INTEGRATED RISK MANAGEMENT

INTEGRATED RISK MANAGEMENT

BEYOND THE BASEL II CAPITAL ACCORD

University : Rijksuniversiteit Groningen Program : Bedrijfskunde

Author : Drs. M.J. Arends

Primary advisor : Dr. J.H. von Eije

Secondary advisor : Dr. E.H. Bax

CONTENTS Acknowledgements

Proverb

Introduction

Subject 1

Definitions 2

Problem statement 2

Goal statement 2

Demarcation 3

Structure 3

1 Risk management

1.1 Introduction 4

1.2 Risk 4

1.2.1 Risk concepts 4

1.2.2 Risk typology 5

1.3 Risk management 6

1.3.1 Risk management rationale 6

1.3.2 Founding theories 7

1.3.3 Evolution of risk management 7

1.4 Summary 8

2 Banking regulation and the Basel Capital Accords

2.1 Introduction 9

2.2 Banking regulation 9

2.2.1 Regulation rationale 9

2.2.2 Predominant information asymmetry mechanisms 10

2.2.3 Optimal design of banking regulation 12

2.3 Basel I Capital Accord 12

2.3.1 Prelude 12

2.3.2 Objectives 13

2.3.3 Key components 13

2.3.4 Intrinsic flaws 14

2.4 Basel II Capital Accord 15

2.4.1 Prelude 15

2.4.2 Objectives 15

2.4.3 Key components 15

2.4.4 Intrinsic flaws 17

2.5 Summary 18

3 Credit risk

3.1 Introduction 19

3.2 Basel II pillar 1: The internal models approach 19

3.3 Credit risk measurement techniques 20

3.3.1 Structural models 20

3.3.2 Reduced form models 22

3.3.3 Actuarial models 22

3.3.4 Macro-economic models 23

3.4 Limitations of contemporary credit risk measurement techniques 23

3.5 Summary 24

4 Market risk

4.1 Introduction 25

4.2 Basel II pillar 1: The internal models approach 25

4.3 Market risk measurement techniques 26

4.3.1 Probability distribution function fundamentals 26

4.3.2 VaR parameters 28

4.3.3 VaR techniques 28

4.4 Strengths and weaknesses of VaR techniques 28

4.5 Refinement techniques 29

4.6 Summary 30

5 Operational risk

5.1 Introduction 31

5.2 Basel II pillar 1: The internal models approach 31

5.3 Operational risk measurement techniques 32

5.3.1 Tree analysis 32

5.3.2 Scorecard approach 33

5.3.3 Bayesian network 33

5.4 Limitations of contemporary operational risk measurement techniques 34

5.5 Summary 35

6 Integrated risk management

6.1 Introduction 36

6.2 The integrated risk management process 36

6.2.1 Risk strategy 36

6.2.2 Risk identification 38

6.2.3 Risk measurement 38

6.2.4 Risk management 38

6.3 Summary 40

Appendix

Prompt Corrective Action

Bibliography

ACKNOWLEDGEMENTS

The quest has been completed.

I owe special gratitude to Henk von Eije whose expertise and helpful comments deserve to be honoured.

Special thanks also to Erik Bax for his constant contribution over time, acting as secondary advisor for both my theses.

Finally I wish to thank those who will join me in the many quests to come.

Martijn Arends

Amsterdam, May 2006

IF YOU RISK NOTHING, YOU RISK TO LOSE EVERYTHING

INTRODUCTION

Subject

Risk management has been the central theme of both my university education as well as my professional career to date. With regard to my university education, this culminated in the thesis “Integrated risk management: an enterprise-wide control model” which I wrote to complete the program “Doctoraal Sociologie” at the “Rijksuniversiteit Groningen“. With regard to my professional career, this is reflected by the fact that risk management has been at the heart of all my job assignments, having worked in the inherently risk prone petrochemical industry for over 7 years.

¹

Evidently, risk management was destined to be the subject of this thesis.

With the passage of time, the risk management discipline has developed significantly in both theory and practice. Especially the field of financial risk management in banking, the central theme of this thesis, has seen an extraordinary evolution. The need for sound risk management in banking was illustrated by some major risk management fiascos in the early 1990s with losses well in excess over $ 1 billion per case

²

. These cases raised the banks’ awareness of the need to adopt vigorous risk management practices.

The institutional structure of banking has changed profoundly over the last three decades by four major (accelerating) trends: globalisation, integration of financial institutions, financial innovation and the increase in competition. First, globalisation is evidenced by the fact that financial activity is no longer confined to national financial markets but indeed part of a single global financial marketplace. Second, the integration of financial institutions is evidenced

³

by (i) consolidation, reflected by a higher degree of concentration in banking systems leading to a reduction in the number of banks (ii) internationalisation, reflected by the increased number of banks that operate across national borders

⁴

and (iii) conglomeration, reflected by the integration of hitherto discrete segments

⁵

of the financial services sector. Third, financial innovation is evidenced by a shift in core banking business away from traditional balance sheet intermediation into off-balance sheet operations

⁶

and fee-income business. Financial innovation has resulted in an unprecedented expansion of sophisticated custom-made financial products like securitisation and credit derivatives. Fourth, the increase in competition is evidenced by

l

ower net operating margins.

The increase in competition is threefold: between banks themselves, between banking systems, capital markets and funds (e.g. mutual funds, pension funds, insurance funds) and between banks and non- financial institutions (e.g. General Electric Capital Corporation).

The interplay between these trends changed the context for banking to the extent that banks faced a significant increase in (the complexity of) risks with detrimental effect on national and global financial stability. Consequently, national and international bank regulators established minimum capital requirements to counteract this threat.

⁷

In July 1998 the international Basel Committee on Banking Supervision

⁸

(henceforth BC) issued the Basel I Capital Accord, imposing a capital adequacy norm to internationally active banks. In essence, the capital adequacy norm prescribed these banks to hold total capital equivalent to at least 8% of their risk-weighted assets. The Basel I Capital Accord has been implemented well beyond the membership of the BC in over 100 countries world-wide. In function of intrinsic flaws of Basel I, market developments and advances in risk management practices, the BC issued the Basel II Capital Accord in June 2004. Although stipulating the same capital adequacy norm, the Basel II capital adequacy framework is far more sophisticated, risk being differentiated to credit risk, market risk and operational risk. As the due date to meet regulatory compliance is end 2006, the challenge set forth to the banking industry is daunting.

