Tough loan regime for banks

News analysis: Planned new rules aim to promote more prudent lending

BANKS COULD be required to hold more capital under new regulatory proposals published yesterday by the Bank for International Settlements.

In a tacit admission that capital requirements had not proved adequate during the global financial crisis, the central bankers' bank is pushing for a more sophisticated system of risk assessment involving private ratings agencies and big banks' own internal risk models.

The BIS's Basle Committee on banking supervision is also proposing an additional capital charge for banks whose loan books or operations are deemed unusually risky.

"We very much do not want levels of capital to go down," said William McDonough, president of the New York Federal Reserve Bank and chair of the Basle Committee. The plan, he said, "pushes the banks more than the present accord in the direction of a wiser use of capital".

The 1998 capital adequacy accord requires a minimum 8 per cent ratio of capital - half of it core equity capital - to loans weighted by risk according to a standard formula. In its place the Basle Committee is proposing a more flexible system of risk weighting, closer supervisory involvement in risk assessment, and a place for market discipline.

There is to be less of a blanket approach to the first of these "three pillars", the minimum capital requirement. The existing 8 per cent ratio treats many types of lending as equally risky, in some cases actually encouraging perverse risk-taking.

The existing standard risk weightings for certain types of loan are therefore to be modified by allowing the use of banks' own internal risk ratings when supervisors judge them prudent enough. In addition, ratings by external agencies such as Standard & Poors, Fitch IBCA and Moody's can be incorporated.

So, for example, sovereign lending to governments will get a zero risk weighting for countries rated AAA or AA, but 20 per cent for A-rated countries, and so on along the scale. Banks will have to stick to one agency, rather than picking the most attractive rating for any particular loan they are considering.

During the Asian crisis some ratings agencies were criticised for reacting slowly. Robin Munro-Davies of Fitch IBCA said yesterday: "Nobody would claim ratings agencies are infallible. This will not be a perfect system, but it should be a better system."

Also, big banks with their own sophisticated risk assessments might be able to apply these in working out their capital requirements. This would involve working closely with their supervisors. The BIS is to publish another consultative document on this shortly.

Mr McDonough described the new approach as a "refinement" of the existing system. Claes Norgren, head of the Swedish bank supervisory agency and chairman of the BIS taskforce, said: "Banks' minimum capital requirements might alter."

The refinements will help the BIS overcome a row which delayed publication of yesterday's paper. German banks have large portfolios of commercial mortgages that they say are far less risky than property loans by US banks. The new system will still assign a 100 per cent risk weighting to commercial property - as Mr McDonough said: "The ability of banks to make bad real estate loans is legendary." But German banks might be able to exploit the new flexibility to reduce the risk weightings on their mortgage loan books.

The second pillar of the new accord is a supervisory review of each banking institution's capital adequacy. For the first time this will apply to entire bank holding groups as well as individual banks. Supervisors will be able to require banks to hold more than the minimum capital ratios. "This will put a very heavy requirement on the capabilities of bank supervisors," said Mr McDonough. "Supervisors must have an ability to intervene at an early stage."

Howard Davies, head of Britain's Financial Services Authority, is "comfortable" with the new Basle requirements. "We are used to operating on a judgmental basis. These proposals go with the grain and we think they would be manageable for us," he said yesterday. However, Mr McDonough said some countries might need to devote more resources to bank supervision.

Although the BIS rules will apply formally only to G10 countries - actually 12 leading industrialised nations - other states will find it hard not to fall into line over time. Yesterday's consultation paper made it clear that effective regulation will place a burden on regulators that some, especially in emerging markets, are far from meeting.

The third pillar is market discipline; it is in the interest of banks themselves to make an accurate assessment of the risks and to hold adequate capital to cover them. Mr McDonough said: "We want to maximise the incentive for banks to do what they ought to be doing anyway." All banks should be encouraged to become more like good banks.

But, as he pointed out, market discipline will only work if there is a high degree of transparency. "We are very much in the church of transparency being the first and greatest of commandments."

Greater transparency should start with governments. For example, Mr McDonough said he would like all G10 governments to publish the sovereign ratings calculated by their export credit guarantee agencies.

Consultation on the new BIS proposals lasts until March 2000, and the framework should replace the old accord within two years. Mr Norgren said the new accord would not be perfect. "But it is better than not changing the system at all."