When Capital is Inadequate: A Hypothetical Case for Amending the Basel Accord’s Capital Adequacy Requirements to Facilitate Third World Development and Disaster Recovery
The Basel Accord is a protocol for the prudential regulation of banks. Partly it provides a Capital Adequacy regime by which banks calculate how much reserve liquidity they need for safety - essentially money doing nothing - when lending to major borrowers. Less liquidity is needed to counterbalance loans to borrowers with high credit ratings and vice-versa. Lending to a safe, high rated customer requires no reserve liquidity, while the other extreme is somewhat punitive. This encourages safe practices, but the problem is it reduces the money supply in developing countries, especially to customers further harmed by major disasters. After considering five benefits and six detriments in the current scheme, the conclusion is drawn that some small amount of liquidity should be required when loans are given to low risk customers, and less liquidity should be required when lending to higher risk customers. This article was first published in the Journal of Banking and Finance, Law and Practice. I wrote this article while I was still studying for my JD.
This article has been published in the Journal of Banking and Finance Law and Practice, published by Reuters.
The Basel Accord’s capital adequacy regime includes risk weighting categories of substantial variance. While no liquid capital need be held for loans to the most stable of borrowers, 12 percent of loan value is required for safety against loans to the least stable. This creates inefficiency for lenders with unstable clients. Unstable borrowers are more common in less developed and developing countries and sometimes in major disaster areas. This in turn creates a disincentive for lenders to do business in such areas, creates an unfair advantage for the developed world, and thereby may contribute to the difficulties faced by third world development and disaster recovery efforts. This study relies largely on pure theory due to a lack of relevant empirical data, and reviews a variety of plausible reasons for and against having high risk-weighting for unstable borrowers. Where data is available it is found that sophisticated, developed economies are capable of managing their own disaster recovery efforts through government intervention. It is also found that poorer nations and entities therein are able to obtain finance and debt resolution through a variety of back-door means, and have shown solid economic growth in recent years accordingly. However, if international banking is to be subject to ever tighter regulation to minimise risk and the financial back doors are closed, then the developing world may face an uphill battle in obtaining further finance. Only if the risk-weighting categories are brought closer together, with some liquidity required behind loans to stable borrowers and less required behind loans to unstable borrowers, will the developing world be able to obtain good quality finance and continue overcoming poverty while the world risk-proofs its financial system.
Out of concerns arising from the credit crisis of the early 1980s and an earlier banking crisis, the Basel Committee on Banking Supervision determined that banks should be compelled to maintain a certain amount of liquid capital. This would enable the global banking system to respond to wide-scale loan defaults. The Committee introduced a capital adequacy requirement with a risk-weighting system so that more capital is required to cover loans to higher-risk borrowers and less for loans to low-risk borrowers. The risk-weighting system was presented in Basel I in 1988 and carried through to Basel II unchanged. The credit ratings of borrowers set by Standard and Poors are the normal indicators used in determining the amount of risk associated with a loan.
Of particular interest to this study is the fifth category of risk-weighting in which the balances of loans to borrowers with a credit rating of B- or lower are taken at 150% of their value in calculating the minimum capital requirement on the lender. This weighty requirement contrasts with the opposite end of the scale where risk-weightings of 0% and 20% are found. The question asked here then is whether this weighty requirement placed on banks actually discourages institutions from lending to customers in the greatest need. Such customers may include organisations that operate predominantly in less developed countries (LDCs) or developing countries (DCs), or whose activities are concentrated in major disaster areas, and may not necessarily have unsound management to blame for their difficulties. When in trouble, such an entity could benefit enormously from a capital injection at a competitive interest rate, and its own customers will need it for their funds to remain secure. While there are risk-weighting categories of 0% and 20%, lending to higher-risk customers is rather burdensome when banks prefer to deploy all available capital in the making of profit. In essence then, the question is asked whether the Basel Accord, in drawing such a strong distinction, acts against development and economic recovery from major disasters, even where a borrower’s management practices are of the highest order.
