Basel II: a risky strategy

Development Centre

A proposal to link international capital requirements to credit ratings, rather than to whether or not the loan recipient is from an OECD country, will reflect market risk more accurately. But it could make capital flows to developing countries even more volatile. There may be a solution. 

In June 1999 the Basel Committee on Banking Supervision, which meets at the Bank for International Settlements (BIS) and whose decisions influence national regulators, issued a proposal for a new bank capital adequacy framework to replace the Capital Accord of 1988, known as the Basel Accord. If this Basel II proposal survives the broad consultation process now coming to a close, the importance of sovereign ratings for future emerging-market finance will rise even more. It is a framework which has its merits, but it has inherent dangers too.

The proposed revisions to the Basel Accord on bank capital adequacy will maintain the current 8% risk-weighted capital requirement set by BIS. However, the new risk weightings will be calculated using external credit assessments for all borrowers, rather than relying on internal ones. The new proposal will replace the present, over-simplistic, system of dividing the world up between OECD countries on the one hand and non-OECD countries on the other, and applying risk weightings accordingly.

Risk weights set the banks’ loan supply and funding costs. They tell banks how much of a loan they must cover in capital, as banks have to acquire a corresponding amount of capital relative to their risk-weighted assets. The current Basel Accord gives OECD governments and central banks a zero risk weighting, while private banks get a favourable 20% capital weighting. Non-OECD countries face a hefty 100% weight, although private banks in emerging markets can obtain a 20% weighting on short-term loans. However, a punitive 100% risk weight has dissuaded creditors from offering loans with a residual maturity of more than one year to non-OECD banks. The upshot has been a bias towards short-term lending to emerging markets and away from long-term investment. It has also meant an over-reliance on the short-term interbank market, whose unpredictable volatility has made it the “Achilles’ heel” of the international financial system. It is now accepted that this distortion is at least partly the fault of the 1988 Basel Accord and correcting it is one of the principle reasons behind the new proposal.

Another weakness of the present system is that OECD area banks and governments have benefited from rather lenient treatment by international creditors, even if their sovereign risks are inferior to some non-OECD emerging markets. Since the 1988 Accord went into effect, five countries have joined the OECD and are now enjoying lower risk weights on bank loans to their governments (0% instead of 100% as non-members) and to their banks (20% on long-term credit instead of 100%). These lower risk weights have naturally translated into reduced interest costs on new loan commitments to these new OECD countries, a fact that stands out when comparing interest rates of new members with their regional benchmark group.

The trouble is, with the new proposal to use independent credit ratings to set the risk weights, the reverse becomes true. In fact, OECD countries currently rated below double A have much to lose under the Basel II proposals. For example, risk weights for claims on Turkish sovereigns, whose B credit rating puts them in a non-investment grade, would jump from the zero rating they get from being an OECD member to 100%, a rise which would probably drive up borrowing costs. In contrast, non-OECD countries could benefit from the changes, particularly some emerging markets. Take Chile, which has an A credit rating, although it is not an OECD country. Its sovereign risk weighting would drop from 100% to a much lower weight if the Basel II proposals were adopted. The case of Chile, which in fact receives different ratings from different leading agencies, also raises the question of how the Basel II Accord will deal with split ratings, which are quite common in emerging markets. One supervisory concern is that the more lenient rating agencies would dominate, possibly leading to dangerously low risk weights and over-exposed lending.

Another potentially important impact of the Basel II proposals are the two options for claims on recipient banks. Option 1 would base the risk weighting on the sovereign risk weighting of the country in which the bank is incorporated. Option 2 would base the risk weighting on the individual rating of the respective bank. From the perspective of developing countries, Option 2 seems preferable, unless their sovereign rating suddenly climbs to an A level. But from a supervisory (and macroeconomic) perspective, Option 1 would be better since it would make long-term lending more attractive and would reduce the bias towards short-term interbank lending inherent in the existing Basel framework.

More boom and bust

Beyond these effects loom the widely ignored macroeconomic impact of Basel II. Both theory and practice suggest that the new accord could destabilise private capital flows to the developing countries. There are two reasons for this.

First, theory shows that linking bank lending to regulatory capital via a rigid capital ratio requirement acts pro-cyclically to amplify macroeconomic fluctuations. A negative shock to aggregate demand would reduce the ability of debtors to service their loans, causing bank equity to suffer and lending and investment to be restrained. And because of rigid capital adequacy requirements, banks will always lend more when times are good, but less when times are bad.

The second, empirical, reason is that sovereign ratings lag, rather than lead, the markets. There is little hope of that ever changing, as the nature of sovereign risk and the rather slow availability of sovereign default determinants make it nearly impossible for rating agencies to acquire an information lead over financial markets.

Another point to bear in mind is that current income growth has a positive influence on credit ratings. During boom times ratings will improve, but decline during bust periods. The Basel II proposals would simply reinforce this tendency.

