Alternative or Complementary Approaches to Basel - Modern Banking

The Basel Committee claims that Basel 2 has been designed to encourage banks to use their own internal models to compute a capital charge. Critics argue the incentives are not there, the approaches discussed here are examples of incentive compatible regulation: the objective is to improve the incentive of individual banks to have accurate risk management systems, either through use of the market or regulators, or both.

The Pre-commitment Approach

This proposal would deal with private banks’ criticism of Basel, that if a bank is allowed to use its own internal model, the minimum capital requirement is too high because it is based on VaR multiplied by 3 or even 4. The larger banks claim this requirement creates a disincentive to use more sophisticated models of risk management.

The Fed’s pre-commitment proposal (1995): The Federal Reserve suggested that banks and trading houses ‘‘pre-commit’’ a level of capital they believe to be necessary to cover losses arising from market/trading risks. The amount pre-committed would be based on the bank’s own VaR model.

At the end of a specified period, the regulator would be able to impose penalties (e.g. a fine or a non-monetary fine, such as not being able to incur certain types of market risk over a period of time) on a bank which failed to set aside enough capital. If the bank over-commits, it penalises itself by setting aside too much capital.

Such a system would remove the responsibility of the regulator to endorse a particular model, which is necessary in Basel 2’s internal model approach. It gives each firm an incentive to find the best model and to add the appropriate multiplication factor to the estimate of possible losses to ensure against incurring a penalty.

The problem with pre-commitment is that banks are penalised at a time when they are under-capitalised – similar to the pro-cyclical problem discussed in Basel. Also, if all banks failed to meet their target because of an unexpected event, it could create systemic problems itself.

Subordinated Debt

Another example of an incentive based approach is that all banks be required to have a certain percentage of their capital in subordinated debt: uninsured, unsecured loans which are junior to all other types of lender, that is, the lenders would be the last to be paid off in the event of bankruptcy. However, a number of issues need to be dealt with if it is to be successful. A clear signal that these creditors will not be bailed out is necessary. Thus, only well-informed buyers, such as institutional investors, should have access to it, which could be done if the debt is issued in very high denominations. The choice of correct maturity is also important. If too short, there is a reduced incentive to monitor. If too long, banks would issue the debt at infrequent intervals, and the market would be unable to give an indication of its view on that debt, which would undermine market discipline. Most proposals suggest a maturity of at least 1 year. The amount suggested is between 2% and 5% of total assets, with a reduction in capital contributions to ensure a fair capital burden. Some propose quarterly debt issues so the market can adequately signal the banks’ debt value. However, there is a question of whether even the largest banks could issue this debt so frequently. Subordinated debt is most likely to work with the largest banks, i.e. with assets of at least $10 million. For smaller banks, the transactions costs would be high and it is unlikely there would be enough liquidity for small bank issues, meaning the spreads would convey very little information.

To be effective, regulators must take punitive action if the yield on the debt falls below a certain level, e.g. the equivalent of BBB corporate debt or junk bond yields on the secondary market. The regulators would then intervene and declare the bank insolvent.

There are a number of advantages arising from the use of subordinated debt. The holders of the subordinated debt, sophisticated creditors, have a strong incentive to monitor the actions of the bank because they lose all their investment in the event of failure. If traded, the debt would be a means of providing a transparent, market price of the risk a given bank is taking. Finally, regulators in some countries (e.g. the USA) are required to take prompt, corrective action or a least a cost approach when dealing with a problem bank. Regulators would be concerned about runs on debt if there were any rumours about the condition of the bank, which would reinforce this requirement.

There are also disadvantages. First, the same rules would apply to all banks above a certain size, independent of the type of bank, its management and the riskiness level. The use of such debt also implies that bank regulators have access to less information than the market place, since the idea is to use sophisticated investors to provide early warning of problems via the sale of the debt. In some developed economies, such as the USA, the opposite is true. Ely (2000) states that a US bank with assets of $100 billion pays bank regulators over $4 million in fees, which should be enough for all the bank’s financial information to be carefully examined. By contrast, the market relies on the publication of quarterly indicators, and does not have access to detailed information that regulators have. Second, if each bank subsidiary in a financial holding company structure was required to issue subordinated debt, there would be two-tier disclosure with the regulator: at the FHC consolidated level and at subsidiary level. This would be costly for the banks. Next, in the case of a financial conglomerate the issue arises as to which parts of the conglomerate would have to comply with the requirement to issue such debt. Also, problem banks would be tempted to avoid full disclosure or massage the figures at the time the debt was issued. However, with the Sarabane Oxley rules, the bank executives run a high risk of jail or heavy fines. As was noted above, if the debt was issued quarterly, it would be costly for the bank and could mean the market was flooded with bank debt, thereby forcing up yields, which merely indicated excess supply rather than anything inherently wrong with the bank. Yields would also be forced up in times of systematic problems, for example, in 1998 with the LTCM and Russian government debt default.

Finally, requiring banks to issue subordinated debt might cause market manipulation. For example, an institutional investor could buy up a large portion of a bank’s subordinated debt and short sell its common stock at the same time. The speculators would then dump the debt in an illiquid market, forcing up the yields, which could trigger intervention. This would be likely to cause the stock price of the bank to fall, at which time the investor closes out the short position: the gain would exceed the loss on the sale of the SD. Bank management could do nothing about it – a bank can buy back its own common stock but its management would not be allowed to buy subordinated debt.

Cross-Guarantee Contracts

Ely (2000) argues this is another market oriented method to encourage banks to be safe and sound. A cross-guarantee contract is a form of private insurance against insolvency.

The guarantors provide unconditional guarantees of the financial firms’ (including banks) liabilities. It would be negotiated on a firm by firm basis, and to operate in the financial sector, a firm would be required to find a guarantor. The guarantor would be paid a premium that would reflect how risky each bank’s activities were. In a simplistic example, a retail bank offering a diversified range of intermediary services would be far less risky than a firm specialising in proprietary trading.

The guarantor and guaranteed firm would jointly agree on a supervisor to monitor compliance with the cross-guarantee contract; hence supervisory arrangements would apply to a particular bank according to the risk profile of that particular bank’s assets. It would get rid of the ‘‘one size fits all’’ approach, though so do the Basel 2 proposals. Also the large universal banks would need a group of guarantors, and close monitoring of the guarantors would be necessary to ensure they have the funds to cover an insolvency.

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