This study begins with a theoretical enquiry into the strengths and weaknesses of the capital adequacy regime of the Basel Accord. It then refers one-by-one to the few empirical studies and data sets that have been found in the course of research. It looks at alternative means of finance, ways of distributing risk and assisting large debtors, which allows risky borrowers continued access to credit and debt relief. The study is rounded off with a brief discussion of the preceding observations. The conclusion is tentative due to a lack of evidence, but a cautious recommendation is made to amend the Basel Accord.
Strengths of 150% risk-weighting
Precise information is lacking as to the reasons why the regulators from the Group of Ten chose the particular risk-weights used for the capital adequacy parameters. One therefore needs to determine the strengths and weaknesses speculatively. First and foremost, the Basel Accord was aimed at controlling the risks that banks take with their money as they apply available cash for profit. The risk-weighting plainly aims at requiring banks to take steps that will secure their own position and that of the whole economic system. By implication the position of obligors is also secured against recall.
Secondly, the loan principle is multiplied by the risk-weight and then by 8%, to find the minimum amount of liquid capital required of the bank. The heaviest risk-weighted capital requirement then is only 12% of the principle. For any bank with geographically and economically diverse interests, and with plenty of customers in lower risk-weighted categories, 12% of the principle on some loans is unlikely to present a real burden.
Thirdly, when a lender who has a number of high-risk borrowers on its books finds itself in difficulty and wishes to recall its debts, it will have to approach many of these for the return of its funds. A borrower with poor liquidity, low revenue, or a poor quality asset base will have difficulty in meeting a foreclosure – thus the lower credit rating. The lender will then experience a crisis caused either by delay or nonfeasance in a time of need. Furthermore, if a lender’s loan assets are to a large extent among high-risk borrowers, the potential for default or insolvency is relatively high and one reasonably may expect crises of this sort to be a common occurrence. In the event of a major systemic failure, even banks whose loan assets are sensibly balanced between high and low risk are still likely to have difficulty with foreclosures on high-risk borrowers. This would create a need to foreclose more widely than otherwise, and potentially would exacerbate any resultant economic downturn.
Fourthly, if a lender’s activities are geographically concentrated and include high-risk borrowers, and a localised economic recession occurs, an especially serious risk will arise for the individual lender. If a small bank has difficulty finding low-risk borrowers in the area where its branches are concentrated, then the Basel Accord serves to encourage geographic diversification and the building of defences against localised risk.
Fifthly, if in the event of default, a lender elects to maintain a borrower as a client instead of foreclosing, interest is added to the principal. This may occur if a lender genuinely believes its borrower is undergoing difficulties that are only temporary, from which it will recover strongly. In the case of a high-interest loan, as is to be expected with a high-risk borrower, the adding of interest without it being met by adequate repayments can make a more substantial difference to the principal than the same occurring with a low-interest, low-risk loan. A greater probability of default translates mathematically to defaults occurring earlier in a loan’s repayment schedule, and so with a higher principal, the amount owing in interest is higher. Thus if a bank were to behave tolerantly with a one-time defaulting borrower and later find them in much greater difficulty, there may be a greater amount of capital reserve required to cover expectations of profit. An expectation of profit in the long term may be relevant for any foreclosure; however, when a foreclosure occurs soon after settlement, a greater amount of profit is foregone and the principal is largely lost.
Weaknesses of 150% risk-weighting
As for the weaknesses of using a high risk-weighting, first it can be seen that once a number of high-risk loans are given, a bank may find that its liquid capital is too heavily committed to continue on that course. Its lending activities may have to be restrained and focussed for a time on low-risk borrowers at low interest. Means of risk redistribution exist that can allow a lender to move risks off their books so that this issue is less important than it appears at face value. However, this practice has been heavily criticised in the context of its immense popularity and its resulting role in creating the systemic risk that contributed to the Global Financial Crisis of 2008. The extent to which risk was insured against through derivative trading by some institutions (most notably Lehman Brothers and AIG) may be characterised as the heavy concentration of risk upon some major market participants. If such practices are to be restricted by regulators in the future, lenders will more readily have to resort to simple, self-restrictive strategies.
