Basel Capital Adequacy Research Articles

Why markets do not trust Basel II Internal Ratings-Based Approach: What can be done about it?

The Basel capital adequacy standard is in crisis. The cherished goal of a global level playing field has fallen by the wayside, replaced by an over complicated regime that many of the world’s most important banks have not adopted, while those that have are facing outright rebellion from capital markets that no longer trust risk-weighted assets (RWAs). While some of the debate on this topic is superficial and generates more heat than light, the further investors dig into the apparent inconsistencies in RWA calculations the less confident they become. Faced with this, it is argued the Basel Committee has two options — either try and ‘prove’ RWAs work or else dumb it down. The fear is that the committee’s instinct is to focus only on the former, something that might end up with the Basel framework becoming increasingly irrelevant.

Financial market reforms and corporate financing in Korea

Following the Asian financial crisis of 1997, the Korean economy experienced radical structural reforms, particularly in the financial sector. In this environment, Korea's corporate sector, once characterized by a high degree of leverage, turned to the capital market for financing, while banks diversified their lending targets. Our analysis of large firm-level data finds that, following the crisis, the corporate financing behaviour of both chaebol-affiliated and independent firms became more responsive to such factors as return on assets, cash flows and credit rating. On the lenders' side, the tighter prudential enforcement of the 1988 Basel capital adequacy requirements limited the supply of bank loans. We conclude that both the changed corporate incentives in an environment of greater market discipline and the improved prudential supervision explain much of the more diversified pattern of Korean corporate financing practices in the post-crisis period.

On Time-scaling of Risk and the Square-root-of-time Rule

Many financial applications, such as risk analysis and derivatives pricing, depend on time scaling of risk. A common method for this purpose, though only correct when returns are iid normal, is the square-root-of-time rule where an estimated quantile of a return distribution is scaled to a lower frequency by the square-root of the time horizon. The aim of this paper is to examine time scaling of risk when returns follow a jump diffusion process. It is argued that a jump diffusion is well-suited for the modeling of systemic risk, which is the raison d'etre of the Basel capital adequacy proposals. We demonstrate that the square-root-of-time rule leads to a systematic underestimation of risk, whereby the degree of underestimation worsens with the time horizon, the jump intensity and the confidence level. As a result, even if the square-root-of-time rule has widespread applications in the Basel Accords, it fails to address the objective of the Accords.

Can International Capital Standards Strengthen Banks In Emerging Markets?

Who should determine banks' capital standards: authorities or markets? What is the right definition of core capital: equity only or equity plus subordinated debt? Can the assessment of banks' individual credit risks by external rating agencies be of equal or better quality than the assessments derived from banks' own internal rating systems? These are some of the key financial regulatory issues currently being discussed by analysts in industrial countries, especially in the context of the proposed modification to the Basel Capital Adequacy Accord: Basel II is expected to replace the original 1988 Accord. With a few exceptions, these issues are certainly not at the center of the debate in emerging market financial circles. There, the financial issues at hand depend on the country's level of development. For the least developed countries, reform agendas are just advancing in the implementation of accounting standards, disclosure, and other principles of bank supervision; Basel II is certainly not in the medium-term future. If anything, implementation of the original Accord is the issue. The more advanced emerging economies face a different dilemma. Albeit at very different paces, most of these countries embarked on a financial sector reform process in the early 1990s. One of the most important efforts by individual countries, also strongly supported by multilateral organizations, has been the adoption of the recommendations on capital adequacy requirements by the Basel Committee on Banking Supervision. However, in spite of significant advances in implementation, banking crises have abounded in emerging markets during the 1990s and early 2000s. Not surprisingly, some disillusion with a traditional reform agenda has emerged. A key debate, therefore, centers on assessing whether regulatory standards that work in industrial countries are appropriate for emerging markets. Among the most relevant issues are: (a) Can an early warning system of banking crisis particular to emerging markets be constructed? (b) How should capital adequacy ratios be designed in emerging markets? Should they diverge from the recommendations of Basel? And, (c) rather than focusing on banks, shouldn't emerging markets limit the role of banks, and instead, focus on the development of corporate bond markets? This paper deals with the appropriateness for emerging markets of implementing capital requirements as recommended by the Basel Committee on Banking Supervision. The paper is part of a research agenda that I initiated in the late-1990s. In my previous research I concluded that such capital standards have had very little usefulness as a supervisory tool in emerging markets. For fundamental reasons that go beyond the improvements in regulatory procedures, and, instead center on the particular features of financial sectors in many emerging economies, the capital-to-asset ratio has not been a useful early warning indicator of banking problems. While the limitations of capital requirements as a supervisory tool remain severe in most emerging markets, there are some countries where the increasing participation of foreign banks has helped to improve, at least to a certain extent, the usefulness of capital ratios. For these countries the appropriate choice of capital standards is key. In this paper, I advance the following questions: Can the adoption of the Basel recommendations weaken, rather than strengthen, the stability of banks in emerging markets where capital requirements are binding? Would the proposed modification of the Accord (Basel II) weaken even further the franchise value of emerging market banks? Unfortunately, the evidence seems to provide a positive answer to these questions. Therefore, I propose a set of alternative recommendations capable of strengthening banks in emerging markets. The rest of the paper is organized as follows: relying on some of my previous work on the subject, section II first shows and then explains the reasons why capital requirements have not served their intended role as supervisory tools in many emerging markets. Section III demonstrates that adopting capital requirements as advanced by Basel, and especially by the proposed Basel II, may actually deteriorate the strength of banking systems in emerging markets. Section IV presents alternative proposals to strengthen banks according to the degree of financial development in emerging markets. Where capital requirements can be enforced, the paper advances suggestions for an improved capital standard. Section V concludes the paper.