⁹

1 Exxon Corporation (later Exxon Mobil Corporation).

2 E.g. Barings and Daiwa (by rogue traders Nick Leeson and Toshihide Iguchi respectively).

3 See Group of Ten (2001), Bank for International Settlements (2001) and International Monetary Fund (2001).

4 One can discern multinational banking and international banking; the former requires an institutional banking presence in the form of branches in one or more foreign countries where the latter does not. See Cho (1985).

5 The financial services sector comprises three segments: banking, insurance and securities business.

6 Classified as off-balance-sheet operations as from an accounting viewpoint none of these operations corresponds to a genuine liability or asset for a bank but only to a random cash flow.

7 Capital adequacy is the most important measure of a bank’s soundness. The link between capital adequacy and bank failure is undisputed: a bank has failed only when it has exhausted its capital.

8 The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten Countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States.

The Basel Committee officially changed the spelling from Basle to Basel in May 1999. For sake of clarity, Basel is used throughout this thesis.

9 The Basel Capital Accords are a code of best practices without legal force. The adoption is self-imposed and enforced by peer pressure (so called soft law) and by transposition of the Accords into national laws.

Definitions

At this stage definitions will be provided of those terms that are directly related to the goal and problem statements. These terms will be covered in further detail and placed within the context of integrated risk management in the course of this thesis.

A bank is an institution whose current operations consist in granting loans and receiving deposits from the public.

¹⁰

One can discern commercial banks (retail client base), investment banks (wholesale client base) and universal banks (combined). With the emergence of financial conglomerates

¹¹

the functional distinction between banks versus insurance and securities firms has become blurred, giving rise to mixed forms (e.g. bancassurance).

Risk stems from the uncertainty about the manifestation of financial loss to a bank’s portfolio.

¹²

One can discern three components of uncertainty in this working definition of risk: uncertainty about (i) the risk factors (events) that cause risk to originate (ii) the objects that are affected by risk, and (iii) the magnitude of financial loss. These three components work in conjunction and together constitute risk.

There is no risk if one of these components does not materialise. An example may clarify. If there is no exchange rate devaluation (i.e. risk factor) there is no risk. If there is an exchange rate devaluation but a bank’s portfolio does not hold currency exposures (i.e. risk objects) that would be affected by such a devaluation, there is no risk. If there is an exchange rate devaluation and a bank’s portfolio does hold currency exposures that are affected by such a devaluation, again there is no risk if there is no financial loss (e.g. by perfect hedge).

Credit risk is defined as the risk of counterparty failure.

¹³

Market risk is defined as the risk of losses in on- and off-balance sheet positions arising from movements in market prices.

¹⁴

Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.

¹⁵

The capital adequacy norm of the Basel II Capital Accord reads:

Integrated risk management comprises the identification, measurement and management of the overall risk of a bank across all risk categories and business lines (i.e. portfolio context) employing a coherent strategy.

Both bank regulators and banks center on risk measurement in dealing with the capital adequacy norm of the Basel II Capital Accord. On the basis of literature study, this thesis seeks to cover the prevalent risk measurement techniques and to relate risk measurement to the concept of integrated risk management.

The goal and problem statement read:

Goal statement

Place risk measurement within the framework of integrated risk management.

Problem statement

Which risk measurement techniques can be applied to meet regulatory compliance with the capital adequacy norm of the Basel II Capital Accord, differentiated to credit risk, market risk and operational risk?

10 Freixas & Rochet (1997).

Note that the concept and definition of a bank varies from country to country and deposit-taking institutions may, for regulatory purposes, be differentiated according to whether or not they enjoy full banking status.

11 A financial conglomerate is any group of companies under common control whose exclusive or predominant activities consist of providing services in at least two different segments of the financial services sector. See Swaan de (1995).

12 Portfolio comprising liabilities, assets and off-balance sheet items.

13 Basle Committee on Banking Supervision (1988). Pp. 2.

14 Basle Committee on Banking Supervision (1996). Pp. 1.

15 Basel Committee on Banking Supervision (2004). Pp. 137.

capital

credit risk + market risk + operational risk

≥

^8%

Demarcation

The scope of this thesis is in line with the scope of the Basel II Capital Accord. Derived from that the following subjects are out of scope:

-

Insurance

-

Securities business

-

Political context

-

Monetary context

-

Fiscal (including tax & accounting) context

-

Legal context

Given the level of detail of the Basel Capital Accords, it is outside the scope of this thesis to provide an all inclusive overview of Basel I and II as this would require a full presentation of the original documents.

¹⁶

In order to assist the reader, reference is made to relevant sections of the original documents via footnotes.

Structure

By analogy with a house, the thesis is structered around three building blocks: the foundation, the pillars and the roof. The foundation is formed by the capital base, the pillars by credit risk, market risk and operational risk and the roof by integrated risk management. This analogy serves to explain the interrelationship between the three building blocks and will be used as point of reference throughout this thesis. In a consistent manner, the summary section of each chapter will relate to the house analogy.

Figure I: The basic¹⁷ house analogy

Chapter 1 covers risk categories and risk management.

Chapter 2 covers banking regulation and the Basel Capital Accords.

Chapters 3 to 5 cover risk measurement techniques for credit risk, market risk and operational risk respectively.

Chapter 6 covers integrated risk management.

16 See www.bis.org for original documents (website Bank for International Settlements).

17 The house analogy will be nuanced throughout the thesis. Chapter 6 provides the advanced house analogy which consolidates all information (see page 40).

Risk Management Integrated Risk Management

Chapter 6

Risk Category Credit Risk Market Risk Operational Risk

Chapter 1 1 1

Risk Measurement

Chapter 2, 3 2, 4 2, 5

Capital Base

CHAPTER 1 RISK MANAGEMENT

1.1 Introduction

Risk management would be irrelevant in a Modigliani & Miller

¹⁸

world of perfect capital markets, symmetric information, equal access and given investment strategies. Under these assumptions, the market value of a firm is independent of its capital structure. In such a hypothetical world, risk management cannot enhance the market value of a firm as shareholders can offset any financial transaction made by that firm.

However, these assumptions do not hold in the real world. Indeed, dealing with risk and balancing risk- return tradeoffs is the essence of modern banking.

The outline of the chapter is as follows. Section 2 covers risk concepts and a typology of risks. Section 3 places risk management in a broader perspective: the rationale of risk management, the founding theories and the evolution of the risk management discipline. Section 4 offers conclusions.

1.2 Risk

1.2.1 Risk concepts

Establishing a common understanding of risk is by no means a trivial task. The fact that there is no universal definition of risk requires the use of different risk concepts employed in various disciplines like economics, statistics and finance.