Secondly, financial institutions in developing regions of the world which contain a number of high risk potential borrowers face difficulty if they wish to support local business. If they lend heavily to local business, or refinance local lenders heavily, then they risk amassing a relatively large capital adequacy requirement due to the generally poorer than average credit ratings that are associated with developing countries. In order to maintain an efficient operation, they need to lend to low risk borrowers to reduce their liquidity requirements. Even if this may work for the individual lender, it may overall encourage a flight of capital out of developing countries and into developed countries. Alternatively it may result in the concentration of capital and economic power in the hands of a small elite located within developing countries and who enjoy the benefits of a healthy credit rating. Any such groups may then be ever more able to manipulate economic conditions in their own favour. It would appear therefore that the Basel Accord could contribute to more than just a restriction on economic development, but to inequality within developing countries.
Thirdly, the Basel Accord may add to the incentive for high-interest lending to high-risk borrowers. When a high-risk borrower seeks funding, they may be offered an interest rate higher than one offered to a low-risk borrower. The higher interest rate, while putting the borrower under greater pressure than they otherwise may be under, theoretically could enhance the lender’s safety by ensuring the borrowed amount is repaid sooner. Whether this does enhance safety, however, is a delicate balance depending on the financial security that the borrower shall experience in the interim, and conservative judgment is warranted on the lender’s part when maximising overall profitability. However, when a bank is required to maintain a larger amount of liquid capital as of settlement, the extra liquidity coming in from a high-interest loan becomes all the more attractive as a source of liquid capital. Basel I then may reinforce disparity in interest rates.
Fourthly, when a bank has a large number of high-risk customers on their books, the large amount of capital they are required to keep in liquid form will create a conspicuous amount of inefficiency. There would thus be a strong incentive to lend to borrowers in low risk-weighting categories so as to open up sources of income that allow more efficient revenue-raising practices, without the uncertainty noted above in charging higher interest against high-risk borrowers. Banks that operate in developing countries or in major disaster areas may face such problems and would have a need to lend outside their chosen area of operation rather than continuing to inject capital where it is most needed.
Fifthly, even while a bank lends at relatively high interest rates to its high-risk borrowers, the capital adequacy requirement has a long-term binding effect. Some other forms of financial activity only tie up funds for short periods and yet can give higher yields; such activities include derivative trading involving contracts lasting only days or hours. Therefore in so much as the legal requirement is duly followed, it is detrimental to efficiency and competitiveness in a financial environment that embraces short-term trading. While multitudes or small transfers of money are difficult (if not impossible) for regulators to monitor, liquid reserves held for Basel purposes could instead be held mandatorily in accounts that are monitored directly by regulators. It would be possible for regulators to detect and correctly classify diversions of liquid reserves to short-term contracts, and the inefficiency impact of the Basel Accord may then be felt.
Sixthly, as observed by Barajas et al, when a loan portfolio attains a high overall risk level, this may prompt a bank to adjust by reducing its loan portfolio. The authors likened this to the “risk retrenchment hypothesis” of Berger and Udell. While banks are free to engage in regulatory capital arbitrage – that is, to novate or assign their loans, or to diffuse their risks through securitisation – an alternative result may be a long-term preference to low-risk borrowers, which could have a deflationary effect in economies where high-risk borrowers are concentrated. Barajas et al found that the manner in which banks go about regulatory arbitrage varies with the financial development level of the banks and/or the markets they deal in.
Unfortunately very little useful data has been discovered during this study; moreover, it is beyond the expertise of this author – a student of law, not economics – to fill the gap with something satisfactory. What little data that has been found is analysed below.
