credit quality. The capital base included any debt subordinated to other commitments by the bank. Equity represented at least 50 % of the total capital base for credit risk, also called the “tier 1” of capital or “core capital”. The available capital puts a limit to risk taking, which, in turn, limits the ability to develop business. Under a deficiency of capital, the constraint requires raising new equity, or liquidation of assets, or taking risk-mitigating actions.
The original Cooke ratio of the 1988 Accord stipulates that the capital base should be at least 8 % of weighted assets. Risk-weighted assets (RWA) are calculated as the product of the size of loans with risk weights. The risk weights serve for differentiating the capital load according to the credit quality of borrowers. The calculation of the capital, which is still implemented today, is:
Capital=8 %×Risk weight×Asset size
The 8 % is the capital adequacy ratio, which is evolving with regulations and getting closer to around 10 % as new regulations are gradually enforced. The regulators' 8 % capital adequacy ratio can be interpreted as a view that banks could not lose more than 8 % of their total risk-weighted portfolio of loans for credit risk, thanks to risk diversification. With this value of the ratio, the debt-equity ratio is: 92/8=11.5
The original Basel 1 Accord was designed for keeping calculations simple and allowing an easy implementation. For example, a loan of value 1000 with a risk weight of 100 % has a capital charge of 80; if the loan is a mortgage, backed by property, it would have a capital charge of: 50 %×8%×1000=40
The weight scale started from zero, for commitments with sovereign counterparties within the OECD, at the time when Basel 1 was implemented, and up to 100 % for non-public businesses. Other weights were: 20 % for banks and municipalities within OECD countries, and 50 % for residential mortgage-backed loans. Some off-balance sheet commitments, the commitments without any outlay of cash, were weighted 50 %, in conjunction with these risk weights.
Today, the same general concepts prevail, using a capital ratio that is a percentage of risk-weighted assets and risk weights being far more risk sensitive.
Regulations do not imply that the true risk of a portfolio is exactly measured by the capital charges. They determine capital charges for portfolios representative of the industry as a whole, not of the specifics of the portfolios of individual banks. Regulators recommended that banks develop their own estimates of credit risk through models. Economic capital refers to better measures of the specific risk of the banks' portfolios.
The 1988 Accord was followed by capital regulations on market risk in 1996, amended in 1997. The extension to market risk was a major step in 1996/97 as it allowed banks to use models for assessing capital charge for market risk. Since traded assets can be liquidated over short periods, the relevant losses are due to market movements over the same horizon. Capital for market risk should provide a protection against the loss of value that could occur over the liquidation horizon. The regulation promoted the value-at-risk concept. The value-at-risk, or VaR, is the potential future loss for a given portfolio and a given horizon, which is not exceeded in more than a small fraction of outcomes, which is the confidence level. The basic idea is the same, defining the minimum amount of the capital charge, as a function of risks. The risks are assessed either through rules defining capital charge by transaction or VaR-based risk models for market risk. Once VaR-based capital charges were authorized, they became widespread in the financial industry.
The Basel 2 Accord of January 2007 considerably enhanced the credit risk regulations. The schedule of successive Accords, from Basel 1 to Basel 2, is summarized as follows:
2 Basel Committee on Banking Supervision (1996, updated 2005), Amendment to the capital accord to incorporate market risk, [19].
The approaches of Basel 2 for credit and the update for market risk were published in June 2006 in “International Convergence of Capital Measurement and Capital Standards – A Revised Framework, Comprehensive Version” [21].
The goals of the new Accord were:
• To promote stronger management practices;
• To promote more risk-sensitive capital requirements through a greater use of banks' own assessment of the credit standing of the borrowers;
• To provide a range of approaches for determining the capital charges for credit risk by allowing banks and supervisors to select the options that were most appropriate for their operations.
The Accord also introduced new capital requirements for operational risks.
For making the capital charge risk sensitive, the Accord provides incentives to use the “internal ratings-based” (IRB) approach, using as inputs for the risk weights the internal ratings, or credit risk assessments, of banks. When not applicable, the banks can rely instead on a “standardized approach” where the risk weights are regulatorily defined.
2.3 Some Lessons of the Financial Crisis
The new waves of regulations, known under Basel 2.5 and Basel 3, are inspired by the lessons of the crisis, which are briefly summarized hereafter. The crisis raised a number of issues, with respect to liquidity, fair value accounting or solvency, as they interact and result in contagion and pro-cyclicality. Contagion refers to the waves of failures triggered from individual failures to the system as a whole. Pro-cyclicality refers to the mechanisms that amplify the cycles of the financial system.
The crisis was characterized by the liquidity crunch that plagued the financial system in 2008.5 A lack of liquidity can emerge from the risk aversion of lenders in stressed times. Players refrain from providing liquidity in a context of failures as no one knows who is next to fail. The “who is going to be next to lose” issue makes potential lenders reduce their exposures to others, for fear that they would suffer unexpected losses of undetermined magnitudes.
Other mechanisms contributed to the liquidity squeeze. The overreliance on short-term funds, a characteristic of the system at the time of the crisis, exacerbates the effect of a liquidity crunch. Once liquidity dried up, all liquidity commitments of banks, whereby banks commit to lend within limits to borrowers, were triggered and translated in a great deal of “involuntary lending”. Financial players had to comply with their commitments precisely when they had insufficient liquidity for themselves. Involuntary lending was a source of liquidity for some, but it made liquidity even scarcer as financial firms started to hoard liquidity.
The liquidity crunch lasted even after massive injections of liquidity by central banks through various programs of purchases of financial assets from banks. Presumably, banks and financial firms were “hoarding liquidity” as a protection against a lack of liquidity instead of using it for extending credit. Monetary authorities could not prevent the credit crunch that followed.
Fair value is pro-cyclical as it extends the markdowns to all assets accounted for at fair value, traded or not.6 Many assets lost value in inactive and illiquid markets. As a consequence of the magnitude of the downturn, fair values appeared disconnected from the fundamental values of assets. The category of assets subject to model valuation extended to assets that, in normal circumstances, would have been fairly valued from prices. Model prices were subject to a negative perception, since many assets lost perceived value as the confidence in models evaporated.
When
There are numerous papers on the liquidity crunch of 2008. See, for example, Brunnermeier, M. K. (2009), Deciphering the liquidity and credit crunch 2007–2008, [39], and Brunnermeier, M. K., Pedersen, L. H. (2009), Market liquidity and funding liquidity, [40].
See, for example, Laux, C., Leuz, C. (2010), Did fair-value accounting contribute to the financial crisis?, [89].