¹⁹

The first concept is the distinction between risk and uncertainty. According to the interpretation of Willet

“risk and uncertainty are the objective and subjective aspects of apparent variability in the course of natural events”.

²⁰

To Willet “…it seems necessary to define risk with reference to the degree of uncertainty about the occurrence of a loss, and not with reference to the degree of probability that it will occur. Risk in this sense is the objective correlative of the subjective uncertainty. It is the uncertainty considered as embodied in the course of events in the external world, of which subjective uncertainty is a more or less faithful interpretation”.

²¹

Knight offered an interpretation that rested on a similar objective-subjective distinction. According to Knight “to preserve the distinction… between the measurable uncertainty and an unmeasurable one we may use the term ‘risk’ to designate the former and the term ‘uncertainty’ for the latter. The practical difference between the two categories, risk and uncertainty, is that in the former the distribution of the outcome in a group of instances is known (either through calculation a priori or from statistics of the past experience), while in the case of uncertainty this is not true, the reason being in general that it is impossible to form a group of instances, because the situation dealt with is in a high degree unique”.

²²

Risk thus represents quantifiable random variables whereas uncertainty represents unquantifiable random variables. Uncertainty cannot be measured as in absence of any classification the possible outcomes are infinite.

²³

The second concept relates to statistical probability in reference to the likelihood of an event.

²⁴

Certainty is defined as a situation where the probability of an event is one. By contrast, uncertainty is defined as a situation where the probability of an event is judged to be between zero and one. Impossibility is defined as a situation where the probability of an event is zero. It follows that risk only materialises in case of uncertainty. The concept of probability can be extended to include risk and return. For this purpose the probability distribution

²⁵

(i.e. dispersion of possible outcomes) of a random variable is matched with the utility function of an investor (i.e. reflection of an investor’s risk attitude).

The third concept is the distinction between pure and speculative risk. According to Mowbray “pure risks are those that offer only the prospect of loss. Thus the possible outcomes from activities or events exhibiting pure risk range from zero to negative. Speculative risks are those that offer the firm a chance of

18 Modigliani & Miller (1958).

19 See Bernstein (1996) for a comprehensive history of risk. According to Bernstein “the essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us”. Pp. 197.

20 Willet (1901). Pp. 24.

21Ibid. Pp. 8.

22Knight (1921). Pp. 233.

23 The implication is that uncertainty as such cannot be modeled (but indeed is still present).

24 Keynes (1921) rejected the term event because it implies that forecasts must depend on statistical frequencies of past occurences. He preferred the term proposition which reflects degrees of belief about the probability of future events.

25 See chapter 4, section 4.3.1.

gain or loss. Such activities are usually undertaken in the hope of gain, although the range of possible outcomes includes those that will register to the owner an economic loss. Investment in business activity is invariably risky in the speculative sense; other examples of speculative risk arise with the holding of currency, stocks, real estate, etc., where price fluctuation can either benefit or deprive the owner”.

²⁶ Pure

risk is thus defined as a situation where there is only downside potential (i.e. the possibility of loss or no loss). Speculative risk, by contrast, is defined as a situation where there is both downside and upside potential (i.e. either a possibility of loss or gain).

²⁷

1.2.2 Risk typology

Banks face a wide array of risks in their course of business. These different risks need careful definition to provide a sound basis for integrated risk management. As the Basel II Capital Accord impose capital charges against credit risk, market risk and operational risk, the importance of precise definition and accurate measurement is evident.

Table 1.1 decomposes the three risk categories credit risk, market risk and operational risk into financial risk subsets. The last section (other) provides definitions of liquidity and solvency risk.

²⁸

Table 1.1 Risk typology (source: table compiled by author based on literature study)

26 Mowbray (1930).

27 Pure and speculative risk are also called on-way and two-way risk respectively.

28 Liquidity and solvency risk are induced by credit, market and operational risk.

Risk category Definition

Credit risk Risk of counterparty failure

Herstatt risk Risk stemming from the non-simultaneous settlement of the delivery and payment legs of foreign exchange transactions

Country risk Risk that adverse political or economic developments in a particular country might prevent borrowers from meeting their foreign obligations

Rating transition risk Risk that a counterparty will have its credit rating upgraded or downgraded

Market risk The risk of losses in on- and off-balance sheet positions arising from movements in market prices

Interest rate risk Risk arising from fluctuations in interest rates Equity risk Risk arising from fluctuations in equity prices Commodity risk Risk arising from fluctuations in commodity prices Currency risk Risk arising from fluctuations in currency rates

Operational risk Risk of loss resulting from inadequate or failed internal processes, people and systems or from external events

Legal risk Risk that a counterparty to a transaction will not be able to meet its obligations under

Model risk Risk associated with mismatch between model dynamics and actual dynamics Regulatory risk Risk that regulation will be changed in a manner that will adversely affect the

profitability of a bank

Other

Liquidity risk Risk arising from an inability to generate or obtain funding (cash or equivalents) at an economically reasonable price to timely meet obligations when they fall due

Solvency risk Risk that the total value of a firm’s assets falls below the total value of its liabilities (i.e. negative net worth)

One should recognise that these categories of risk may be correlated and that providing definitions is only the first step in managing them.

At this stage, it is worth devoting attention to the traditional distinction between a bank’s banking and trading book. In essence, the banking book consists of assets and liabilities with the intent to hold these items to maturity. By contrast, the trading book consists of positions in financial instruments and commodities held either with trading intent or in order to hedge other elements of the trading book.

Accounting methods differ for the banking and trading book: the former is based on book value accounting (backward-looking) whereas the latter is based on market value accounting (forward-looking).

Traditionally credit risk was solely associated with the banking book. However, securitisation

²⁹

and credit derivatives

³⁰

has made part of the credit risk tradable and as a consequence part of the trading book.

Market risk is by definition associated with the trading book whereas operational risk is associated with the banking book.

1.3 Risk management

1.3.1 Risk management rationale

In essence, risk management serves to maximise the value of a bank by enhancing risk-return tradeoffs.

Against this background one can discern four main reasons for risk management

³¹

: (i) to minimise financial distress costs (ii) to minimise cost of funding (iii) to avoid dysfunctional investment decisions, and (iv) to increase share value via the discount rate.

The first reason for risk management is to minimise financial distress costs which become apparent in case of liquidity or solvency problems.