Credit availability in Latin America
Barajas et al studied the effect of the Basel Accord on the provision of credit in Latin American countries (LACs). Examining the theoretical background, they found that 'the adoption of Basel I around the world is associated with an expansion of equity capital along with increased lending.' After analysing their own data, they conclude: 'The evidence for the United States suggests that Basel may have been at least partially responsible for the credit decline of the early 1990s and the ensuing slow recovery.' This deflationary effect is rationally to be expected in the context of reduced credit availability. However, in regards to LACs they found that:
...after Basel, Latin American banks increased capital to meet Basel I requirements, and increased the size of their loan portfolios. As a result, since Basel implementation they have tended to hold a capital-asset ratio that is 4% more than the world average, and a loan to asset ratio about 1% over the world average. Comparing pre- and post-Basel I periods, return on equity decreased quite substantially in LAC, by about 7%, while the world average decreased by 3½%... Compared with other regions, Latin America’s behaviour was about average.
They went on:
Our results give only weak evidence of a Basel-induced credit crunch in Latin America. Overall, we do not find evidence that the loan supply curve shifted on average after Basel, although we do find some evidence of risk retrenchment, as loan growth became more sensitive to the lagged equity-asset ratio.
The final conclusion they reach is that:
...given the environment under which Basel I adoption has taken place, risk-based capital requirements have not been responsible for widespread reductions in the credit supply in Latin America.
Thus although there have been bad experiences in Latin America, there is no reason to blame the Basel Accord.
As for the rest of the world, the International Monetary Fund publishes data on national and international Gross Domestic Product (GDP) performances since 1980 via the application, Data Mapper, on its website. This data was examined to see whether any upward or downward trends could be detected, originating in 1988 or soon after. Grouping data according to the categories of advanced economies and emerging/developing economies, it can be seen that emerging/developing economies outperform advanced economies in terms of proportional growth from 2000, and increasingly so until 2007. Also, the GDP performance of advanced economies declined from the key year of 1988 to 1991 at which point it stabilised for a few years at a low growth level. It is reasonable to believe that this decline offers an explanation for any corresponding pattern in emerging and developing countries, as an alternative to any reduction in the availability of credit.
Grouping data by regions, it is shown that Sub Saharan Africa experienced a marked decline in GDP growth from 1988 until 1992 when its GDP shrank by 1.3%. That may hypothetically be linked to the performance of advanced economies; however, from that time on, the Sub Saharan African economies have performed well on average – notwithstanding significant changeability, they have not declined as a whole since 1992. North Africa has, from 1986, followed a similar pattern (notwithstanding greater volatility), except that it has not fallen below zero GDP growth.
The Southeast Asian economies enjoyed a period of substantial growth from 1986 to 1996, which was then ended by the Asian economic crisis. In 1999, Southeast Asia returned to strong GDP growth and has continued to grow in spite of the GFC downturn.
Central America has experienced strong, though changeable, growth from 1984 onwards. The general trend of the GDP growth also appears to be increasing, with the obvious exception of 2008 when growth dropped to -0.6%. This suggests that in spite of credit restrictions Central American economies are burgeoning.
South American GDP growth slowed from a significant peak in 1986 and reached a trough of ‑1.3% in 1990. After further growth a similar trough was reached in 1999. Prior to the GFC, strong growth was recorded for several years, until an almost identical decline as that of Central America was experienced.
The Pacific Islands region (including Papua New Guinea) performed modestly from 1981 to 1990. Then, conversely to the developed economies, their GDPs as a whole grew substantially for the next four years. From 2002 onwards the Pacific appears to have enjoyed stability in GDP growth, even during the GFC. The apparent escape from harm may suggest that the Pacific economies are not highly reliant on credit, and therefore their data would be of little value to this study. The Caribbean nations (those of which that are represented in the data) experienced the effects of the GFC; however, they otherwise show a volatile pattern that bears no visible relationship to the rest of the world and evince no pattern leading on from 1988.
The only pattern that has been found of interest to this study is that developing/emerging economies have overall tended to show higher growth rates than developed economies in recent years. Overall good performance of these economies could be explained by the taking up of the “slack” of unused labour capacity, which in a low-wage, high-unemployment economy may be a much greater economic advantage than investments in expensive labour-saving machinery and infrastructure. It is unsatisfactory that the available data only goes back as far as 1980, but the pattern of accelerated GDP growth from 2000 is an interesting one that tends to speak against the working hypothesis of this study. As for individual regions, the only roughly corresponding pattern is to be observed in Central America. But without similar patterns in other regions, the possibility of local factors should be considered, and a test of standard deviation among the individual national figures would be appropriate.
