Patricia Jackson

Procyclicality and the new Basel Accord - banks’ choice of loan rating system

Summary.The Basel Committee on Banking Supervision is proposing to introduce, in 2006, new risk-based requirements for internationally active (and other significant) banks. These will replace the relatively risk-invariant requirements in the current Accord. The new requirements for the largest bank will be based on bank ratings of the probability of default of the borrowers. There is evidence that the choice of loan ratings which are conditional on the point in the economic cycle could lead to sharp increases in capital requirements in recessions. This makes the question of which rating schemes banks will use very important. The paper uses a general equilibrium model of the financial system to explore whether banks would choose to use a countercyclical, procyclical or neutral rating scheme. The results indicate that banks would not choose a stable rating approach, which has important policy implications for the design of the Accord. It makes it important that banks are given incentives to adopt more stable rating schemes. This consideration has been reflected in the Committee’s latest proposals, in October 2002.

Regulatory implications of credit risk modelling

Abstract This introduction places in context the papers on credit risk modelling contained in the special issue. We explain why credit risk modelling has become such a focus of interest for practitioners and financial supervisors. Even though, as we explain, the current modelling technologies have significant weaknesses, they offer the possibility of major changes in the ways banks are managed and regulated. The main impediment to greater use of these models, especially by regulators, is the difficulty involved in back-testing the risk measures they produce. We suggest some thoughts on how back-testing and other types of model assessment might be performed.

Introduction: Banks and systemic risk

The papers in this special issue were presented at a conference on Banks and Systemic Risk held at the Bank of England from 23–25 May 2001. 1 The papers covered three broad areas – banks and systemic risk; theory and evidence of market discipline and signals of bank fragility; and capital requirements and crisis prevention. The view that weakness in the banking sector may have serious systemic effects on the economy more generally hinges on several issues. Since the early 19th century (Thornton, 1802), it has been recognised that problems in one bank can spill over into more widespread difficulties in the sector. The nature of the contracts banks hold (short-term deposits and longer-term loans) exposes them to the possibility of runs; and linkages between banks combined with information asymmetries between counterparties and banks make them vulnerable to contagion. A number of papers have focussed on bank runs (e.g. Diamond and Dybvig, 1983) and the transmission mechanism of problems from one bank to others (e.g. Freixas et al., 2000). Other papers (e.g. Bernanke, 1983) have focussed on the wider costs to the economy if banks fail. This reflects the central position of banks in the payments system and their special role in intermediating flows of funds to small firms and the retail sector. One issue addressed at the conference was whether banking crises do in fact impose externalities on the system. It has been suggested that, with the growth of substitutes for bank intermediation particularly through the development of securities markets, bank failures may not impose substantial costs on economies. Hoggarth, Reis and Saporta (‘Costs of banking system instability: some empirical evidence’) review the estimates of fiscal costs incurred in dealing with a banking crisis and also Journal of Banking & Finance 26 (2002) 819–823

Fair value accounting and the future of financial instruments

Discusses the recently published draft standard from the Bank of England that covers most controversial banking regulatory areas. States that there may well be advantages in a fair value approach for banks but disclosure of fair values would probably be preferable. Looks at the S&L crisis in the USA and how legislation worked in its case. Elaborates on Denmark’s comprehensive fair value approach that suggests that adjustments in this system do increase earnings and value of capital volatility. Pinpoints bond market problems and liabilities valuation. Contends that there would be advantages in adopting disclosure of fair values.

Financial stability as a policy objective

Explains why financial stability is important for official policy: its disruption leads to huge economic costs. Analyses why the involvement of the public sector is necessary to ensure stability; market self‐interest is not sufficient because of externalities, meaning that individual firms’ decisions take into account only their own costs and benefits. Outlines the kinds of action needed: ex ante, the authorities can influence the robust shock‐absorbing capacity of the system by levering capital and liquidity buffers, and oversee the financial infrastructure of payment, clearing and settlement systems. Indicates the balance that has to be made between system safety and the cost of buffers or system improvements. Goes on to the authorities’ influence over market discipline, and to the need for crisis management on certain occasions. Stresses also the importance of market integrity and concludes with the international dimension to financial stability policy.