³²

A bank will be able to meet its obligations as they come due under normal business conditions. However, unanticipated events demanding substantial cash resources may result in a lack of liquidity. In such a situation, a bank may be forced to liquidate assets at fire sale prices (i.e. selling assets below carrying value) thereby incurring significant losses. This situation may be aggravated by associated deadweight costs (e.g. legal costs). In extremo, a liquidity problem can turn into a solvency problem with the potential to culminate in bankruptcy. The primary focus of risk management at banks is therefore not on traditional financial risk, but rather on extreme (i.e. low probability, high impact) events that may generate catastrophic financial losses.

The second reason for risk management is to minimise cost of funding which relates to the choice between internal or external funding. A bank will prefer internal sources of funding over external sources of funding as the latter tend to be more costly because of transaction costs (e.g. issuance costs associated with new shares). Risk management allows a bank to make optimal use of internal sources of funding thereby reducing the overall cost of funding.

The third reason for risk management is to avoid dysfunctional investment decisions. Investment decisions vary in their net present value and in their risk profile. Risk management allows a bank to make investment decisions based on risk-adjusted performance analysis to optimise the aggregate net present value of future cash flows.

³³

The fourth reason of risk management is to increase share value via the discount rate. For the valuation of a bank, investors will look closely at both the level of earnings and the stability of those earnings. Risk management serves to minimise the volatility of reported earnings, demonstrated by a stable earnings stream. As a result, investors will judge the bank to be less risky and will require a lower rate of return on their investment. This discount rate implies a higher value for the bank’s shares.

29 Securitisation involves the sale of assets to a special purpose vehicle (SPV) which finances this purchase through issuance of asset-backed securities (ABS) to investors. See Kendall & Fishman (1996).

30 Credit derivatives are instruments that allow banks to trade credit risk without terminating the underlying lending relationships.

31 Additional reasons (e.g. to reduce corporate taxes) are not addressed here as they are outside the scope of this thesis.

32 While liquidity and solvency are related they are indeed different concepts: liquidity is ascertained by a cash flow calculation, as distinct from solvency which is ascertained by a value calculation

.

Both are needed if a bank is to operate as a going concern, but they are still separate and unique: a bank that is technically solvent can fail from lack of liquidity, while a bank that is liquid may become technically insolvent.

33 Metrics for risk-adjusted performance are covered in chapter 6, section 6.2.

1.3.2 Founding theories

The theoretical origins of modern risk management can be traced back to the mean-variance portfolio theory, the Capital Asset Pricing Model and option pricing models. These theories have laid the foundation for contemporary risk measurement techniques as covered in this thesis.

The mean-variance portfolio theory by Markowitz is based on the recognition that portfolio diversification can reduce risk using the covariance matrix of portfolio returns.

³⁴

The value of a portfolio is the weighted (by size of positions) sum of the values of the securities in the portfolio, and the portfolio return is the weighted (by proportion of portfolio value) sum of the returns of the constituent securities. According to this normative theory of portfolio selection, investors will select mean-variance efficient portfolios (portfolios that have the maximum expected return for a given level of risk).

The Capital Asset Pricing Model by Sharpe and Lintner expanded the mean-variance portfolio theory by introducing the notion of a risk-free asset.

³⁵

This theory is based on the assumption that, in case of capital market equilibrium, risky assets are incorporated in a market portfolio (distinct from risk-free assets) and are priced according to their relative contribution to the total risk of that market portfolio. The relative contribution is measured by the ratio (beta

³⁶

) between the covariance of the rate of return of the asset and the rate of return of the market portfolio, and the variance of the market portfolio. Investors who hold a portfolio will value assets using their betas as an index of risk. If an asset has a positive beta with respect to that portfolio, then adding it into the portfolio will increase the volatility of the portfolio’s returns. The theory demonstrates that such an asset must have a positive expected rate of return proportional to its beta to compensate investors for this increase in volatility.

The option pricing models by Black & Scholes and Merton make use of a framework similar to that used by Markowitz, Sharpe and Lintner. The Black-Scholes model for European options is significant for its option pricing equation (a formula for the valuation of options) and its implications for hedging.

³⁷

The model’s hedge ratio (delta) measures the change in the value of an option resulting from a small change in the price of the underlying asset. The hedge ratio shows how the risk of the underlying security over a very short time interval can be hedged dynamically with derivatives. The Merton model extended the Black- Scholes model by refining its assumptions, making the Merton model suitable for a wider range of applications.

³⁸

1.3.3 Evolution of risk management

One can discern three evolution stages of the risk management discipline. Table 1.2 differentiates the stages to application scope, management method, approach and focus.

Table 1.2 Evolution stages of risk management

In retrospect, the origins of risk management can be traced back to insurance. At the start of stage 1, in the 1940s, firms confined themselves to the identification of insurable risks and the purchase of appropriate insurance. A term that captures this traditional approach to risk management is ‘sleep insurance’: if a firm buys insurance on all insurable risks, management is free to go home for a ‘good night’s sleep’.

³⁹

Over time firms adopted a more active stance, making cost-benefit analyses to optimise their insurance portfolio. The predominant approach was the formulation of theory, reflected by a wide variety of definitions of risk and risk management. In stage 2, which started in the 1960s, firms explored alternatives to insurance to reduce their risk exposure. In order to attain that goal, firms applied risk

34 Markowitz (1952, 1959).

35 Sharpe (1964) & Lintner (1965).

36 Technically, the total risk of an asset can be decomposed into a specific risk component and a systematic risk component. The former can be can be diversified away through the law of large numbers whereas the latter cannot.

Beta measures the systematic risk of an asset.

37 Black & Scholes (1973).

38 Merton (1973). The model also points out that shares are in effect call options on a firm’s assets, a view with far reaching implications for corporate finance.The structural models of default are based on this notion, see chapter 4 section 4.3.1.

39 Mehr & Hedges (1974).

Application scope Management method Approach Focus

Stage 1 Insurance Insurance management Theory Definitions of risk and risk management Stage 2 Components of firm Stand-alone risk management Specialism Techniques of risk management Stage 3 Firm Integrated risk management Multi-disciplinary Active portfolio management

management techniques from disciplines like statistics, economics and finance. These techniques were applied on a stand-alone basis within different components of the firm (e.g. treasury, insurance). Doherty summarises this shortcoming aptly: “the existing structure encourages a piecemeal approach to the handling of risk rather than an integrative approach. Risk is identified, measured, and handled on the implicit assumption that the degree of risk measured for an individual exposure unit translates into an equivalent degree of risk to be absorbed by the firm’s owners. However, risk does not follow a simple additive process. Possibilities for diversification exist at various levels”.