Therefore once again it seems there is no solid evidence as to the effect of the Basel Accord, and only an indication that it has not caused any harm. In fact, there is some doubt as to the reliability of this sort of analysis due to the inherent complexity of the subject matter. Furthermore, the results of the stock market crash of 1987 and the following 1990/1991 recession may serve to explain any economic declines observed in the period aimed at in this study. A more thorough study using statistical tools would therefore be warranted.
Lending practices to emerging/developing markets before and after 1988
In a study of access to international credit markets, Gelos et al examined the relevance of certain factors in determining the ability of developing countries to obtain loans. They used data from the World Bank on 150 countries and other data, and examined public syndicated borrowing and public bond issues. Their four-fold conclusion is:
'[P]opulation and GDP per capita alone explain a considerable fraction of the total variation of market access across countries.'
'[T]he perceived quality of policies and institutions matters substantially.'
'[C]ountries that are more vulnerable to shocks are less likely to be able to tap international credit markets.'
'[H]igher shares of FDI investments in GDP are generally associated with higher access by sovereigns. However, contrary to a-priori expectations, a country's trade integration with the rest of the world is not.'
Their data presentation includes a histogram showing what the authors describe as a period of stagnation and a period of expansion. Credit inflows reach a peak of approximately US$40 billion in 1982 and then fall back to approximately US$6 billion in 1990, before rising again to just over US$40 billion in 1998. Curiously there is a crash in 1999 and a negative inflow figure in 2000, which the authors do not comment on. It may be tempting to attribute the low credit access in 1990 to the introduction of the Basel Accord in 1988, and the recovery to adjustments made by lenders to get high-risk loans off their books, but this was only the end of a decline lasting several years.
Standard and Poors’ media releases on Christchurch and northern Japan
The effects of large natural disasters on urban centres, key infrastructure or vast primary industry areas can be economically detrimental. This is particularly of concern for financial institutions with strong business interests in devastated areas.
Standard and Poors published a series of bulletins on the economic outlook in Christchurch, New Zealand, after its two recent earthquakes, and northern Japan after its triplet disasters of earthquake, tsunami, and nuclear power crisis. In both cases, in spite of the direct cost of rebuilding and the systemic disruption, the forecasts view the economic situation as not particularly bad. The general theme is that both countries have sophisticated economic systems and, above all, generous government assistance available to support domestic institutions exposed to the disaster areas. The only concessions of note are pressure on New Zealand insurers and localised financial institutions in Christchurch. Since the publication of those bulletins, however, Christchurch-based insurer, AMI Insurance, has concern that its reserves and reinsurance may not be sufficient to cover its commitments. AMI holds about one third of the domestic insurance market in Christchurch and at the time of writing was considering a NZ$500 million government support package. A small local insurer, Western Pacific, had already gone into liquidation after being refused government support. The New Zealand Reserve Bank, however, does not expect further bailouts.
One expects that wherever the safety nets of backing from a government with substantial reserves and international reinsurance networks exist, the impact of any disaster will be spread out and the chance of an economic repercussion limited. As an example, the New Zealand Earthquake Commission manages a relief fund, many billion dollars in size, which is used to cover a portion of the amount of retail home and contents insurance pay-outs. It also has insurance with an Australian provider, Gallagher Bassett. The Reserve Bank of New Zealand publishes a list of banks under its oversight along with their credit ratings from the three main credit agencies. The two lowest rated institutions had BBB- ratings from Standard and Poors at the time of writing. A convincing majority of companies have ratings of A+ to AAA. Although some of those are foreign-owned, some are domestic.
