Basel II: The Route Ahead or Cul-de-Sac?

Abstract

Ideally, one would like to be able to view individual loans as parts of portfolios, with better diversified portfolios assigned lower risks and capital requirements. But because of the difficulty of measuring the risk of loan portfolios (which stems from their complicated covariance structure), the author suggests that the regulators and their constituencies would be better served by requiring more realistic valuations of loan portfolios and other bank assets. In this sense, the design of effective capital adequacy rules involves a trade-off between developing developing more precise measures of risk, on the one hand, and improving the frequency and accuracy of asset valuations, on the other. The author urges bank regulators to focus less on refinements of risk measurement and more on efforts to incorporate fair value accounting. Despite the best efforts of regulators, banking crises throughout the world have been on the rise and proved costly both in terms of the burden on taxpayers and the effect on output. The revised Basel Accord establishes new procedures for measuring the risk of bank loans and for calculating the capital that needs to be held against these loans. But if these new rules are undoubtedly an improvement on the existing ones, their continued focus on the risk of individual loans suggests that bank regulation is heading down a cul-de-sac. Ideally, one would like to be able to view individual loans as parts of portfolios, with better diversified portfolios assigned lower risks and capital requirements. But because of the difficulty of measuring the risk of loan portfolios (which stems from their complicated covariance structure), the author suggests that the regulators and their constituencies would be better served by requiring more realistic valuations of loan portfolios and other bank assets. In this sense, the design of effective capital adequacy rules involves a trade-off between developing developing more precise measures of risk, on the one hand, and improving the frequency and accuracy of asset valuations, on the other. The author urges bank regulators to focus less on refinements of risk measurement and more on efforts to incorporate fair value accounting.