⁴⁰

Stage 3 has yet to commence, although significant progress has been made over the last decade to move in that direction. Ultimately, integrated risk management is firm-wide, multi-disciplinary (integrating statistics, economics and finance) and facilitates active portfolio management.

1.4 Summary

Figure 1.3 relates the information of this chapter to the house analogy.

Figure 1.1 The house analogy: chapter 1

This chapter elaborated on risk and risk management. In absence of a universal definition of risk, three risk concepts were discussed which shed light on the different dimensions of risk: the distinction between risk and uncertainty, the statistical probability in reference to the likelihood of an event and the distinction between pure and speculative risk. Next, the three risk categories of Basel II (credit risk, market risk and operational risk) were decomposed into financial risk subsets. Within this context, it should be noticed that credit risk only has downside potential, market risk both upside and downside potential and operational risk only downside potential. The distinction was made between a bank’s banking and trading book which parallels the distinction between book value accounting and market value accounting. Where credit risk is associated with both the banking book (hold to maturity intent) and the trading book (trading intent), market risk and operational risk are associated with the trading book and the banking book respectively.

Based on the proposition that risk management serves to maximise firm value, the four main reasons of risk management were discussed: (i) to minimise financial distress costs (ii) to minimise cost of funding (iii) to avoid dysfunctional investment decisions, and (iv) to increase share value via the discount rate. Of major importance is the recognition that the primary focus of risk management at banks is not on traditional financial risk, but rather on extreme events that may generate catastrophic financial losses.

The penultimate section covered the essence of the mean-variance portfolio theory by Markowitz, the Capital Asset Pricing Model by Sharpe and Lintner and the option pricing models by Black & Scholes and Merton. These theories have laid the foundation for contemporary risk measurement techniques as discussed in subsequent chapters. Finally, three evolution stages of the risk management discipline were identified, differentiated to application scope, management method, approach and focus. It was postulated that stage 3, characterised by integrated risk management, has yet to start.

40 Doherty (1985). Pp. 37.

Risk Category Credit Risk Market Risk Operational Risk

Chapter 1 1 1

Subset Herstatt risk Interest rate risk Legal risk

Country risk Equity risk Model risk

Rating transition risk Commodity risk Regulatory risk

Currency risk

Upside / downside Downside Upside & downside Downside

Banking / trading book Banking & trading book Trading book Banking book

Accounting method Book & market value accounting Market value accounting Book value accounting

CHAPTER 2 BANKING REGULATION AND THE BASEL CAPITAL ACCORDS

2.1 Introduction

The history of banking regulation is one of continuous change in response to market developments.

Globalisation, facilitated by technological advance and deregulation

⁴¹

, has been the all pervasive market development since the 1960s.

⁴²

From the outset there has been a clear recognition that the emergence of a highly integrated global banking system may endanger global financial stability. One can discern two potential sources: (i) nations may engage in a competition of regulatory laxity, exploiting disparities between national banking regulation regimes to attract international banking business and (ii) transnational linkages across banks and banking systems may serve as a transmission mechanism of financial crises, expanding the geographic range over which financial crises can be transmitted.

⁴³

The emergence of a global banking system straddling a multitude of regulatory jurisdictions pointed to the need for international harmonisation of banking regulation. The Basel Capital Accords have made an important contribution to securing international convergence of banking regulation governing capital adequacy.

The outline of the chapter is as follows. Section 2 covers banking regulation in a broader perspective: the rationale of banking regulation, the predominant information asymmetry mechanisms and a forward- looking reflection on the optimal design of banking regulation. Sections 3 and 4 provide a high-level overview of the Basel I and Basel II Capital Accords respectively, structured around the objectives, key components and intrinsic flaws. Note that chapters 3 to 5 will cover Basel II pillar 1 in further detail.

Section 5 offers conclusions.

2.2 Banking regulation

2.2.1 Regulation rationale

The economic theory of regulation rests on the notion of market imperfection and failure. Regulation is justified in order to prevent or mitigate the manifest or potentially adverse effects of (natural) monopoly power, externalities and asymmetric information between market participants.

⁴⁴

Although resting on the same notion, banking regulation is singled out to be more stringent because banks hold the pivotal position in the financial system (i.e. the provision of the payment system) and consequently in the real economy.

⁴⁵

Banking regulation is both preventive (to reduce the likelihood of bank failure) and protective (to mitigate the consequences of bank failure). This is reflected in the three core objectives of banking regulation: to sustain systematic financial stability, to maintain the safety and soundness of financial institutions and to protect the consumer.

⁴⁶

Regulation to sustain systematic financial stability and to maintain the safety and soundness of financial institutions rests on the concept of systemic risk. Banks’ vulnerability to systemic risk is attributed to contagion: the mechanism through which financial problems propagate from one individual bank to another endangering the banking system as a whole. There are two potential contagion scenarios.

⁴⁷

First, bank runs that are caused by depositors seeking to withdraw their funds in response to the (perceived) fear of individual bank insolvency may trigger contagious bank runs.

⁴⁸

Second, malfunction

⁴⁹

of interbank

41 National laws that traditionally prohibited cross-border transactions have been relaxed or dismantled.

42 The origins of globalisation can be traced back to the rise of eurocurrency markets.

43 The 1997 South-East Asia crisis may serve as an example.

44 This line of reasoning follows the public interest theory of regulation (versus the private interest theory c.q. public choice theory of regulation where regulation is justified in order to secure regulatory benefits for private interest groups). Conversely, the free banking theory advocates a financial system without government intervention. See Dowd (1992, 1993), Hayek (1976) and Selgin (1988, 1996). In the past many countries operated free banking systems, notably Scotland (1716-1844), Canada (1817-1914), Sweden (1831-1902) and the USA (1837-1913). On a contemporary note, in January 1996 New Zealand moved to a limited form of free banking.

45 One may argue that the social costs associated with a dislocation of the financial system and the real economy provide a justification for banking regulation in its own right.

See Caprio & Klingebiel (1996) for a cross-country study analysing the impact of banking crises to the real economy.

46 Llewellyn (1999).

47 Reputation risk has a contagion dimension: e.g. financial conglomerates using the same brand name in banking and insurance may experience negative cross-over effects when the brand name is damaged.

48 Note that the nature of the deposit contract (fixed nominal claim) incorporates the first-come-first-served principle implying a strong incentive for depositors to run first as latecomers may not be repaid in full (in absence of deposit insurance). See Bryant (1980) and Diamond & Dybvig (1983) for deposit insurance models.