Disasters in LDC/DC’s – Pakistan
However, if a disaster were to occur in a developing country the effect may be quite different due to less economic sophistication, the inability of governments to maintain reserves (or a lack of will on the part of corrupt or inhumane regimes to deliver support), and the practice of international financial institutions and insurers to avoid exposure to unstable economies.
The aftermath of the earthquake in Haiti and the flood in Pakistan are both highly-relevant areas for research in this study. Unfortunately, data regarding Haiti has not been forthcoming. The State Bank of Pakistan sought to encourage economic recovery by easing regulations, offering concessional refinancing schemes and encouraging private banks to lend more in flood-affected areas. Credit ratings on Pakistan’s banks, including domestic private sector banks, are mostly healthy. This kind of strategy may be effective when a nation’s economic hub is still functioning largely as normal, and effectively enough to cope with a crisis in its hinterland. However, in any instance where it is the financial hub itself that is damaged and there is no other infrastructure capable of stepping in, then lending – if not aid – from international sources will be necessary.
Ways around the regulators
The apparently good performance of LDCs and DCs ultimately suggests that capital continues to be available from somewhere in spite of regulatory restrictions and practices of commercial conservatism. The existence of regulatory work-arounds, and the capacity of the finance industry to find them, would tend to negate a case for easing of regulatory restrictions. LDC/DC debt grew ten-fold from the early 1970s to the early 1990s.
One rather curious point is that while low-rated borrowers are subject to a 150% risk-weighting, there are many more that are unrated and receive a 100% risk-weighting. This in itself favours borrowers that are too small to rate a mention over those that have at some stage risen above that lowly status. Another is that banks that use an internal ratings approach are not relying on external credit ratings and may see some borrowers differently; they may have insider knowledge of a few, or more emphasis on short-term profit when loans are secured, and therefore conclude that they can ride the waves of LDC/DC economic volatility.
These factors may contribute to concealment of the face-value implications of the Basel Accord. However, as the G10 regulators continue to examine ways of defeating the regulatory work-arounds, as they did to some extent in the design of Basel II, the LDC/DC economies may experience some degree of strangulation if Basel III turns out to be too effective.
Securitisation is another means by which LDC/DC entities can obtain finance. According to the Basel Committee, the use of securitisation operates as a means of obtaining liquid capital from illiquid assets. Not only does this assist LDC/DC entities to obtain finance, but it also assists those who wish to improve the efficiency with which they provide finance at higher than normal rates of return. The American Bar Association argues that a driving force behind banks’ earlier demand for securitisation was the international harmonisation of regulation and decreased transaction cost. However, they argue, when the Basel Accord came along capital arbitrage became a more significant motive. Arner also comments on the incentive the Basel Accord provided for the use of securitisation.
Moreover, it was a major finding in Berger and Udell that American banks’ reliance on securitisation had nothing to do with the risk associated with their clients. Furthermore, Gelos et al found that among DCs the likelihood of governments being able to access international credit – in both syndicated loans and bond issues – does not depend on their frequency of defaults, nor their trade openness, nor on traditional liquidity and macroeconomic indicators. They found that only the country’s vulnerability to economic shocks and the perceived quality of their economic policies and institutions are determinative. The authors found that defaults only have effect while they remain unresolved. Therefore securitisation is a powerful tool for any entities that are large enough to engage in it. This is very likely a means by which LDC/DC entities and their financiers can get around the restrictions presented by Basel.
Debt and liability reduction techniques
Notwithstanding the growth in LDC/DC debt cited above, such debts have been reduced on occasions through a variety of debt conversion schemes that allow LDC/DC economies to connect with the philanthropic instincts of some developed world groups and corporations. The significance of these is simply that as pressure on smaller economies is relieved, the chance of default by would-be borrowers is reduced. Among the instruments in use are 'debt for equity swaps,' in which the lender acquires equity in some of the borrower’s quality assets alongside foreclosure sales. This would also be a plausible alternative when foreclosure becomes likely.
Then there are 'debt for nature swaps,' undertaken by environmentalist groups that buy government debt at a discount and the government declares and maintains a national park in return. In a “debt for development” or “debt for education swap” the creditor’s rights and obligations are donated to developing world charities or education programs involved in the particular LDC/DC concerned.
