Basle II & CAD3: Response to the UK Treasury’s Consultation Paper

This paper is a contribution to the UK Treasury’s consultations on the new Basle Accord (Basle 2). It urges reconsideration of the current version of Basle 2 – which will influence European Union law – raising a number of concerns about its impacts on both the European and the international financial system, and on developing countries in particular.

The G-10’s Basle Accord and the corresponding European agreement, the Capital Adequacy Directive (CAD) are agreements governing lending activities of banks and securities companies, which were developed to reduce the vulnerability of the international economy to systemic shocks arising from bank collapse. These agreements define methods for calculating the levels of risk involved in various forms of lending, and from this establish the levels of capital which banks are required to hold against that risk.

The paper first notes wide acceptance of the idea that diversifying loans across countries and regions, and across different sectors, reduces the risk of bank collapse – and shocks to national and international financial systems more broadly – because it allows banks to offset losses in one geographical region or sector against gains made elsewhere. Therefore, the paper argues, even though developing countries may have lower credit ratings than the developed economies, banks can actually reduce their level of lending risk overall through including loans to these economies in their loan portfolios. The authors note the successes of international banks which are highly internationally diversified.

The paper finds that by failing to recognise this, and calculating the risks of lending on a stand-alone basis rather than factoring in the level of geographic diversification across the bank’s loan portfolio, the Basle 2 Accord is flawed. It argues, as a result Basle 2:

• significantly overestimates the risks of lending to countries with low credit ratings, and consequently requires banks lending to developing countries to hold a far higher level of capital than the real level of risk would require
• is likely to result in an increased cost of loans to developing countries, and/or a reduction in the volume of loans which, given the importance of loans to developing countries, could have a serious impact on the achievement of the Millennium Development Goals
• will provide disincentives to geographic diversification, and therefore increase rather than reduce the risk of systemic shock, particularly among European banks

In concluding, the paper strongly emphasises that despite the difficulties in calculating the effects of diversification, the Basle 2 risk calculation methods should not be used, and that the Basle Committee should instead consider adopting other existing, albeit flawed, mechanisms for recognising portfolio diversification effects, at least as a transitional measure until more accurate models are available.