Financial Markets and Institutions (2-downloads)

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banks’ holdings of risky assets and about the increase in banks’ off-balance-sheet

activities, activities that involve trading financial instruments and generating income

from fees, which do not appear on bank balance sheets but nevertheless expose banks

to risk. An agreement among banking officials from industrialized nations set up

the Basel Committee on Banking Supervision (because it meets under the aus-

pices of the Bank for International Settlements in Basel, Switzerland), which has

implemented the Basel Accord that deals with a second type of capital require-

ments, risk-based capital requirements. The initial Basel Accord, which still applies

to all but the largest banks in the United States, required that banks hold as capital

at least 8% of their risk-weighted assets, was adopted by more than 100 countries,

including the United States. Assets and off-balance-sheet activities were allocated

into four categories, each with a different weight to reflect the degree of credit risk.

The first category carried a zero weight and included items that have little default

risk, such as reserves and government securities issued by the Organization for

Economic Cooperation and Development (OECD—industrialized) countries. The sec-

ond category had a 20% weight and included claims on banks in OECD countries. The

third category had a weight of 50% and included municipal bonds and residential

mortgages. The fourth category had the maximum weight of 100% and included loans

to consumers and corporations. Off-balance-sheet activities were treated in a simi-

lar manner by assigning a credit-equivalent percentage that converted them to 

on-balance-sheet items to which the appropriate risk weight applied.

Over time, limitations of the Basel Accord became apparent, because the regu-

latory measure of bank risk as stipulated by the risk weights differed substantially from

the actual risk the bank faced. This resulted in regulatory arbitrage, a practice in

which banks keep on their books assets that have the same risk-based capital require-

ment but are relatively risky, such as a loan to a company with a very low credit rat-

ing, while taking off their books low-risk assets, such as a loan to a company with a

very high credit rating. The Basel Accord thus led to increased risk taking, the oppo-

site of its intent. To address these limitations, the Basel Committee on Bank

Supervision came up with a new capital accord, referred to as Basel 2 and is now begin-

ning work on developing a new accord, which the media has dubbed “Basel 3.” These

accords are described in the Global box, “Whither the Basel Accord?”

Prompt Corrective Action

If the amount of a financial institution’s capital falls to low levels, there are two seri-

ous problems. First, the bank is more likely to fail because it has a smaller capital

cushion if it suffers loan losses or other asset write-downs. Second, with less capi-

tal, a financial institution has less “skin in the game” and is therefore more likely to

take on excessive risks. In other words, the moral hazard problem becomes more

severe, making it more likely that the institution will fail and the taxpayer will be

left holding the bag. To prevent this, the Federal Deposit Insurance Corporation

Improvement Act of 1991 adopted prompt corrective action provisions that require

the FDIC to intervene earlier and more vigorously when a bank gets into trouble.

Banks in the United States are now classified into five groups based on bank capi-

tal. Group 1, classified as “well capitalized,” are banks that significantly exceed minimum

capital requirements and are allowed privileges such as the ability to do some securi-

ties underwriting. Banks in group 2, classified as “adequately capitalized,” meet mini-

mum capital requirements and are not subject to corrective actions but are not allowed

the privileges of the well-capitalized banks. Banks in group 3, “undercapitalized,” fail

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