Another scheme in use is a debt buy-back, in which a LCD/DC pays back a certain number of cents in the dollar of a loan in return for a total write-off. The only positive in this for a creditor is found when the total amount repaid exceeds the original amount borrowed plus funding costs. Otherwise it is simply charity by means of debt forgiveness.
The Brady Plan was a strategy arrived at by the United States government, which involved replacing LDC/DC debts with specially formulated 'Brady bonds,' decided country-by-country, with approval of the United States Treasury. This is described in depth by Buckley. In addition to this, some LDCs have undertaken discounted buy-backs of Brady bonds funded by other bond issues. The capital liberated by this process is used to retire further debt.
Lenders to LDCs/DCs can also reduce their own liabilities by obtaining participants through assignment or novation. This can spread the highly risk-weighted loans away from institutions that deal frequently with LDCs/DCs; however, as there are only a finite number of potential lenders, the advantage of this practice for high-risk borrowers will have to decline as debts continue to rise. Nevertheless, while other debt conversion schemes exist, a partial safety net is afforded lenders. Moreover, not all banks in LDCs are low rated; some have quite solid ratings and can attract more finance. In turn, their domestic lending policies may favour local borrowers who may be unrated or superficially undesirable (for reasons such as language, culture or inappropriate comparisons with customers in developed economies) to international lenders. This would be a backdoor means for many LDC/DC borrowers who would otherwise be out of consideration, to access international capital. The contrasting picture between the United States and Latin America that Barajas et al discussed is suggestive of this, provided one assumes that American regulators have been more effective domestically than internationally.
Final analysis on empirical observations
To the extent that all these backdoor approaches work, the Basel Accord fails in its mission to control exposure of the global financial system to risk. Due to the large potential of the work-around strategies, it may be argued that the Basel Accord alone is not capable of controlling the global financial system to the extent that would bring these backdoor, risk-prone lines of business to heel. Apart from further widening of its rules, if the Accord is to succeed it must be accompanied by close scrutiny, especially of securitisations (and the resulting burden of government must also be assessed). But the result would be a somewhat straight-jacketed system that could undermine creativity in commerce.
Given the preceding theoretical arguments this may have negative repercussions, not the least of which would be a most unfortunate justification of the working hypothesis of this study. If there is both a broadening of rules and an intensification of monitoring, the risk-weighting system may result in deflationary pressure upon economies that need growth, enhanced monetary advantages to economies that are already doing well, and possibly contributing to inequality within developing countries. This would be contrary to common humanitarian instincts. What remains is an argument in favour of moderation in both the extreme ends of the risk-weighting scale. As a suggestion, a risk-weight of 150% (or whatever maximum rate national regulators currently apply) should only apply to a D-rated borrower (indicating current default). There should be no borrower assigned a zero risk-weight regardless of the certainty of repayment and all risk-weights should be brought closer together toward either a mean or median risk-weight. Appropriate risk-weights (or credit ratings) should be calculated upon more thorough data relating to quality of management where economic difficulties would otherwise depress a borrower’s credit worthiness, so as to find a balance that will maintain risk limitation alongside continued fostering of economic development where it is needed most.
This study is incomplete due to a lack of applicable empirical data on the subject. Nevertheless, a theoretical case is created that while there are both strengths and weaknesses of merit, the little data presented infers that the Basel Accord has not had a negative impact on development in LDC/DC economies or on disaster recovery. It has been shown that credit is still available where needed, as is debt relief, through strategies such as securitisation and debt conversion. It is shown that LDC/DC borrowers are lacking neither in ingenuity nor the benefits of others’ philanthropy, and that may be masking the potential effects of the Basel Accord. The ability of LDCs/DCs to obtain finance suggests the Accord is not working as designed and change may need to be considered. It is a logical step then to moderate the extreme ends of the risk-weighting scale to avoid the bad outcome of LDC/DC economies being deprived of good quality credit.