A better approach for Basel II would be to continue to base risk weights on banks’ internal ratings, rather than on external risk assessments, and introduce more flexible capital requirement ratios which could fluctuate anti-cyclically. This would strengthen the risk analysis within banks, obviate the tendency of angry creditors and debtors to look for external scapegoats whenever there is a crisis and, above all, it would reduce herd-like behaviour in international lending. Such a balanced approach would be good, not just for global financial markets by making them more stable, but for development too. END

Bibliography

Reisen, H. “Revisions to the Basel Accord and Sovereign Ratings”, in R. Hausmann and U. Hiemenz (eds.), Global Finance From a Latin American Viewpoint, IDB/OECD Development Centre, 2000.

Reisen, H. and von Maltzan, J. “Boom and Bust and Sovereign Ratings”, OECD Development Centre Technical Paper No. 148, 1999. Also available at: www.oecd.org/dev/publication/tp1a.htm

©OECD Observer No 220, April 2000 




Economic data

GDP growth: +0.6% Q4 2017 year-on-year
Consumer price inflation: 2.6% May 2018 annual
Trade: +2.7% exp, +3.0% imp, Q4 2017
Unemployment: 5.4% Mar 2018
Last update: 06 Jul 2018

E-Newsletter

Stay up-to-date with the latest news from the OECD by signing up for our e-newsletter :

Twitter feed

Suscribe now

<b>Subscribe now!</b>

To receive your exclusive paper editions delivered to you directly


Online edition
Previous editions

Don't miss

  • Watch the webcast of the final press conference of the OECD annual ministerial meeting 2018.
  • International co-operation, inclusive growth and digitalisation lead the themes of the 2018 OECD Forum in Paris on 29-30 May, under the banner of What brings us together www.oecd.org/forum. It is held alongside the annual OECD Ministerial Council Meeting on 30-31 May, chaired this year by France with a focus on multilateralism www.oecd.org/mcm.
  • Listen to the "Robots are coming for our jobs" episode of The Guardian's "Chips with Everything podcast", in which The Guardian’s economics editor, Larry Elliott, and Jeremy Wyatt, a professor of robotics and artificial intelligence at the University of Birmingham, and Jordan Erica Webber, freelance journalist, discuss the findings of the new OECD report "Automation, skills use and training". Listen here.
  • Do we really know the difference between right and wrong? Alison Taylor of BSR and Susan Hawley of Corruption Watch tell us why it matters to play by the rules. Watch the recording of our Facebook live interview here.
  • Has public decision-making been hijacked by a privileged few? Watch the recording of our Facebook live interview with Stav Shaffir, MK (Zionist Union) Chair of the Knesset Committee on Transparency here.
  • Can a nudge help us make more ethical decisions? Watch the recording of our Facebook live interview with Saugatto Datta, managing director at ideas42 here.
  • Ambassador Aleksander Surdej, Permanent Representative of Poland to the OECD, was a guest on France 24’s English-language show “The Debate”, where he discussed French President Emmanuel Macron’s speech at the World Economic Forum in Davos.
  • The fight against tax evasion is gaining further momentum as Barbados, Côte d’Ivoire, Jamaica, Malaysia, Panama and Tunisia signed the BEPS Multilateral Convention on 24 January, bringing the total number of signatories to 78. The Convention strengthens existing tax treaties and reduces opportunities for tax avoidance by multinational enterprises.
  • Rousseau
  • Do you trust your government? The OECD’s How's life 2017 report finds that only 38% of people in OECD countries trust their government. How can we improve our old "Social contract?" Read more.
  • Papers show “past coming back to haunt us”: OECD Secretary-General Angel Gurria tells Sky News that the so-called "Paradise Papers" show a past coming back to haunt us, but one which is now being dismantled. Please watch the video.
  • When someone asks me to describe an ideal girl, in my head, she is a person who is physically and mentally independent, brave to speak her mind, treated with respect just like she treats others, and inspiring to herself and others. But I know that the reality is still so much different. By Alda, 18, on International Day of the Girl. Read more.
  • Globalisation’s many benefits have been unequally shared, and public policy has struggled to keep up with a rapidly-shifting world. The OECD is working alongside governments and international organisations to help improve and harness the gains while tackling the root causes of inequality, and ensuring a level playing field globally. Please watch.
  • Read some of the insightful remarks made at OECD Forum 2017, held on 6-7 June. OECD Forum kick-started events with a focus on inclusive growth, digitalisation, and trust, under the overall theme of Bridging Divides.
  • Checking out the job situation with the OECD scoreboard of labour market performances: do you want to know how your country compares with neighbours and competitors on income levels or employment?
  • Trade is an important point of focus in today’s international economy. This video presents facts and statistics from OECD’s most recent publications on this topic.
  • The OECD Gender Initiative examines existing barriers to gender equality in education, employment, and entrepreneurship. The gender portal monitors the progress made by governments to promote gender equality in both OECD and non-OECD countries and provides good practices based on analytical tools and reliable data.
  • Interested in a career in Paris at the OECD? The OECD is a major international organisation, with a mission to build better policies for better lives. With our hub based in one of the world's global cities and offices across continents, find out more at www.oecd.org/careers .
  • Visit the OECD Gender Data Portal. Selected indicators shedding light on gender inequalities in education, employment and entrepreneurship.

Most Popular Articles

OECD Insights Blog

NOTE: All signed articles in the OECD Observer express the opinions of the authors
and do not necessarily represent the official views of OECD member countries.

All rights reserved. OECD 2018