Credit Risk Management and the Basel Accords Explained

Introduction to Banking and Credit Risk

Banks are an important part of the economy of any nation. Traditionally, banks operate as financial intermediaries serving to satisfy the demand of people in need of various forms of financing. Through this function, banks enable individuals to purchase homes and businesses to expand. These financial institutions therefore facilitate investment and spending that fuel economic growth. In spite of their vital role in the economy, banks are nevertheless prone to failure, and just like other types of businesses, they can go bankrupt. Unfortunately, bank failures carry far more significant implications than failures in most other industries. As witnessed during the Great Depression, and more recently following the global economic crisis and recession, the stability — or lack of it — in the banking system can trigger economic epidemics that impact millions of people.

With respect to this vulnerability, it is important for banks to operate in a sound and safe manner. One means of achieving this is ensuring that governments have put in place practical and strict regulations for banks. At the same time, with the spread of globalization, the activities of banks are no longer restricted within the borders of individual countries. As a result, there is an increasing need for international cooperation in the regulation of the banking system (Larson, 2011).

There appears to be some light at the end of the tunnel, as the Basel Committee on Banking Supervision (BCBS) is positioned to meet this need. As an international advisory authority on bank regulation, the BCBS has issued guidance on matters crucial to ensuring the healthy operations of banks across the globe. One such pressing issue is the regulation of bank capital. The process of addressing this issue has been ongoing for over two decades and has led to the promulgation of capital adequacy standards that can be implemented by regulators of individual countries. Collectively, these standards are referred to as the Basel Accords. At times these Accords have resulted in disagreements, yet they remain critical to the formulation of regulatory policy associated with bank capital. The BCBS has so far produced three such Accords; Basel III, published in 2010, is the most recent. Each Accord purports to improve upon the specifics of the previous one. However, there are indications that the most recent Accord is not without flaws, and it may not be the last (Larson, 2011).

The Banking Sector: History and Financial Intermediaries

Introduction to the Basel Framework

Rather than focusing narrowly on the stability of individual banks or the Basel framework in isolation, it is worth considering whether the Basel Committee has addressed even the smallest details of the new Accord correctly — a task that could greatly impact the bottom lines of banks. It is therefore more productive to focus on some general and fundamental questions. For instance: To what extent has Basel I succeeded in accomplishing its stated goals? How successful is Basel II expected to be in achieving its goals? Are those stated goals themselves desirable? And perhaps most fundamentally: is the Basel Accord — specifically, the international harmonization of bank capital standards — necessary or desirable for the stability of the financial system? (Rodriguez, 2003).

History

After several years of deliberations following the Latin American sovereign defaults of 1982, the BCBS finally completed the Basel Capital Accord in 1988. It was established with two main objectives: to strengthen the stability and soundness of the international banking system, and to achieve a high level of consistency in its application across separate nations — thereby reducing a source of competitive inequality among international banks. To this end, the Basel Accord requires banks to satisfy a predetermined minimum capital ratio mandatorily equivalent to at least eight percent of total risk-weighted assets (Rodriguez, 2003).

The BCBS focused on capital standards for two major reasons: first, because Congress directed banking regulators to work with regulators from other nations to ensure that banks maintained sufficient capital bases (Kapstein, 1991; Oatley & Nabors, 1998); and second, because capital acts as a buffer protecting bank deposits in the event of asset losses (Rodriguez, 2003).

Are Banks Special?

For a long time, banks and other financial institutions have been subject to greater government oversight than most other sectors of the economy. Bank regulations have historically taken the form of entry restrictions, limitations on activities, reserve requirements, geographical limitations, and capital requirements (Benston, 1998, pp. 27–85; Kroszner, 1998, p. 421; Kane, 1997; Goodhart et al., 1998, Chapter 9). Today, most regulation rests on the rationale of safety, soundness, or consumer protection.

According to Kroszner, the primary historical reason governments regulated banks and financial institutions was to finance wars (1998, p. 419). However, a long-standing tradition among economists, dating back to Adam Smith, has held that the banking system differs from other industries because of the nature of the activities in which banks engage — and that this difference justifies a form of regulation and supervision.

Smith alluded to the inherent instability of banks operating under a fractional reserve system, which, if true, justifies the need for regulation (Smith [1776] 1937, pp. 285, 308). Banks act as financial intermediaries: they make profits by taking deposits, extending loans, and investing in marketable securities and other financial assets. In the aggregate, this process produces a multiple expansion of the money supply. The liabilities of banks are normally fixed in value and payable on demand, while the value of banks' assets is variable and not immediately collectible. For these two reasons, banks are generally considered more prone to failure and bank runs — particularly in the event of a sudden, large-scale withdrawal of funds by depositors who have lost confidence. This could adversely affect solvent institutions through a contagion effect, in turn negatively impacting the entire financial system. This largely explains why banking regulation is vital (Rodriguez, 2003).

Federal Deposit Insurance and Bank Runs

Banks operating under the fractional reserve system are inherently fragile and at risk of runs when depositors have limited information about a bank's activities and financial health (Diamond et al., 1983; Dowd, 2001). Moreover, a run on a bank can theoretically destabilize otherwise sound institutions.

Historically, the private sector was adept at managing this fragility before government-sponsored deposit insurance began addressing the issue. Initially, banks would make their capital levels known to depositors and investors to boost confidence. As Benston (1998, p. 39) notes, banks regularly advertised the size of their capital and surplus prominently in newspapers and within their branches. It is worth noting that capital and surplus levels at that time were considerably higher than they are today (Kaufman, 1988).

Additionally, depositors and investors continuously monitored bank activities and demanded higher rates of return if they suspected their bank was taking on excessive risk. Before government-sponsored deposit insurance, banks also formed private clubs and clearinghouses to assist one another. Timberlake explains that a bank seeking membership in such associations had to meet specified requirements regarding capital levels, permissible activities, and risk profiles (1993, Chapter 14). Furthermore, option clauses in contracts permitted banks to defer payments for a set period in exchange for paying depositors a higher interest rate on the debt. These clauses were used extensively during the Scottish free banking period of the 18th century and effectively eliminated panic runs while giving banks breathing room to reorganize assets without engaging in fire sales. Finally, debt holders signed covenants with banks restricting the activities and investments banks could pursue.

Market discipline by shareholders and depositors worked well in preventing runs and, when runs occurred, in containing their spread. In the period between the end of the Civil War and the end of World War I, bank failures in the United States were low relative to non-financial firms. Moreover, banks that failed were typically insolvent before the run, not as a result of it. In this regard, runs on insolvent banks actually served the useful economic purpose of eliminating firms within the financial system that were motivated to engage in risky lending to recover their solvency — a strategy that would have harmed other market participants. During the Great Depression, depositors were able to distinguish between banks suffering from liquidity problems (though solvent) and those that were genuinely insolvent (Calomiris & Mason, 1997).

The large number of bank failures during 1929–1933 resulted in the restructuring of the banking industry along product lines and led to the creation of the Federal Deposit Insurance Corporation (FDIC) following the passage of the Banking Act of 1933 (Friedman & Schwartz, 1963). The FDIC was established to achieve three goals: to restore public trust in the banking system, to safeguard the payments system, and to protect existing branching limitations (White, 1997). Its creation had three major effects: it deprived shareholders and depositors of incentives to monitor bank activities; bank runs became rare, even though they were not catastrophic to financial system stability when they did occur; and by charging a flat fee, the FDIC created a classic moral hazard by effectively subsidizing risk-taking by banks (Kaufman, 2002).