The Basel Committee for Banking Supervision's risk-based capital proposal has finally been pried loose.
Pressure from on high-namely finance ministers eager for something to take credit for at the Group of Seven summit meeting this month-forced recalcitrant bank regulators to put aside their pet projects and agree to the proposed framework.
Nothing really to worry about, of course. The finance ministers wanted quick action, and the international central bankers have obliged.
Comment on the proposal is not due until the end of March next year. It will be followed by other proposals, and final action is not likely until 2002.
The lag time does not mean that the new proposal can be safely shelved. It is a highly consequential document that will have an immediate impact in setting the terms under which U.S. and other bank regulators will make revisions to current capital rules.
And once the framework is implemented, its impact will be so dramatic that it is now an urgent management priority to plan for future effects.
Indeed, the impact has already been felt in financial markets, where bond prices moved in reaction.
There is no doubt and little debate that the current Basel rules are no longer having their desired effect on the financial system.
When adopted a decade ago, the regulatory accord did what it was supposed to do. It led to a dramatic increase in bank capital levels, even in countries where regulators permitted so many accounting fiddles as to mute the meaning of the risk-based requirements.
It was widely recognized, however, that the rules were a meat-ax approach to capital, with only the most crude categorization of wildly different risks into "baskets" for risk-weighting purposes.
As anticipated, bankers quickly adjusted to the new regime.
One of the reasons banks were able to more than double their capital in a decade-and, at least in the United States, also post record returns-is that they developed sophisticated ways to engineer balance sheets to take on risk without capital consequences.
They also moved to the edge of each risk basket, taking on the highest- yielding assets they could in each category to increase return on capital.
The new capital framework is intended to correct what turned out to be perverse incentives to risk taking in the current rules. In doing so, however, the complexity of the risk-based rules is exponentially increased.
Almost certainly, an entirely new set of unintended consequences would ensue, resulting in new risks and substantial changes in the flows of funds within nations and around the world.
The new system would substitute risk determinations made by external ratings agencies for the four big baskets in the current rules.
Banks might be allowed to rely on their own credit models, but only if their regulators deemed them "sophisticated"-and even then, only if the Basel Committee can come up with an equitable way for supervisors to judge widely different risk-management practices.
Reliance on ratings agencies would refine the risk baskets and thus reduce incentives to risk taking. It would also result in an enormous delegation of rule-making to a few unregulated enterprises with their own business imperatives and with a poor track record as far as sovereign and bank credit ratings are concerned.
Companies that are now unrated would doubtless flock to the agencies for review, and nations where ratings by international agencies are rare would soon see the error of their ways.
If anyone were sure to come out a big winner, it would undoubtedly be the ratings agencies. Were they shareholder-owned, their stocks would have instantly hit new highs.
Another winner in the new proposal would be nonbank issuers or guarantors of debt.
The current system favors government and bank obligations over even the highest-rated corporate ones. The new system would put highly rated corporate claims on the same footing as bank and government-sponsored- enterprise obligations. This should level the proverbial playing field for the financial guarantee industry, while putting Fannie Mae, Freddie Mac, and the Federal Home Loan banks under price pressure.
First among the losers: most banks, which would need to add more capital to their books. This would put them under earnings pressure, just as many are foreseeing the end of their recent profitable run.
Reflecting this, smaller banks that do not fall under the "internationally active" designation to which Basel rules apply may seek an exemption from the new framework. The Office of the Comptroller of the Currency has already asked for comment on a separate set of capital rules for small banks, and pressure for a two-tiered system would doubtless grow as the implications of the Basel proposal are recognized.
Banks interested in diversification into nontraditional activities may be hardest hit.
U.S. banks are accustomed to having capital rules apply at the holding company as well as the bank level.
This is not common practice elsewhere, and it could be costly to Japanese banks in particular.
Deduction of securities and insurance capital from the consolidated book would also be costly, even in the United States, and this proposal should be carefully considered as companies contemplate the Citigroup model of diversification.
It takes careful analysis of the complex Basel proposal to identify all the winners and losers. One easily identified casualty is any hope that bank capital requirements will be transparent, simple, and easy to use as an instrument of supervisory policy.
One might have thought the regulators would have learned that the more complex the set of rules they devise, the more adroit will be bank strategies to maximize competitive advantage under them. This is the clear lesson of the last decade of complicated credit- and market-risk-based rules.
Indeed, it is the lesson to which the regulators applied themselves as they worked on this new proposal.
Yet the new proposal would put in place still more complex standards that come close to setting bank capital on a day-to-day, asset-by-asset, position-by-position basis.
Supervisors will be very hard-pressed to keep up with their crafty charges, especially as new financial instruments exploit the inconsistencies or omissions in the new framework.
There is tacit recognition of this problem buried in the new Basel Committee paper. It includes not only a new capital system, but also injunctions to supervisors to take it seriously.
A "prompt corrective action" framework, similar to that in the Federal Deposit Insurance Corporation Improvement Act of 1991, is proposed, under which supervisors would intervene as a bank's capital position slipped.
The paper notes that it may be hard for supervisors to know when a bank's capital is impaired because the complexity of the new framework will confuse even them. As a result, it suggests that a more simple scheme might be used to determine when regulators will intervene.
For example, intervention might be based on a straight percentage of Tier 1 capital to on- and off-balance-sheet risk, gross revenues, or some similar criterion.
One has to think hard about a risk-based proposal so complicated that even its proponents acknowledge that they may be unable to use it for the most important function of capital adequacy: knowing when a bank is in trouble.
Regulatory capital standards should facilitate regulatory policy, not attempt to second-guess market judgments about bank capital.
If the new framework is problematic for regulators, then it is even more so for the private sector, which would find its decision-making distorted by the need to comply both with market standards and a new, complex set of regulatory ones as well.
In science, breakthroughs are often made with blinding simplicity. Blackboards full of complex equations are transformed into simple ones that explain observed phenomena and permit the development of new machines, products, and processes.
Bank regulation is an art, not a science, but regulators would benefit from a refresher course on "best practices" for scientific thought. Simple is not always stupid, and complex is not always clever.
A simple risk-based capital standard could well be the smartest way to put financial institutions on firm ground as the next round of risks looms ever larger.