49 Root cause can be technical or non-technical (e.g. failure of one bank to meet payment obligations).

payment and settlement systems may trigger a chain reaction of liquidity problems in the interbank market. Three distinctive bank features exacerbate the contagion issue: (i) banks operate on a fractional reserve basis

⁵⁰ (ii) banks engage in asymmetric transformation of liquid value-certain liabilities to illiquid

value-uncertain assets

⁵¹

and (iii) banks’ liabilities are for the greater part composed of on-demand redeemable deposits.

Regulation to protect the consumer rests on the notion that, due to the inherent opacity of banks and the ensuing information asymmetry, consumers are unable to ascertain the risk profile and condition of a bank. Therefore consumers are to be protected from opportunistic behaviour by banks and from the consequences of bank failure.

Table 2.1 shows the three core objectives of financial regulation versus the types of regulation differentiated to public and private sector regulation.

Financial regulation objectives Public sector regulation Private sector regulation 1 Systemic financial stability Macroprudential regulation Market discipline

2 Safety and soundness of financial institutions Microprudential regulation Corporate governance 3 Consumer protection Conduct of business regulation Corporate governance Table 2.1: Financial regulation objectives versus public and private sector regulation types

Public sector regulation has both a prudential and a conduct of business dimension. Prudential regulation is designed to curb bank risk-taking and thereby to reduce the probability of bank failure. The main prudential instruments are market entry control, range of activity control, deposit interest-rate ceilings and required balance sheet ratios. Conduct of business regulation is designed to establish rules and guidelines to promote appropriate behaviour and business practices in dealing with consumers.

Private sector regulation has both a market discipline and corporate governance dimension. Market discipline relates to actions by market participants to monitor and influence the behaviour of banks to improve their performance.

⁵²

Key prerequisite for market discipline to be effective is market transparency facilitated by timely, comprehensive and accurate information disclosure enabling stakeholders to assess a bank’s condition and risk profile.

⁵³

Corporate governance is the method by which a bank is directed and controlled to ensure compliance with the overall corporate strategy, regulation and the rule of law. Key prerequisites for attaining corporate governance objectives are independent oversight, internal checks and balances and clear lines of responsibility and accountability between the principal stakeholders:

management, board of directors, shareholders and auditors (internal and external).

2.2.2 Predominant information asymmetry mechanisms

In essence banking regulation is to have decision makers in the financial services sector, faced by incentive structures and moral hazards, to act in a way that satisfies the objectives of regulation. In the presence of information asymmetry, each decision maker acts upon differential information affecting the effectiveness and efficiency of banking regulation. Table 2.2 shows the predominant information asymmetry mechanisms (embodied by incentive structures and moral hazards) differentiated to key decision makers: regulators, bank managers (i.e. regulated agents) and depositors.

50 Banks operate on a relatively low leverage (debt/equity) ratio versus non-financialinstitutions.

51 One can distinguish three types of asset transformation: convenience of denomination, quality transformation and maturity transformation. See Freixas & Rochet (1997).

52 Bliss & Flannery (2002).

Note that market signals which reflect bank risk-taking (e.g. share price) serve as indirect market discipline.

53 The U.S. Sarbanes-Oxley Act (SOX) of 2002 may serve as an example. This law, which is aimed at improving the reliability of corporate disclosures, requires that (i) quarterly and annual reports fully comply with the reporting requirements of the Securities Exchange Act of 1934 and that (ii) by executive certification, these reports fairly present the financial condition and operating results of the firm. Included in the legislation are criminal fines and imprisonment for false reporting.

Predominant information asymmetry mechanisms

Decision makers Regulation Safety net Miscellaneous

Regulators Regulatory capture Regulatory forbearance

Too-big-to-fail doctrine N.a.

Bank managers Regulatory arbitrage Strict compliance

Excessive risk-taking Looting

Pay c.q. bonus structure Herd behaviour

Depositors Absence of due diligence Adverse monitoring incentive Extent imperfection

Absence of due diligence N.a.

Table 2.2 Predominant information asymmetry mechanisms differentiated to decision makers (source: table compiled by author based on literature study)

Banking regulation itself may induce moral hazard for key decision makers. Regulators may be prone to regulatory capture; based on the consumers’ assumption that regulation is a free good

⁵⁴

(and hence the tendency to overdemand), self-interested regulators may not be trying to achieve socially desired goals but pursue their own objectives. Bank managers may engage in regulatory arbitrage by exploiting regulatory loopholes or concessions in different jurisdictions. Bank managers may also judge strict compliance with regulation as sufficient where more prudent behaviour may be appropriate. Depositors may not exercise due diligence where regulation embodies an implicit contract between regulator and depositors. In addition regulation might eliminate the incentive for depositors to monitor banks; to lower their transaction costs they may delegate the monitoring activity to a regulatory agency (potentially reinforcing regulatory capture). Furthermore, as regulation is not supplied through a market mechanism, depositors are unable to signal the extent of regulation required which might result in suboptimal regulation.

The financial services sector has established a safety net aimed at safeguarding financial stability in the presence of information asymmetry. However the instruments of the safety net, deposit insurance and the lender-of-last-resort facility, may induce moral hazard for key decision makers.

⁵⁵

Regulators, in case of a financial crisis, may exercise forbearance instead of prompt and stringent action increasing the bail out costs.

⁵⁶

The associated too-big-to-fail doctrine may provide an incentive for regulators to pursue forbearance in case the financial institution concerns a core bank. Bank managers may take excessive risks assuming their downside risk is covered by the safety net. In extremo, bank managers who foresee the impending downfall of their bank may resort to looting.

⁵⁷ Depositors may not exercise due diligence

assuming full protection against loss is guaranteed by deposit insurance.

Two additional potential moral hazards specific to bank managers are worth mentioning. First, the pay c.q.

bonus structure may create perverse incentives for bank managers to take risk in order to secure their remuneration. Second, bank managers may have the tendency towards herd behaviour to denounce risk rejection (i.e. bank managers mimic each others risk perception).

⁵⁸

54 In fact the public treat regulation mistakenly as a free good. Regulation costs comprise direct costs (regulatory bodies) and indirect costs (compliance costs incurred by regulated banks).

55 Deposit insurance is a public, private or mixed instrument to protect deposits up to a pre-set limit. In principle a deposit insurance scheme is a fund to which deposit-taking financial institutions make premium contributions on a flat- rate basis (the exception being the US where premium contributions are made on a risk-adjusted basis since 1991 as stipulated by the Federal Deposit Insurance Corporation Improvement Act -FDICIA-).

