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

The bank then decides to increase its competitiveness by holding less capital and

to seek to make up for any lost income through securitisation and acting in the swaps

market. It takes two steps:

l	It securitises its home mortgage loans, removing them from its balance sheet and increases its loans to rms, which earn a higher rate of interest.

l	It acts as a guarantor for swap deals to the value of 500, which also does not appearon the balance sheet.

The bank’s risk-weighted balance sheet position now is:

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
Loans to small and medium-sized rms	2,425	1	2,425
Total			2,500

The bank now has to hold only 200 capital and is able to reduce its Tier I capital to

100. Funds that previously had to be kept readily available to cushion possible losses

could be used more productively.

When one takes into account the risk associated with the securitised home mortgages

and the interest rate swaps together with the increase in loans to rms, it seems clear

that the bank now faces more risk than previously. Yet it was required under the Basel

Capital Accord of 1988 to hold less capital against the possibility of default. It is easy to

see why this type of activity worried the Basel Committee and led to the proposals in the

New Basel Capital Accord regarding securitised assets.

The agreement sought both to strengthen the soundness and stability of the inter-

national banking system and to ensure competitive equality among international

banks. The accord incorporated capital requirements for over-the-counter derivatives

(see Chapter 9), with the capital adequacy requirement being determined by estim-

ates of current and potential credit exposure, taking into account the nature of the

counterparty.

Other developments followed. In April 1990, an addendum to the Basel Concordat

encouraged more regular and structured collaboration between supervisors. In the

same year, the Committee tried to deal with the single most important cause of bank

failures: excessive concentration of default risk. It did this by recommending common

denitions and procedures related to large exposures, recommending maximum

limits on single exposures of 25 per cent of the capital base.

That serious problems remained, however, became clear with the forced closure of

the Bank of Credit and Commerce International (BCCI) in July 1991. BCCI’s corporate

structure was based on a non-bank holding company in Luxembourg which owned

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Chapter 13 • The regulation of nancial markets

two separate banking networks incorporated in Luxembourg and the Cayman Islands.

The holding company was unregulated and so consolidated supervision of the group

was not possible, allowing BCCI to hide its problems by shifting assets between

national jurisdictions. The Basel Committee responded to the BCCI affair by issuing

a set of minimum standards for the supervision of international banks.

Meanwhile, other problems were coming to the fore, particularly with the rapid

growth in derivatives trading world-wide. The speed at which risks of derivatives

can be transformed and the complexity of the transformation process results in a

loss of transparency. This makes risk assessment much more difcult and weakens

both market discipline and regulatory oversight, leading to greatly increased sys-

temic risks. Risk was increased also because end-users frequently did not understand

how derivatives worked, and the management of banks and securities houses often

did not understand what their dealers were doing. This last problem is magnied to

the extent that pay systems reward traders hugely for success in achieving prots

and provide them with little incentive to follow cautious strategies. Finally, there

were concerns over the concentration of derivatives trading among a few major

nancial institutions, with the possibility that the failure of a large derivatives dealer

could both inict large losses on counterparties and damage the liquidity of the

derivatives market.

One approach to the potential increase in default risk has been to encourage the

use of netting agreements, which create a single legal obligation covering multiple

transactions between two counterparties, allowing them to reduce both the amount

and the number of payments in comparison to settlements on a gross basis. In the US,

the International Swap Dealers Association (ISDA) drew up a master agreement that

allows an intermediary to reconcile all of its transactions with a defaulted counter-

party and come up with a nal net payment, permitting the amount of capital set

aside to support the business to be reduced by 50 per cent, since the capital adequacy

rules have to be applied only to the net value of transactions payments. In line

with this, the Basel Committee amended the 1988 Accord by reducing the capital

that must be held against those credit exposures subject to bilateral netting, as long

as banks are able to demonstrate to their supervisors the legal enforceability of net-

ting arrangements in all relevant jurisdictions. Regulators have also acted to include

derivatives transactions in large exposure limits, along with conventional on-balance-

sheet exposures.

This still left market risk, not treated at all in the 1988 Accord, to be dealt with.

In April 1993 the Basel Committee (1993) published proposals for minimum capital

requirements to cover banks’ exposure to market uctuations. Derivatives were to

be converted into positions in the relevant underlying asset and become subject

to capital requirements designed to capture specic and general market risk. This

approach is explained in section 13.3 in relation to the EU’s capital adequacy directive.

It was criticised on the grounds that static capital adequacy rules could not capture

the risk proles of individual institutions. A more sophisticated approach was pro-

posed, making use of the complex risk management models used by the major

derivatives dealers. The role of regulators would be to validate the models and set the

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