One of the most frequently discussed very positive effects of Basel II is that over time it will lead to a much bigger emphasis on risk management. The reason is that in order to face dynamic capital adequacy requirements, banks need to sig- nificantly upgrade risk sensitivity and risk control systems. At root, that is what the advanced internal ratings-based (A-IRB) method is all about.
Many bankers say, and they are right, that another fallout will be much greater attention paid to risk-based pricing. Some credit institutions even suggest, at least in private discussion, that they may exit product lines where the risk and return ratio is dubious or highly uncertain. According to expert opinion, Basel II:
● Will also have a significant effect on junk bonds and on distressed debt, and
● This might lead to the emergence of banks specializing in low credit qual- ity counterparties.
Besides that, in all likelihood, the unloading of distressed debt, through massive securitization or direct sale, by credit institutions will hit hedge funds, which control about 70% of very low rated issues in the United States. If this happens, a secondary after-effect of Basel II will be some sort of realignment among finan- cial institutions in terms of the product line each one of them targets.
Still other experts talk of a beginning of quantification of business risk and of reputational risk, including associated control measures. In their opinion, this is likely to follow the implementation of the new capital adequacy framework by the Basel Committee. The reader should notice that:
● All these opinions and hypotheses are reasonable and plausible.
● But they are not complete, in the sense that they are missing one of the vital ingredients of the ongoing change.
When the economic and financial history of this decade is written, much will be made of the fact that the original form of Luca Paciolo’s balance sheet cannot accommodate economic capital on just one side, as happens with core capital, which is part of the bank’s liabilities. The reason is very simple, and it lies in the fact that, as section 2 has stated, many new financial instruments don’t quite fit into a prestructured pattern of A&L.
Before going further in this discussion it is appropriate to appreciate that the foregoing statement will eventually be true also for regulatory capital, as the latter admits Tier 3, which is capital for trading. But mainly the two-sided bal- ance sheet approach concerns economic capital, given that its sources vary widely.
It needs no explaining that this would be a different book– one that borrows from both sides: A&L. What’s more, in all likelihood legally valid solutions would vary by jurisdiction. For example, under German law economic capital includes:
From assets:
⫹contingency reserves pursuant to section 240F of commercial code
⫹unrealized reserves, maximum of 1.4% of weighted risk assets
⫹reserves up to 45%, pursuant to German income tax act From liabilities:
⫹liabilities represented by participation rights
⫹longer-term subordinated liabilities
⫺market management positions in securitized own participation rights/longer-term subordinated liabilities
Other jurisdictions have different criteria in answering the query ‘which side of the B/S?’. Under Japanese law a big chunk of regulatory capital comes from assets, as supervisors permit all banks to write in Tier 2 up to 45% of unrealized profits from securities. Even more ridiculous is the supervisors’ permission to accounts for deferred tax assets (DTAs) as regulatory capital. That’s simply mon- key money.5In this sense, even the T-2 capital does not come from the same side of the balance sheet.
Some experts say these are rough edges which will be smoothed out over time. I personally think the opposite is true, as new financial instruments are developed every day and many of them do not fit the classical A&L classification. This sees to it that a pattern is developing akin to that in Table 14.1. Based on this pattern,
it is better to look at regulatory capital and economic capital as providing a fourth dimension to accounting:
● General ledger
● Balance sheet
● Income statement
● Regulatory and economic capital.
The good news is that this fourth dimension is proactive. ‘The difficulty for risk control in financial institutions,’ said a senior management officer, ‘is that this is a reactive job. Even if we see that an inordinate risk is taken, it is hard to pro- hibit certain trades.’ This statement is true, but there are three forces which may change that landscape:
● The advanced internal ratings-based (A-IRB) method, which is obliging proactive examination of creditworthiness.
● The IFRS, and US GAAP, financial reporting requirement for marking to market, which uses market forces to expose assumed risk.
● Risk-based product pricing and economic capital allocation, which sees to it that banks must assure the liquidity of their positions, in accordance with their risk appetite.
The first of these bullets will oblige banks to use advanced tools for risk man- agement. Internal ratings may prove instrumental in keeping some low credit- worthiness customers at arm’s length, a change from current policy where banks are becoming attached to the client relationship and to the transaction.
The second bullet will ensure that credit institutions will have to monitor the results obtained by the customer’s account, not by means of historical costs and
Table 14.1 On which side of the balance sheet does capital adequacy responsibility fall?
Capital B/S
T-1 L∗
Hybrid t-1 L, (A)
T-2 L, (A)
Hybrid t-2 A, (L)
T-3 A
L ⫽Liabilities; A ⫽Assets; L, (A) stands for primarily lia- bilities and secondarily assets; the opposite is true of A, (L).
past risks, but through cash flow analysis and by marking to market. This would not permit sales people to handle business through ‘dear customer’ relationships;
or traders to hide risks in assumed positions from the eyes of management.
The third bullet will help to assure that procedures regarding capital adequacy, both in the regulatory and in the economic sense, are strong and steadily updated. With Basel II, banks will have to put their money on the line (Pillar 1) under closer and more detailed supervision (Pillar 2). Moreover, the market will steadily watch through greater transparency (Pillar 3).
In conclusion, if we admit that regulatory and economic capital constitute the fourth dimension of financial accounting, thenas in the case of the budget (see Chapter 9) capital adequacy should be computed for the rolling year and be steadily re-evaluated. Furthermore, both capital adequacy and the budget should be matched through cash flow projections:
● Mid-term, under normal conditions
● As frequently as necessary, under tightened inspection.
It is also appropriate to notice that while balance sheets and income statements are financial accounting tools, capital adequacy and the budget are financial plans. As such, they depend on steady cash flow (see Chapter 13) or, alterna- tively, on bought money. According to some expert opinions, capital adequacy and the budget overlap. According to other experts, the budget is a subset of cor- porate capital adequacy.