The lender-of-last-resort facility (c.q. lifeboat rescue) is a tacit instrument of the central bank to provide emergency liquidity assistance to a financial institution in distress. As a rule, central banks pursue a policy of ‘constructive ambiguity’ where bail-out criteria are not specified a priori.

56 Regulatory forbearance is defined as the regulatory body allowing an insolvent bank to continue in operation. Research shows avoidable costs to the taxpayer can be significant. See Hoggarth & Saporta (2001).

57 See Akerlof & Romer (1993).

58 See Fink & Haiss (2000).

2.2.3 Optimal design of banking regulation

The optimal design of banking regulation is dependent on the objectives and the information asymmetries as highlighted in the previous two subsections. Derived from that, five important normative statements can be formulated with regard to the optimal design of banking regulation.

⁵⁹

First, banking regulation should be objective-based (directed at the core objectives) rather than functional-based (directed at the type of business activity) or institutional-based (directed at the type of firm). The effectiveness of functional or institutional regulation is undermined because the financial services sector is a continuously changing entity. With the blurring of dividing lines between segments and firms, regulation should focus on the core objectives as they remain stable over time. Second, banking regulation should cover the full spectrum of public and private sector regulation. Exclusive reliance on either regulation type is sub- optimal as both are complementary and mutually reinforcing. There is a strict limit to what can be achieved by public sector regulation, therefore market discipline and corporate governance should be strengthened. Third, banking regulation should reinforce internal risk management valuing the informational advantage of banks over regulators. Recognising that banks are better informed about their risks than regulators, banking regulation should place emphasis on risk management best practices.

Fourth, banking regulation should be incentive compatible. Any sec rule-based approach is bound to fail as it inevitably will not capture the changing dynamics and complexity of risks and will lag behind evolving risk management practices. To avoid banks from circumventing rules, banking regulation should incorporate incentives that will induce appropriate behaviour by regulated banks. Fifth, banking regulation should allow for policy differentiation. While the objective of competitive neutrality in banking regulation is deemed inviolable, it is not satisfied if unequal banks are treated equally. In this respect, equality should relate to the risk management practices of banks. Banking regulation should encompass a menu approach to allow for policy differentiation.

2.3 Basel I Capital Accord 2.3.1 Prelude

The year 1974 witnessed the failure of three internationally active banks: Bankhaus Herstatt (Cologne), British-Israel Bank (Tel Aviv) and the Franklin National Bank (New York). The significant disruption of international markets in the wake of Herstatt’s collapse focused attention on the interdependence of national banking systems.

⁶⁰

This prompted the formation of the Committee on Banking Regulations and Supervisory Practices (under auspices of the Bank for International Settlements) in February 1975 by the central bank governors of the Group of Ten Countries.

In September 1975 the BC adopted the Basel Concordat.

⁶¹

The 1975 Concordat set out guidelines for co- operation between national authorities in the supervision of banks’ foreign establishments (differentiated to branches, subsidiaries and joint ventures) with regard to liquidity, solvency and foreign exchange operations and positions. By the terms of the 1975 Concordat (i) no foreign banking establishment should escape supervision (ii) supervision should be adequate judged by the standards of both parent and host authorities (iii) the supervision of liquidity should be the primary responsibility of host authorities (iv) the supervision of solvency should be the primary responsibility of parent authorities in case of foreign branches and of host authorities in case of foreign subsidiaries and joint ventures and (v) co-operation should be promoted by the exchange of information between parent and host authorities and by the authorisation of bank inspections by or on behalf of parent authorities on the territory of host authorities.

Although the 1975 Concordat represented a significant step towards greater international regulatory co- operation, it suffered from a major deficiency which became apparent in July 1982 by events surrounding the collapse of the prominent Italian bank Banco Ambrosiano (Milan). Where the Italian authorities protected depositors with the parent bank (by transferring the parent bank’s business to a new entity, Nuovo Banco Ambrosiano) they refused to protect depositors with Banco Ambrosiano’s foreign subsidiaries on the grounds that these entities were located outside their jurisdiction. This refusal applied in particular to the Luxembourg subsidiary Banco Ambrosiano Holdings (BAH), through which Banco Ambrosiano conducted its Euromarket activities. For their part Luxembourg authorities disclaimed responsibility for BAH since it was chartered as a holding company and therefore not subject to Luxembourg bank regulation.

⁶²

59 Note that Basel II incorporates some of these insights.

60 Bankhaus Herstatt, a relatively small private German bank, collapsed due to losses incurred in spot foreign exchange transactions that exceeded half the book value of its assets

.

Timing of closure was of overriding importance:

Bankhaus Herstatt was officially declared bankrupt by the German authorities after the German market had closed (16:00 CET, June 26 1974), but while the U.S. market was still open. This cut short the settlement of the dollar leg of Herstatt’s foreign exchange transactions in the Clearing House Interbank Payments System (CHIPS, the New York settlement system), resulting in significant losses to dollar counterparties. Note that CHIPS did not provide finality of payment at that time (i.e. absence of liquidity reserve and loss-sharing arrangements).

61 Basle Committee on Banking Regulations and Supervisory Practices (1975).

62 Depositors with BAH received partial repayment after considerable delay.

In response to this controversy, in May 1983 the BC issued a revised version of the 1975 Concordat to close identified gaps.

⁶³

The 1983 Concordat reformulated and elaborated on provisions of the 1975 Concordat and introduced the principle of consolidated supervision: parent authorities should monitor the risk exposure of banks and banking groups on the basis of the totality of their global business (point of reference being corporate structures with holding companies). Accordingly, by the terms of the 1983 Concordat the supervision of solvency in case of foreign subsidiaries should be a joint responsibility of both host and parent authorities and the supervision of liquidity and solvency in case of joint ventures should be the primary responsibility of the authorities in the country of incorporation (the remaining guidelines concerning the supervision of liquidity and solvency were equal to the 1975 Concordat).

In parallel, August 1982 marked the beginning of an international debt crisis

⁶⁴

, developing countries being unable to make interest payments on their sovereign debt owed to foreign banks. The United States took the leading role in resolving the crisis, U.S. banks holding the greater part of claims on debtor countries.

Government intervention was required due to the fact that the capital base of banks engaged in international lending had declined significantly over the years leading up to the crisis, removing their financing capacity. In April 1983 the U.S. Congress enacted the International Lending Supervision Act (ILSA). Besides providing financial assistance to the debtor countries (via the IMF) the act stipulated principles to strengthen the supervision of banks involved in international lending (in particular banks’

capital base) and called for convergence of international capital adequacy standards. In January 1986 the Federal Reserve Board issued a capital adequacy standard for U.S. commercial banks based on a fixed capital-to-asset ratio ($5.50 to $100) and on a risk-weighted system where weights were assigned to different categories of assets and off-balance-sheet items.

