and

Narrow/Limited

Broad/Sustained

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)

1Incorporate external

credit ratings into new framework

Recognize internal credit risk models of large banks ?

2

3

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?

Standardized methodology based on fixed risk parameters

Substitute standardized methodology for market risk

(VaR) models?

Link risk weights to external credit ratings

Lower risk weights for rated tranches ?

Objective Initial proposal Industry Recommendation

Final proposal (Basel II)

1Incorporate external

credit ratings into new framework

Recognize internal credit risk models of large banks

Recognition of internal ratings for

large banks; modified Basel I for

other banks2

3

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

‘W factor’ abolished in 2001; no

regulation of trading book

Standardized methodology based on fixed risk parameters

Substitute standardized methodology for market risk

(VaR) models

Recognition of VaR models in 1996

Link risk weights to external credit ratings

Lower risk weights for rated tranches

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

Introduce countercyclical capital buffers linked to

credit-to-GDP ratio in Pillar 1Move buffers to pillar 2 Adoption in Pillar 2