Basel II: The Rise of Risk Assessment

Story Notes:

• The Basel II accord is set to supplant Basel I as the new international banking standard
• While the new accord features improved rules for matching risk to capital requirements, the plan has also attracted many critics
• Basel II has gained wide acceptance and on balance should be a net positive for global financial institutions

It's a universally accepted fact: sequels are never as good as the original. The pro-sequel contingent invariably points to "Godfather 2" as evidence sequels aren't just unimaginative knock-offs, but even they have to feel a pang of disappointment when suffering through the third installment of the Godfather series.

The Basel II Accord is the sequel sweeping through the global banking industry, and while some are expecting "Rocky 2"-type success, others fear a "Weekend at Bernie's 2" disaster. Basel II is the second of the Basel Accords which establish guidelines for regulations and capital requirements in the international banking system.

There are three "pillars" to Basel II. The first pillar deals with regulatory capital requirements and represents the most significant change in the way banks assess risk. Under Basel I, reserve capital requirements are determined by bank regulators. Capital requirements are essentially uniform among banks, and risk assessment is crude at best. For instance, under Basel I, a mortgage loan to a subprime borrower requires the same amount of capital reserves as a mortgage for the most creditworthy customer.

By contrast, the amount of reserves required under Basel II is directly related to risk. The more risk a bank takes on, the more capital it will be required to keep in reserve, and vice versa. Banks lending money to more creditworthy customers can lend more of their capital than banks that lend to riskier customers, all else being equal. Enabling banks holding higher quality loans to utilize more of their capital reduces the perverse incentive to hold high-risk loans and shed low-risk loans.

Furthermore, allowing banks to conduct their own risk assessment empowers them to develop better risk measurement and management processes. As a result, banks themselves will better understand their risk profiles.

The second and third "pillars" are more straightforward but equally important. The second "pillar" deals with regulatory oversight of the first "pillar." Regulators have the ability to step in and adjust capital requirements if a bank's internal risk assessment is deemed inadequate.

The third "pillar" dictates banks' required disclosures. Banks are required to be transparent with the details of their risk assessment and risk management activities to both regulators and the public.

Despite the Accord's many positive attributes, regulators in the US are skeptical. Some fear Basel II will lead to an industry-wide decline in capital reserves, putting the entire banking system at risk. Banks in Europe, Canada and Japan implemented Basel II at the beginning of this year, but the US has delayed implementation until January 2008.

US bank executives are eager to get Basel II in place because delays put them at a disadvantage to foreign competitors. Banks in countries already adopting Basel II are able to earn a higher return on more of their capital, enabling those banks to charge less for products that compete with US banks.

But Basel II isn't a free ride. The risk assessment methodologies involve significant commitments of capital and other resources. The most advanced methods are too costly to be utilized by any but the largest institutions. As a result, economies of scale become increasingly important under the new rules. In fact, Basel II will initially be used by only the largest, internationally active US banks.

Some critics contend the recent turmoil in credit markets revealed some cracks in the Accord. In order to assess risk, Basel II relies on ratings agencies and sophisticated modeling techniques, both of which have had their accuracy called into question. However, banking executives and regulators are more aware now than ever their models are imperfect—an inevitability factored into banks' risk assessment.

Ultimately, Basel II should enable banks to make better use of their capital, benefiting the banking industry and the global economy. Financial innovation is taking place at a remarkable pace, and the health of the global financial system requires financial regulation to keep up. Basel II is an important step in ensuring the safety and efficiency of the banking system. I'm confident it will be one of those rare sequels that eclipses the original blockbuster.