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

Basel II does not aim to increase the total amount of regulatory capital required

by banks but there are likely to be changes among banks. Big banks with sophistic-

ated risk management systems should be able to hold less capital and therefore

strengthen their competitive position. On the other hand, some banks might have

to hold more capital than under the old rules to reect the wider range of risks

considered and a more nely tuned assessment of the credit risk associated with

different types of asset. The calculation of credit risk will also depend on how

exposed a bank is to a single borrower or sector. Further, for the rst time, there will

be a requirement to hold capital to cover operating risk. Securitised loans will need

more capital set aside than in the past unless the risk is completely transferred out

of the bank. However, there will be greater allowance for factors that reduce risk,

such as collateral or guarantees.

The banking industry has expressed two concerns about the new approach. The

rst, given the use of IRB approaches, is that the rules should be evenly and con-

sistently applied between different banks and regulatory authorities. To try to ensure

this, the new accord includes an extensive auditing system and enhanced requirements

for disclosure.

The second concern is that Basel II might increase the pro-cyclical impact inherent

in any credit risk approach to capital requirements – encouraging banks to lend

when economies are doing well but discouraging loans in recessions, thus making

economic cycles more pronounced. Under Basel I, this happened because more

loans become problematic during recessions and the valuation of banks’ capital

falls, requiring banks to set aside more regulatory capital to maintain the minimum

capital asset ratio. Under Basel II, this will continue to happen but, in addition, the

more sensitive assessment of risk applied to assets will increase the calculation of

risk-weighted assets. That is, in a recession, the numerator of the ratio will fall and

the denominator will rise, making it more difcult for banks to make new loans.

The reverse will happen in booms.

The European Commission has followed developments in the Basel Accord. In

May 1996 it proposed the amendment of the First Banking Directive, the Solvency

Ratio Directive and the Capital Adequacy Directive (see section 13.3) to change

supervisory rules for banks to introduce more sophisticated capital requirements for

default risks involved in OTC derivatives in line with the Basel Committee changes.

The Solvency Ratio Directive was also amended in 1996 to encourage bilateral net-

ting agreements, allowing the offsetting of mutual claims and liabilities from OTC

derivatives contracts.

We can sum up by saying that regulation of nancial services faces many serious

problems and may, under certain circumstances, make matters worse. We have seen,

however, that self-regulation does not provide a simple remedy for such problems.

Government regulators have no choice but to work with the industry itself in the

operation of regulatory regimes, but a strong case remains for regulatory bodies that

are external to the industry. Certainly, the difculties of regulation do not justify

complete deregulation of the industry. It has been frequently argued by those in

favour of deregulation that nancial markets are not different in kind from other

markets but only in degree and so should not be treated differently. However, large

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Chapter 13 • The regulation of nancial markets

differences in degree are equivalent to differences in kind. Financial markets are of

great importance to the economy as a whole and to a large number of individual

consumers. Views about their regulation cannot satisfactorily be derived from the

treatment of non-nancial markets.