Vol 2 (2005) - Issue 3

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Levelling the Playing Field - Basel II

Will Basel II achieve its stated aim of evening out the ground rules for an accountable and well-regulated global finance market or will it just succeed in closing down financing options for small and medium-sized traders?

The morning after

As commodity traders and bankers finish spending the last of their 2004 bonuses following a bumper year and look forward to more of the same, some industry analysts are assessing a little more soberly the impact of changes in the way that money will find its way into the international trade and commodity markets in the future. In June 2004 the Basel Committee on banking supervision published the ‘International Convergence of Capital Measurement and Capital Standards: a Revised Framework.’ ‘Basel II’, as it has quickly become known, replaces the Committee’s first offering in 1988 aimed at fostering a common worldwide approach to good practice in capital adequacy and supervision among banks. The likely deadline for implementation is 1 January 2007 and while that may seem some time (and at least another bonus) away, the world’s major banks have been preparing themselves in earnest for the new regime since the end of 2004 and in many cases much earlier.

Who are the Basel Committee and how did they come up with their findings?

The Basel Banking Committee members are drawn from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States - swiftly recognizable as the G10 countries plus Switzerland - and are represented in each case by their central banks. Consultation took place within each state represented and through liaison with countries not represented. The absence of representatives from the emerging markets, in particular South America and from the fastest growing world economies of China and India, does immediately raise some questions about its global legitimacy and the extent to which the Committee can expect to see global adherence, even though it talks with those countries on a regular basis. Immediately after the Committee’s initial publication of its proposal in January 2001, commentators were speculating that small and medium-sized enterprises (SMEs) and particularly those in emerging and poorer economies would be the losers in a mechanism which would encourage banks to exit what the Committee identified as high-risk markets.

What did ‘Basel I’ achieve?

Basel I introduced the rule that banks and other regulated institutions must achieve and preserve a capital of no less than 8% of their risk-weighted assets The aim of both Basel I and Basel II is to ensure that somewhere in the delicately balanced world of international finance to counter the huge borrowings on banks’ balance sheets there are real cash assets available to meet the potential downturns in the world’s markets.

Of course not every bank in the world adheres to these rules. Analysts calculate that something in the region of 25% of the debt books of China’s big four banks is bad. If that analysis is anywhere near accurate then the Chinese banking system is essentially bankrupt. Observers wait with interest to see what the Chinese authorities aim to do with the banking system prior to January 2006, when China is due to meets its final WTO benchmarks and present itself as a genuine competitive market economy. The original 8% rule, known as the Cooke Ratio, which has been in force since 1988 and remains a central feature of Basel II, came with a fairly clumsy risk-weighting scale which rated OECD sovereign debts at 0% in terms of the risk to be allocated in the bank’s books and then weighted OECD banks at 20% and certain state institutions at 50%. The rest of the market was rated at 100% with no real account taken of individual credit worthiness. The problem with that approach inevitably was that banks were being invited to apply the same risk tariff to lending made available to an international oil major as that they applied to a SME (defined by the Basel Committee as a company with a turnover less than EUR 50 million) or a recently privatized Eastern European smelter or other emerging market risk.