Toward a New Global Banking Standard: The Basel Committee's Proposals

• Author: Cem Karacadag and Michael W. Taylor
• Position: Economist in the Financial Systems Surveillance II Division/Senior Economist in the Systemic Banking Issues Division, of the IMF's Monetary and Exchange Affairs Department

The Basel Committee's new capital framework proposals will have important implications for developed and developing countries alike. Although many details remain to be worked out, it is not too early for countries to start preparing for the proposals' implementation.

Since its launch in 1988, the Basel Capital Accord has become the global standard by which the financial soundness of banks is assessed. The outcome of an agreement among the members of the Basel Committee on Banking Supervision, comprising bank regulators from the Group of 10 countries, the Accord was originally intended to apply only to internationally active banks headquartered in those countries. It is now applied, however, in most countries-industrial, emerging, and developing-and to most banks, including many that operate only domestically. Hence, recent proposals from the Basel Committee to update its now 12-year-old agreement raise significant issues that affect many countries besides the small group of countries represented on the Committee. The Committee recognizes this and has therefore been consulting widely on its proposals.

The Accord's original aims were to stem the decline in bank capital observed for much of the twentieth century (see Chart 1 for an illustration drawn from Canada, the United Kingdom, and the United States) and to level the playing field for internationally active banks. To achieve these objectives, the Basel Committee developed a simple risk-measurement framework that assigned all bank assets to one of four risk-weighting categories, ranging from zero to 100 percent, depending on the credit risk of the borrower. Thus, a bank loan to a commercial company is 100 percent weighted, whereas a domestic bank loan made to the central government in national currency (a loan that is effectively riskless) is zero weighted. Interbank lending generally attracts a 20 percent risk weighting. The Basel methodology requires banks to maintain a minimum ratio of capital to total risk-adjusted assets-that is, the total for all of a bank's assets, after the amount of each asset has been multiplied by the relevant risk weighting-of 8 percent. Although its methodology is rather crude-for example, it makes no allowance for the effect of portfolio diversification-the Accord has a number of advantages: it is relatively simple to apply, and produces an easily comparable and verifiable measure of bank soundness. Moreover, by the early 1990s, its implementation had first halted, and then reversed, the decline in banks' capital ratios in most Group of 10 countries (Chart 2).

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

The Basel Committee has decided to revise the Accord now for a number of reasons. One of the most important is that the last 12 years have seen the rapid development of new risk-management techniques that have left the Accord looking increasingly outdated. Many leading banks have argued that their internal risk-management systems provide better evaluations of risk than the Basel Committee's framework, which, they argue, provides insufficient differentiation of bank assets by broad risk categories.

A second important reason is the effects of a decade of financial innovation, often undertaken to circumvent capital rules. Thus, recent innovations like securitization and credit derivatives have been driven, in part, by the Basel Committee's rules, and the emergence of such innovations has reduced the Accord's effectiveness. Although the Accord initially forced banks from the Group of 10 countries to raise additional capital, more than a decade of financial innovation has created risks that are not encompassed by its measurement framework. In effect, the...