Impact of Basel II Accord on banking system and bank behavior
There are two major impacts of Basel II on banking system:
q The standardized approach often yields much lower regulatory capital levels than the internal model approach, precisely the opposite of what was intended. This may destroy the incentives for banks to migrate toward the IRB approach. It remains an open question just how different the impact between the standardized and IRB approaches are in the emerging market context, and whether that difference provides the right incentives.
q A second example is the Accord’s impact, if any, on the business cycle, the so-called pro-cyclicality debate. Allen and Saunders (2002) and Borio, Furfine and Lowe (2001) claim that the new Basel would exacerbate pro-cyclicality, while Carpenter, Whitesell and Zakrajsek (2001) argue otherwise. The basic concern is that tying banks’ capital to dynamically changing credit ratings will result in pro-cyclical behavior on the part of the banks. When the business environment softens, firms (borrowers) become riskier as predicted by the credit risk (internal ratings) models, which often have obligor probability as a driver. As a result, banks need to hold more capital against loans to those firms. Yet firms may need additional funds precisely during those challenging times to ensure that they are in a viable position when demand resumes. Thus, business cycle fluctuations can have a major impact on credit portfolio loss distributions. Bangia et al. (2002) find that capital held by banks over a one-year horizon needs to be 25 – 30% higher in a recession that in an extension.
Back to the econometric analysis, the research hold by Barth, Caprio, and Levine (2005) has implications for the three pillars of Basel II. Regarding pillar one, they did not find a significant impact of capital regulations on bank development, efficiency, stability. Many factors may explain this result. The harmonization of national capital regulations makes it difficult to find a relationship between capital regulations and bank performance. Or, the lack of clear evidence on the beneficial effects of current capital regulations may reflect the inadequacy of the Basel I capital regulations and the need for implementing Basel II. Or, banks may evade capital regulations.
Moreover, the capital adequacy ratio is an effective indicator of bank soundness as long as best accounting standards and reporting requirements are practiced. For example, a lack of adequate accounting, auditing and reporting requirements in Asia, therefore, explains partly why there was a lack of awareness among market participants and regulators that the growing concentration of foreign bank loans to unhedged borrowers would cause serious banking crisis once the exchange rate depreciated sharply. For example, Rojas-Suarez (2001) has reported that the mean ratio of risk-weighted capital to assets amounted to as much as 8.1% in 1995 – 1997 for Thai banks that experienced a crisis later on (crisis banks) and this ratio was higher than for those Thai banks that did not experience the crisis (non-crisis banks). In the Republic of Korea, those ratios reached 7.9% for crisis banks and 8.3% for non-crisis banks.
The findings, however, support Basel II’s third pillar, but not its second. For most countries, the data indicate that strengthening official supervisory powers will make things worse, not better (see Table 5, regression 8). Unless the country is “top ten” in terms of the development of its political institutions, the evidence suggests that strengthening official supervisory powers hurts bank development and leads to greater corruption in bank lending without any compensating positive effects. Instead, the results advertise the efficacy of Basel II’s third pillar: market discipline (see Table 5, regression 6). Regulations that require informational transparency and that strengthen the ability and incentives of the private sector to monitor banks tend to promote sound banking.
Given its objectives and strong analytical foundations the New Basel Accord opens the door to many research questions that can be put in three groups:
1. The impact of the proposal on the global banking system through possible changes in bank behavior;
2. A set of issues around risk analysis such as model validation, correlations and portfolio aggregation, operational risk metrics and relevant summary statistics of a bank’s risk profile;
3. Issues brought about by Pillar 2 (supervisory review) and Pillar 3 (public disclosure).
The very introduction of the new Basel II, which is planned for more than 100 countries around the world by 2009 (Chart 1 show the scope and the scaleof banks’ assets around the world which are planned to be subject to Basel II regulation), will likely influence bank behavior. For some banks, the output of the risk calculations may serve as useful input to many decisions points for bank management, including capital allocation between different lending activities, risk-based pricing and performance measurement. The potential and channels for changing bank behavior is an important issue that merits more research.
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