FINANCIAL INSTITUTION MANAGEMENT AND MODELING

Financial Institution Management and Modeling



Financial Institution Management and Modeling

Introduction

In June 1999, the Basel Committee on Banking Supervision announced plans to revise the capital standards for banks. The Basel Committee believed that project loans were significantly riskier than corporate loans and, therefore, warranted higher capital charges under the new proposal (known as Basel II). Bankers, fearing that higher capital charges would damage project lending by lowering profits and driving borrowers to nonbank competitors, formed a consortium to oppose the proposal by studying the actual default and loss characteristics of their combined portfolios of project loans. The study showed that project loans were not riskier than corporate loans. Armed with this data, the consortium sent a letter to the Basel Committee in August 2002 urging them to lower the proposed capital charges on project finance loans.

Case study Review

The Basel Committee's objective is to develop a comprehensive framework for securitization that is risk sensitive and provides banks with the proper incentives to move from the standardized to the IRB approach. In recognition of asset securitization as an important source of funding and mechanism for credit risk transference, the IRB approach should be neutral with regard to the capital requirements it produces in order not to create incentives or disincentives for banks to engage in securitizations (Passmore and Roger, 1996).

Consistent with the stated objective of the Basel Committee, for both the investment-grade and non-investment-grade portfolios, the minimum regulatory capital requirement calculated using the Standardized Approach is larger than the capital requirements calculated using either of the IRB Approaches (Myers and Majluf, 1984).

Figure 1: Margin Loans and Repo-Style Transactions

However, for both portfolios, the minimum regulatory capital requirement calculated using the advanced IRB Approach is larger than the minimum regulatory capital requirement calculated using the Foundation IRB Approach. The difference is small for the investment-grade portfolio; however, it is substantial for the non-investment-grade portfolio. This result does not appear to be consistent with the Basel Committee's objectives (Mingo, 2000).

The Committee's ongoing work has affirmed the importance of the three pillars of the new framework: minimum capital requirements, a supervisory review process and effective use of market discipline. The pillars are mutually reinforcing, working together to contribute to a higher level of safety and soundness in the financial system. The Committee stresses the need for full implementation of all three pillars and plans to play an active role with fellow supervisors - for example, through enhanced information exchange - to achieve this goal (Jones and Mingo, 1999).

The Committee recognises that the New Basel Capital Accord (the New Accord) is more extensive and complex than the 1988 Accord. This is the result of the Committee's efforts to develop a risk-sensitive framework that contains a range of new options for measuring both credit and operational risk. In its simplest form, however, this more risksensitive framework is only slightly more complex than the 1988 Accord(Avery et al, 2000). Moreover, in the New Accord, the Committee is emphasising the role of supervisory review ...