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The BIS Basel International
Bank Capital Accord
Hammes and Shapiro (2001) delineate several key drivers motivating BIS II, including:
1. Structural changes in the credit markets. Regulatory capital require- ments must reflect the increased competitiveness of credit markets, particularly in the high default risk categories; the trading of credit risk through credit derivatives or collateralized loan obligations; mod- ern credit risk measurement technology; and increased liquidity in the new credit risk markets.
2. Opportunities to remove inefficiencies in the lending market. In con- trast to the insurance industry which uses derivatives markets and rein- surance companies to transfer risk, the banking industry is dominated by the “originate and hold” approach in which the bank fully absorbs credit risk.
3. Ballooning debt levels during the economic upturn, with a potential debt servicing crisis in an economic downturn. For example, in 1999, debt-to- equity ratios at S&P 500 companies rose to 115.8 percent (as compared to 84.4 percent in 1990) and household debt to personal disposable income rose to 95 percent (as compared to 72 percent in 1985) [Hammes and Shapiro (2001), p. 102].7
BIS II follows a three-step (potentially evolutionary) paradigm. Banks can choose from among: (1) the basic standardized model, (2) the internal ratings-based (IRB) model foundation approach, and (3) the advanced inter- nal ratings-based model. The standardized model is based on external credit ratings assigned by independent ratings agencies (such as Moody’s, Standard
& Poor’s and Fitch IBCA). Both internal ratings approaches require the bank to formulate and use its own internal ratings system (see Chapter 2). The risk weight assigned to each commercial obligation is based on the ratings assignment (either external or internal), so that higher (lower) rated, high (low) credit quality obligations have lower (higher) risk weights and there- fore lower (higher) capital requirements, thereby eliminating the incentives to engage in risk shifting and regulatory arbitrage.
Whichever of the three models is chosen, the BIS II proposal states that overall capital adequacy after 2005 will be measured as follows:8
Regulatory total capital =Credit risk capital requirement +Market risk capital requirement +Operational risk capital requirement where
1. The credit risk capital requirement depends on the bank’s choice of either the standardized approach or an internal ratings-based (founda- tion or advanced) models.
2. The market risk capital requirement depends on the bank’s choice of either the standardized approach or internal model (e.g., RiskMetrics, historical simulation, or Monte Carlo simulation). This capital require- ment was introduced in 1996 in the European Union and in 1998 in the United States.
3. The operational risk capital requirement (as proposed in 2001) depends on the bank’s choice among a basic indicator approach, a standardized approach, and an advanced measurement approach (AMA).9While part of the 8 percent ratio under BIS I was viewed as capital allocated to ab- sorb operational risk, the proposed new operational risk requirement (to be introduced in 2005) aims to separate out operational risk from credit risk and, at least for the basic indicator approach, has attempted to cali- brate operational risk capital to equal 12 percent of a bank’s total regu- latory capital requirement.10Specifically, on November 5, 2001, the BIS released potential modifications to the BIS II proposals that reduced the proposed target of operational risk capital as a percent of minimum reg- ulatory capital requirements from 20 percent to 12 percent.
BIS II incorporates both expected and unexpected losses into capital re- quirements, in contrast to the market risk amendment of BIS I which is only concerned with unexpected losses. Thus, loan loss reserves are considered the portion of capital that cushions expected credit losses, whereas eco- nomic capital covers unexpected losses. The BIS (2000) sound practices for loan accounting state that allowances for loan losses (loan loss reserves) should be sufficient to “absorb estimated credit losses” (p. 4). However, loan loss reserves may be distorted by the stipulation that they are consid- ered eligible for Tier 2 capital up to a maximum 1.25 percent of risk- weighted assets.11That is, if expected credit losses exceed 1.25 percent of risk-weighted assets, then some portion of loan loss reserves would not be eligible to meet the bank’s capital requirement, thereby requiring excess capital to meet some portion of expected losses and leading to redundant capital charges. In November 2001, the BIS proposed modifications that would relax these constraints and permit the use of “excess” provisions to offset expected losses. Capital requirements for credit and operational risk can be satisfied only with Tier 1 and Tier 2 capital, but part of the market risk capital requirement can be satisfied with Tier 3 capital, which includes subordinated debt of more than two years maturity.12
The new capital requirements in BIS II are applied, on both a consoli- dated and an unconsolidated basis, to holding companies of banking
firms.13When BIS II is completely adopted, overall regulatory capital lev- els, on average, are targeted (by the BIS) to remain unchanged for the sys- tem as a whole.14 However, recent tests conducted by 138 banks in 25 countries have led to a downward calibration of the capital levels required to cover credit risk (under the internal ratings-based foundation approach) and operational risk (under the standardized model, basic indicator model, and advanced measurement approach). See BIS (September 2001) and BIS (November 5, 2001a).