13.4 The problems of globalisation and the growing complexity of derivatives markets

The Concordat was voluntary but all countries represented on the committee

adopted its rules. There was, however, a good deal of confusion over the interpreta-

tion of the rules. The different supervisory standards among countries also led some

countries, notably the US, to be more reluctant than others to share or delegate

supervisory responsibilities. The collapse of Banco Ambrosiano’s Luxembourg sub-

sidiary in the summer of 1982 caused particular concern as neither the Luxembourg

nor the Italian authorities would accept responsibility for either supervision or

emergency support of the bank.

In an attempt to overcome such problems, the Concordat was revised in 1983, with

the revision being based upon the principle of consolidated supervision and provisions

designed to ensure adequate supervisory standards. The aim was to encourage national

authorities to lock out foreign banks originating from permissive jurisdictions and to

prevent their own banks from conducting their international operations from poorly

regulated centres. The adoption of the principle of consolidated supervision was

intended to make the solvency of foreign subsidiaries a joint responsibility of parent

and host authorities. Foreign bank subsidiaries were required to be nancially sound

in their own right, while also being supervised as integral parts of the group to

which they belonged. Responsibility for the supervision of liquidity of both foreign

branches and subsidiaries was to remain with host authorities. The new agreement

also introduced more precise guidelines for the supervision of holding companies.

Problems remained and these were highlighted by the pressure placed on the inter-

national banking system by the debt crisis of the developing countries during the

early 1980s. When, early in 1982, the Mexican government declared a moratorium

on debt repayments, there was a potential crisis not only for those banks that had

lent Mexico vast amounts over the previous eight years but also for the whole inter-

national nancial system. If Mexico had continued to default on its repayments

and if other countries had followed suit, a number of banks would have been wiped

out. This possibility raised the spectre of the contagious bankruptcy of many other

banks. The IMF, the World Bank and the US combined to help banks out of these

particular problems, but the view took hold that a degree of harmonisation of super-

visory standards was needed among national regulatory authorities.

The principal outcome of this was the Basel minimum capital adequacy guide-

lines for international banks approved in July 1988. As mentioned in section 13.2.2,

these established common prudential risk-adjusted ratios for banks to apply from the

beginning of 1993. In discussing the risk–asset approach above, we mentioned the

need to dene the elements of capital for supervisory purposes. The Basel agreement

initially distinguished between two types of capital:

l	Tier I capital (core capital)consists principally of shareholders’ equity, disclosedreserves and the current year’s retained prots, which are readily available tocushion losses.

l	Tier II capital (supplementary capital)comprises funds available but not fully ownedor controlled by the institution, such as ‘general’ provisions that the bank has setaside against unidentied future losses and medium- or long-term subordinateddebt issued by the bank.

391

....

FINM_C13.qxd 1/18/07 11:39 AM Page 392

Chapter 13 • The regulation of nancial markets

Tier II capital cannot be greater than 50 per cent of total Tier I and Tier II capital

for the purposes of calculating the risk–asset ratio. A third type of capital (Tier III)

was later dened. It consists of:

l	subordinated debt of at least two years’ maturity that is subject to a ‘lock-in’ clause (that is, it can only be repaid with the regulatory authority’s permission if repayment would cause the bank to breach the required capital ratio); and

l	accumulated prot arising from the trading book (that is, securities and invest- ment activities not traditionally regarded in the UK as banking business).

The weights to be attached to bank assets included cash 0; loans to the discount

market 0.1; interbank lending 0.2; home mortgage loans 0.5; other commercial

loans 1. The Basel Committee proposed a lower limit of 8 per cent for the ratio of

total capital to risk-adjusted assets, though national bank supervisors had some dis-

cretion in applying this to different types of banks and countries were free to impose

a higher minimum requirement on their own banks. In the UK, the FSA sets each

UK-incorporated bank a separate target minimum capital adequacy requirement for

both its banking and investment business, with an 8 per cent risk–asset ratio being

an absolute minimum requirement for all banks.

The Basel Accord also made allowance for off-balance-sheet credit exposures,

which are converted into balance sheet equivalent amounts using a formula that

takes account of the likely extent of the default risk involved. Box 13.6 provides a

simplied example of the calculation of risk–asset ratios.

Box 13.6

Risk–asset ratios and off-balance-sheet activities – a simplied example

A bank had the following set of assets:

Asset	Face	Risk	Risk-weighted
	value	weighting	value

Cash	50	0	0
Loans to discount market	150	0.1	15
Interbank loans	300	0.2	60
Home mortgage loans	1,550	0.5	775
Loans to small and medium-sized rms	2,150	1	2,150
Total			3,000

Under the rules of the Basel Accord of 1988, the bank was required to hold a

minimum of 8 per cent of its risk-weighted assets as capital for regulatory purposes,

50 per cent of which had to be in the form of Tier I capital. Thus, it was required to hold

8 per cent of 3000 240. Tier II capital gives greater exibility than Tier I capital and the

bank chooses to do no more than meet the minimum requirement. Thus, it holds 120 in

Tier I capital and 120 in Tier II capital.

392

....

FINM_C13.qxd 1/18/07 11:39 AM Page 393