* BA (Hons), Deakin University, Australia. Currently studying toward a Juris Doctor at Monash University, Australia. The bulk of this article was written during the first half of 2010.
1. An example of a localised recession is found in the recession following the collapse of Pyramid Building Society and its group of companies of 1989/1990, which brought the small city of Geelong, Australia, into recession ahead of the rest of Australia, which foreran the global recession of 1991. The cause of the local recession is commonly attributed to a run on funds by Pyramid’s depositors.
2. Arner D, The Credit Crisis of 2008: Causes and Consequences (Working Paper No 3, Asian Institute of International Financial Law, 2009).
3. Coudert V and Gex M, The Credit Default Swap Market and the Settlement of Large Defaults (Working Paper No 17, CEPII, 2010).
4. See general comments by Barajas A, Chami R and Cosimano T, Did the Basel Accord Cause a Credit Slowdown in Latin America? (Working Paper No 9, International Monetary Fund, 2005).
5. Barajas et al, n 4, p 16.
6. Berger AN and Udell GF, Did Risk-Based Capital Allocate Bank Credit and Cause a ‘Credit Crunch’ in the United States? (1994) 26 Journal of Money, Credit and Banking 585.
7. A term used by Barajas et al, n 4, p 9.
8. Barajas et al, n 4, p 22.
9. Barajas et al, n 4.
10. Barajas et al, n 4, p 14.
11. Barajas et al, n 4, p 21.
12. Barajas et al, n 4, p 21.
13. Barajas et al, n 4, pp 21-22.
14. Barajas et al, n 4, p 22.
15. Gelos G, Sahay R and Sandleris G, Sovereign Borrowing by Developing Countries: What Determines Market Access? (2011) 83 Journal of International Economics 243.
16. Gelos et al, n 15 at 249-250.
17. As at the time of writing in mid-2011.
18. Standard and Poors, Christchurch Earthquake will have No Immediate Impact on the New Zealand Sovereign Rating; Christchurch Earthquake will Worsen Insurance Earnings, But Capital and Reinsurance Remain Rating Strengths; Christchurch Earthquake Could Put Downward Rating Pressure on Canterbury-Focused Financial Institutions; Crisis in Japan Insurers' Strong Capital Should Help Forestall Rating Actions Related to the Japanese Earthquake; It's Early to Assess the Effect of the Japan Earthquake on Structured Finance Securities Rating; It's Too Early to Assess the Sovereign Rating Impact an Japan; Long-Term Growth, Fiscal Implications are Key; Limited Ratings Impact or Japanese Financial Institutions from Massive Earthquake (medial releases, 2 April 2011), www.standardandpoors.com viewed 18 April 2012.
19. State Bank of Pakistan, Credit Ratings of Banks & DFI’s: Updated as of August 2, 2010 (2010), http://www.sbp.org.pk/publications/c_rating/Ratings-02-Aug-2010.pdf viewed 18 April 2012. Ratings of native institutions are provided both by the Pakistan Credit Rating Agency Limited (PACRA) and Japan Credit Rating Agency Ltd (JCR-VIS).
20. Buckley R, Emerging Markets Debt: An Analysis of the Secondary Market (Kluwer Law International, 1999) pp 5-212. See also, for a far more pithy account: Tarzi S, Country Risk Analysis: International Banking and the Developing Countries (1997) 22(4) The Journal of Social, Political, and Economic Studies 481 at 481-482.
21. Basel Committee on Banking Supervision, Liquidity Risk: Management and Supervisory Challenges (Bank for International Settlements, Basel, Switzerland, 2008).
22. American Bar Association, The Global Credit Crisis of 2008: Causes and Consequence (2009) 43(1) International Lawyer 91.
23. Arner, n 2, p 15.
24. Berger et al, n 6.
25. Gelos et al, n 15.
26. Buckley, n 20, p 81.
27. Buckley, n 20, pp 83-84.
28. Buckley, n 20, pp 85-86.
29. Buckley, n 20, pp 102-110.
30. Barajas et al, n 4, p 21.