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


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:

©OECD Observer No 220, April 2000 

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