Financial Markets and Institutions (2-downloads)

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Part 6 The Financial Institutions Industry

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Whither the Basel Accord?

Starting in June 1999, the Basel Committee on

Banking Supervision released several proposals to

reform the original 1988 Basel Accord. These efforts

culminated in what bank supervisors refer to as 

Basel 2, which is based on three pillars.

1. Pillar 1 links capital requirements for large, inter-

nationally active banks more closely to actual risk

of three types: market risk, credit risk, and opera-

tional risk. It does so by specifying many more cat-

egories of assets with different risk weights in its

standardized approach. Alternatively, it allows

sophisticated banks to pursue an internal ratings-

based approach that permits banks to use their

own models of credit risk.

2. Pillar 2 focuses on strengthening the supervisory

process, particularly in assessing the quality of risk

management in banking institutions and evaluating

whether these institutions have adequate proce-

dures to determine how much capital they need.

3. Pillar 3 focuses on improving market discipline

through increased disclosure of details about a

bank’s credit exposures, its amount of reserves and

capital, the officials who control the bank, and the

effectiveness of its internal rating system.

Although Basel 2 made strides toward limiting

excessive risk taking by internationally active banking

institutions, it greatly increased the complexity of the

accord. The document describing the original Basel

Accord was 26 pages, while the final draft of 

Basel 2 exceeded 500 pages. The original timetable

called for the completion of the final round of consul-

tation by the end of 2001, with the new rules taking

effect by 2004. However, criticism from banks, trade

associations, and national regulators led to several

postponements. The final draft was not published until

June 2004, and Basel 2 started to be implemented at

the beginning of 2008 by European banks, but full

implementation in the United States did not occur

until 2009. Only the dozen or so largest U.S. banks

are subject to Basel 2: All others will be allowed to

use a simplified version of the standards it imposes.

The financial crisis of 2007 to 2009, however,

revealed many limitations of the new accord. First,

Basel 2 did not require banks to have sufficient capi-

tal to weather the financial disruption during this

period. Second, risk weights in the standardized

approach are heavily reliant on credit ratings, which

proved to be so unreliable in the run-up to the finan-

cial crisis. Third, Basel 2 is very procyclical. That is,

it demands that banks hold less capital when times

are good, but more when times are bad, thereby

exacerbating credit cycles. Because the probability of

default and expected losses for different classes of

assets rises during bad times, Basel 2 may require

more capital at exactly the time when capital is most

short. This has been a particularly serious concern in

the aftermath of the 2007–2009 financial crisis. As a

result of this crisis, banks’ capital balances eroded,

leading to a cutback on lending that was a big drag

on the economy. Basel 2 has made this cutback in

lending even worse, doing even more harm to the

economy. Fourth, Basel 2 did not focus sufficiently on

the dangers of a possible drying up of liquidity,

which brought financial institutions down during the

financial crisis.

As a result of these limitations, the Basel Committee

has begun work on a new accord, Basel 3. Its goal is

to beef up capital standards, make them less procycli-

cal, make new rules on the use of credit ratings, and

require financial institutions to have more stable fund-

ing so they are better able to withstand liquidity

shocks. Measures to achieve these objectives are

highly controversial because there are concerns that

tightening up capital standards might cause banks to

restrict their lending, which would make it harder for

economies throughout the world to recover from the

recent deep recession. When Basel 3 will be imple-

mented is anybody’s guess.

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Chapter 18 Financial Regulation

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to meet capital requirements. Banks in groups 4 and 5 are “significantly undercapital-

ized” and “critically undercapitalized,” respectively, and are not allowed to pay inter-

est on their deposits at rates that are higher than average. In addition, for group 3 banks,

the FDIC is required to take prompt corrective actions such as requiring them to sub-

mit a capital restoration plan, restrict their asset growth, and seek regulatory approval

to open new branches or develop new lines of business. Banks that are so under

capitalized as to have equity capital that amounts to less than 2% of assets fall into 

group 5, and the FDIC must take steps to close them down.

Financial Supervision: 

Chartering and Examination

Overseeing who operates financial institutions and how they are operated, referred

to as financial supervision or prudential supervision, is an important method

for reducing adverse selection and moral hazard in the financial industry. Because

financial institutions can be used by crooks or overambitious entrepreneurs to engage

in highly speculative activities, such undesirable people would be eager to run a finan-

cial institution. Chartering financial institutions is one method for preventing this

adverse selection problem; through chartering, proposals for new institutions are

screened to prevent undesirable people from controlling them.

Regular on-site examinations, which allow regulators to monitor whether the

institution is complying with capital requirements and restrictions on asset 

holdings, also function to limit moral hazard. Bank examiners give banks a CAMELS

rating. The acronym is based on the six areas assessed: capital adequacy, asset qual-

ity, management, earnings, liquidity, and sensitivity to market risk. With this informa-

tion about a bank’s activities, regulators can enforce regulations by taking such formal

actions as cease and desist orders to alter the bank’s behavior or even close a bank

if its CAMELS rating is sufficiently low. Actions taken to reduce moral hazard by

restricting banks from taking on too much risk help reduce the adverse selection

problem further, because with less opportunity for risk taking, risk-loving entrepre-

neurs will be less likely to be attracted to the banking industry. Note that the meth-

ods regulators use to cope with adverse selection and moral hazard have their

counterparts in private financial markets (see Chapters 7 and 17). Chartering is

similar to the screening of potential borrowers, regulations restricting risky asset

holdings are similar to restrictive covenants that prevent borrowing firms from engag-

ing in risky investment activities, capital requirements act like restrictive covenants

that require minimum amounts of net worth for borrowing firms, and regular exam-

inations are similar to the monitoring of borrowers by lending institutions.

A commercial bank obtains a charter either from the Comptroller of the Currency

(in the case of a national bank) or from a state banking authority (in the case of a

state bank). To obtain a charter, the people planning to organize the bank must sub-

mit an application that shows how they plan to operate the bank. In evaluating the appli-

cation, the regulatory authority looks at whether the bank is likely to be sound by

examining the quality of the bank’s intended management, the likely earnings of the

bank, and the amount of the bank’s initial capital. Before 1980, the chartering agency

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Part 6 The Financial Institutions Industry

typically explored the issue of whether the community needed a new bank. Often a new

bank charter would not be granted if existing banks in a community would be hurt

by its presence. Today this anticompetitive stance (justified by the desire to prevent

failures of existing banks) is no longer as strong in the chartering agencies.

Once a bank has been chartered, it is required to file periodic (usually quarterly)