In recent weeks the new Basel capital accord has come under fierce attack from opponents who charge that the accord will have serious, unintended consequences.
For instance, former FDIC chairman William Isaac refers to Basel II as a "runaway train" that might lead to serious erosion of bank capital positions [Community Banking Supplement, "
Mr. Isaac and others also contend that Basel II can cause serious harm to smaller banks that would remain subject to the original accord. In support of the latter charge, these opponents of Basel II have cited a paper we have written on how the accord might affect competition in the mortgage business.
Our paper does argue that Basel II may have some unintended consequences for competition between small and large banks, but it does not support such a strong conclusion regarding the continuing competitive viability of small banks.
Moreover, we do not agree that the potential, unintended consequences of Basel II are serious enough to imply that Basel II should be abandoned altogether. We believe that while it is important to bear such potential consequences in mind and take steps to address them, the new regulatory capital framework advanced by Basel II is an improvement over Basel I in a number of dimensions.
Our paper, to set the record straight, argues the following:
- To the extent that regulatory capital requirements force banks to hold more capital than they otherwise would on relatively low-risk assets, they have an incentive under Basel I to remove low-risk assets from their balance sheet (or obtain credit guarantees that would eliminate the capital requirement).
- Similarly, if such regulatory constraints are removed for a group of banks (the Basel II banks) while others remain constrained, there will be some shift of lower-risk assets to the unconstrained banks.
- With respect to mortgages, it is likely that the original accord forces banks to hold more capital than they otherwise would on prime or near-prime adjustable-rate loans - and possibly on hybrids as well, since these mortgage types are characterized by relatively little interest risk and credit risk.
- This regulatory constraint will be removed for Basel II banks, leaving smaller banks at a disadvantage with respect to holding prime ARMs and hybrids.
- Some of these mortgage assets, or at least the credit risk associated with them (and the income from bearing that risk), will shift from smaller banks to Basel II banks.
- The gain in market share by the Basel II banks will be a function of the size of the capital advantage (which, under the current Basel II proposal, would be quite large) as well as on an "elasticity of market share" parameter that we are unable to quantify with much precision. Moreover, it is difficult to determine from publicly available data the quantity of prime ARMs and hybrids currently retained in portfolio by smaller banks.
- We draw the qualitative conclusion that a competitive impact is likely to result, and we provide some illustrative calculations based on available information and what we consider to be plausible assumptions.
We wish to emphasize such a competitive impact would probably be most significant for mortgage products associated with relatively low interest rate and credit risk and is hard to quantify.For regional or community banks that holding diversified portfolios of loan products the resulting loss of income would be small in relation to total earnings. Small community banks and thrifts that specialize in the holding of residential mortgages, especially ARMs and hybrids, would likely feel a bigger impact.
In general, small banks would probably remain viable because of their potential advantages in operational efficiencies, consumer relationships, strong knowledge of local markets, and their ability to adapt to rapidly changing market conditions.
If the criterion to keep the competitive landscape largely unchanged is a critical one, then adjustments can be made to make the potential competitive impact less disparate.
One option is to reduce the risk weights for qualifying residential mortgages for nonadopters who satisfy certain criteria. These might include adequate geographic diversification of mortgage credit risk, a strong asset-liability management system to control interest rate risk, and the data and processes needed to identify appropriate risk segments.
Another option is to reduce the leverage requirement for institutions that invest primarily in low-risk assets.
It no doubt is important to have a debate about potential unintended consequences of Basel II. Such a debate would highlight areas where the impact of the new accord will require monitoring, or where some mitigating steps might be advisable.
However, such a debate should not lose sight of Basel II's important achievements. These include remedying some of the severe misalignments between regulatory capital and economic risk inherent in the original accord, which may seriously distort risk-taking incentives.
Basel II also promotes the adoption by banks of sound, best-practice risk measurement and management methods. It will probably lead to considerably better quantity and quality of data that banks collect to support their risk management processes.
No one wants a runaway train, but a derailed train is not the answer.