⁶⁵

To avoid U.S. commercial banks would be placed at a competitive disadvantage by the unilateral standard, the United States initiated negotiations with England in July 1986 to discuss a bilateral capital adequacy standard. This bilateral standard was effectuated in January 1987 and extended to a trilateral standard when Japan joined in September 1987.

The fact that the three most powerful banking centers would hold international banks to the new standard spurred the BC to define an international capital adequacy standard.

⁶⁶

In December 1987 the BC distributed the draft version to the G-10 countries for a six month consultation period. In July 1988 the BC endorsed and issued the final version: The Basel I Capital Accord (henceforth Basel I).

2.3.2 Objectives

Two fundamental objectives lay at the heart of Basel I

⁶⁷

:

ƒ The capital adequacy framework should serve to strengthen the soundness and stability of the international banking system.

ƒ The capital adequacy framework should be fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks.

In developing the framework, the underlying objective was to arrive at a set of principles which were conceptually sound and at the same time paid due regard to particular features of the supervisory and accounting systems in individual member countries at the time.

2.3.3 Key components

The capital adequacy framework was designed to establish minimum levels of capital for internationally active banks

⁶⁸

, to be applied on a consolidated basis. The framework was directed towards assessing capital in relation to credit risk. The capital adequacy norm prescribed these banks to hold total capital equivalent to at least 8% of their risk-weighted assets (the target standard ratio

⁶⁹

). National authorities were free to adopt arrangements that set higher levels of minimum capital.

63 Basle Committee on Banking Regulations and Supervisory Practices (1983).

64 The 1982 Mexican debt crisis was followed by the Latin American debt crisis.

65 Prior to that the U.S. capital adequacy standard was based solely on the fixed capital-to-asset ratio ($5.50 to $100).

Note that by that time several G-10 countries already operated on risk-weighted capital adequacy standards (e.g.

England as from 1980).

66 Limited progress had been made by the Basel Committee to define an international capital adequacy standard as G-10 central bankers deemed convergence of capital standards infeasible because of structural differences between national banking systems.

67 Basel Committee on Banking Regulations and Supervisory Practices (1988). Pp. 2.

68 Ibid, pp. 3. The report does not provide a definition of an internationally active bank.

69 Commonly known as the Cooke ratio, named after the chairman of the Basel Committee at the time (governor of the Bank of England).

The Basel I capital adequacy framework distinguishes between core (tier 1) and supplemental (tier 2) capital. Tier 1 capital consists of equity capital and disclosed reserves whereas tier 2 capital consists of undisclosed reserves, revaluation reserves, general loan loss reserves, hybrid debt capital instruments and subordinated debt.

⁷⁰

The sum of tier 1 and tier 2 capital elements are eligible for inclusion in the capital base, subject to limits (i) total tier 2 is maximum 100% of total tier 1 (ii) subordinated debt is maximum 50% of total tier 1

⁷¹

(iii) general loan loss reserves are maximum 1.25% of risk-weighted assets

⁷²

and (iv) latent revaluation reserves are subject to a 55% discount. In addition, deductions are made from the capital base, consisting of (i) goodwill to be deducted from tier 1 (ii) investments in unconsolidated banking and financial subsidiaries to be deducted from total capital and (iii) at the discretion of national authorities, investments in the capital of other banks and financial institutions to be deducted from total capital.

The method for assessing the capital adequacy of banks comprises the weighted risk ratio in which capital is related to different categories of on-balance-sheet assets and off-balance-sheet items.

⁷³

On-balance- sheet assets are, according to counterparty category, assigned to one of five risk buckets (attracting 0, 10, 20, 50 or 100% risk weight

⁷⁴

) and the book value of the asset is multiplied by the respective risk- weight. Off-balance-sheet items are first converted to asset-equivalents by applying a credit conversion factor

⁷⁵

and then treated the same way as on-balance-sheet assets.

Foreign exchange and interest rate contracts are converted to credit-equivalents using the original exposure method or the current exposure method.

⁷⁶

In the original exposure method, the credit- equivalent is obtained by multiplying the notional principal amount of the contract by a conversion factor according to original maturity and contract type.

⁷⁷ In the current exposure method, the credit-equivalent

is obtained by the contract’s current marked-to-market value plus an add-on according to residual maturity and contract type.

⁷⁸

The banks were expected to meet an intermediate target ratio of 7.25%

⁷⁹

by the end of 1990 and to meet the standard target ratio of 8% by the end of 1992.

2.3.4 Intrinsic flaws

The intrinsic flaws of Basel I can be classified as follows:

ƒ Narrow risk scope

The Basel I capital adequacy framework incorporated only credit risk, ignoring other risk categories like market risk and operational risk. Furthermore, Basel I treated credit risk on a stand-alone basis, assuming risk is linear and additive. By ignoring the fact that correlations between components of the portfolio may significantly alter total portfolio risk, Basel I did not reward portfolio diversification.

In addition, the limited number of risk buckets did not allow for adequate differentiation of credit risks. Suffice to say that a framework that required more regulatory capital for a one year loan to an AAA-rated corporation than for a ten year loan to a bank outside the OECD was less discriminating than it might be.

ƒ One-size-fits-all approach to risk management

By applying one uniform approach in terms of calculating the capital adequacy requirement, Basel I did not create incentives for banks to improve their risk management practices.

70 Basle Committee on Banking Supervision (1988). See annex 1 for definitions.

71 Subordinated debt is subject to a 20% discount per year during the last five years to maturity.

72 This limit would apply in the event that no agreement would be reached on a consistent basis for including unencumbered provisions or reserves in capital. An increase was allowed to 2.0% on an exceptional and temporary basis.

73 See Dewatripont & Tirole (1994) for the mathematical rule (pp. 52).

74 Basle Committee on Banking Supervision (1988). See annex 2 for risk weights by category of on-balance-sheet asset.

75 Ibid. See annex 3 for credit conversion factors for off-balance-sheet items.

76 These items are singled out because banks are not exposed to credit risk for the full face value of the respective contracts but only to the potential cost of replacing the cash flow if a counterparty defaults.

77 Basle Committee on Banking Supervision (1988). Pp. 29.

78 Ibid. Pp. 28.

79 Core capital was allowed to be made up of supplemental capital during the transition, the proportion gradually reduced from maximum 25% (until year-end 1990) to maximum 10% (until year-end 1992).