ECONOMIC ANALYSIS OF BASEL II BANKING REGIME
SYED ALAMDAR ALI, Hailey College of Banking & Finance Lahore
Nov 10 - 16, 2008
Globally there is a deep interest in Basel II. There is a strong commitment for it but the pace of implementation would vary from economy to economy and bank to bank. Presently, on one hand there are differences in economy and institutions' risk management processes, state of tech know how, customers portfolio, and on the other hand, the state of development of rating agencies, external auditors, and above all, regulators varies across economies. By virtue of their better infrastructure, resources, and size of operations, the large internationally active banks particularly in Australia, Japan, Singapore, Hong Kong and Korea are expected to adapt to the new regime in relatively shorter span of time. Meanwhile, economies with less sophisticated, small and fragmented financial structure would be implementing Basel II gradually and remain confined to adoption of SA.
The right regulatory regime for banks is critical to the economic vitality of nations and the international economy. But when judged from the perspective of the main market failures that should be addressed by banking regulation, the international economists opine that the new regime outlined in the Basle Committee's proposed second capital accord (Basle II) is not right. It is complex where it should be simple. It focuses on processes when it should be driven by credit outcomes. It is implicitly pro-cyclical, when it should be explicitly contra-cyclical. It relaxes the discipline on systematically important banks when it should tighten that discipline. It is supposed to more accurately align regulatory capital to the risks that banks face, yet in the case of lending to developing countries it ignores the proven benefits of diversification. It is possible that this is just bad luck. It is more probable that it relates to the political economy of Basle II and the odd composition of the Basle Committee on Banking Supervision.
In identifying the market failure that needs to be addressed by the international bank regulator there are three characteristics about banks that we need to know:
SYSTEMIC RISKS, DISCIPLINE AND LARGE BANKS
As is well discussed in the financial literature, banks pose systemic risks, even more so than the average hedge fund. Banks are leveraged: they lend several times their capital. They are in the business of mismatching duration and credit risks: they borrow cash short-term to lend to individuals and companies often long-term. As such they play a key role in financing and supporting overall economic activity. They are at the centre of the payments system: their loans are often used as collateral for other loans, so that if one large bank pulls its loan early, a whole pack of cards could collapse down. The bigger the bank, the bigger the tumble!
A key point about banking is that it is part of the information industry. One of the most visible consequences of the collapse of information costs in society as a whole has been the disappearance of high street bank branches. Form-filling in face-to-face meetings is no longer a cost-effective way of gathering information when digital banking means every dollar or pound you spend or save can be monitored daily and fed through a computer program searching for patterns. A good bank is one that knows its customers better than others and so lends to some that others wouldn't touch, and draws back from others that the broad markets like.
UNCERTAINTY, HERDING AND PRO-CYCLICAL BEHAVIOR
Banks exhibit herd behavior. This is not because they are irrational - though they may be. Herding is a rational response to uncertainty. Most market participants can be characterized as people who think that somebody out there knows something they do not know and if you think that, then the best policy is to follow them. It is also a rational response to the institutional dangers of being wrong and alone. Being wrong and in company is not as uncomfortable a place as it should be. If you are wrong and in company you cannot easily be singled out for punishment by the markets or courts, and if you and the crowd are so spectacularly wrong that you are in danger of bringing down the financial system, you may even get bailed out by the monetary or fiscal authorities. Being wrong and in company is not fatal ñ this is similar to the earlier adage that if you are going to fail, then it is best to fail big.
Here three aspects of banking that need to be addressed by regulation: firstly, the bigger the bank the more the systemic risk; secondly, good banking is about using superior, perhaps internal, information about local risks, and thirdly, bank assessments of risk, whether they are sophisticated or not, are inherently pro-cyclical. This suggests that good banking regulation should:
(1) Place additional regulatory costs and scrutiny on the big, systematically important banks;
(2) Encourage banks with superior local information;
(3) Use measures of inherent risks that, for example, do not chase market prices and market behavior and emphasize the diversification and spread of risks.