Financial Risks, Stability, and Globalization
Chapter

Comment

Author(s):
Omotunde Johnson
Published Date:
April 2002
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As is usually the case with IMF-organized conferences, the quality of the papers is such that for discussants only the humble task remains to find some spare remains of “uncharted territory” left by the author. The paper that the organizers invited me to comment upon is no exception to this rule. It gives a comprehensive overview of the relevant issues in modern financial regulation, thereby nicely bridging theory and practice.

The completeness of the approach in Llewellyn’s paper became all too clear to me when I was first preparing these comments. Reading the first twenty or so pages I gradually became enthusiastic about the idea of trying to link the paper’s theoretical insights to my own work, which is part of the major exercise in which Group of Ten (G-10) supervisors are currently engaged: the revision of the old, 1988 Capital Accord. But as I reached the end of the paper, I realized that this ground also appeared to have been charted well before my approach.

Nonetheless, as a relative insider to this process, I will try to expand here and there on some of the author’s observations. In passing, I will briefly touch upon three issues that surround the current revision of the Capital Accord: the idea of complementarity of the various approaches (rather than erasing false dichotomies), the possibilities—and also the limits—to what the author calls “contract regulation,” and the importance of incentives. These points then take me to a single topic which I believe merited somewhat more attention given its prominence on the agenda of international policymakers: the issue of maintaining a level playing field.

A first point that I strongly sympathize with—and that is stressed throughout the paper—is the complementarity of the various building blocks of any regulatory approach. The current revision of the Capital Accord is a case in point here. The new capital adequacy framework will consist of three complementary pillars: (1) minimum capital requirements, which seek to develop and expand upon the standardized rules set forth in the 1988 Accord; (2) supervisory review of an institution’s capital adequacy and internal assessment process; and (3) effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices.

Unfortunately, too many discussions, also within the Basel Committee itself, are blurred by issues of Pillar 1 versus Pillar 2, or Pillar 2 versus Pillar 3 and so on. These are exactly the type of false dichotomies that have been correctly signaled toward the end of Llewellyn’s paper. While clearly advocating the alternative principle of complementarity, the author acknowledges, however, that there may also be a negative trade-off between official or supervisory monitoring on the one hand (Pillar 2) and market or shareholder monitoring (Pillar 3) on the other.

I would be somewhat less pessimistic here. Although it is indeed not self-evident that market participants always have the necessary expertise to make risk assessment of complex (and sometimes opaque) banks, at the same time, they cannot simply take it for granted that supervisory practices or supervisory resources will always suffice to fill this gap. Yes, supervisors do have access to more and superior data, but extracting the relevant information from that raw data is quite a different matter, and one that can be rather cumbersome.1 In this process, I would therefore see a comparative advantage for relatively well-informed market participants such as rating agencies, where the substantial demand for their activities should enable them to free up a sufficient amount of resources.

A second area where clear elements of the author’s thinking are reflected in the new proposals goes under the heading of “contract regulation.” Under this regime, regulators define the “rules of the game” within which banks are allowed to use their own internal methodologies to allocate and assess capital. Under the current Accord, internal methodologies were only admitted in the area of market risk where the outcome of a bank’s Value at Risk model forms the basis for calculating its capital charge. According to the latest proposals of the Basel Committee on Banking Supervision (1999), internal methodologies are also likely to play an important role in the areas of credit risk (the so-called “internal ratings based approaches” as a prelude to full credit risk modeling), interest rate risk in the banking book, and even operational risk.

The advantages of such an approach are well-known, and neatly summarized in the Llewellyn paper. But also in this area I would like to take the principle of complementarity one step further. Where banks are allowed to use internal methodologies to calculate Pillar 1 type capital requirements, supervisory review (Pillar 2)—as well as public disclosure recommendations under Pillar 2—deserve due attention (Basel Committee on Banking Supervision, 2000). Basing capital requirements on internal methodologies allows banks significant discretion as the capital requirements are by their very nature based on firm-specific characteristics. Both supervisors and market participants will need information on these characteristics in order to exert discipline.

The importance of providing the right incentives is a third area that features prominently on the Basel Committee’s agenda. As a matter of fact, the Committee’s Research Task Force has recently embarked upon a wide-ranging study of the various incentives that might arise from the proposals currently on the table. One important incentive that came across, for instance, has its origin in the choice between so-called “standardized approaches” and more sophisticated internal methodologies entailed in various proposals. Standardized approaches are relatively simple, and therefore easily applicable, but also rather blunt and definitely not very risk sensitive. Internal methodologies, on the contrary, are assumed to be highly risk sensitive and therefore considered to be a step in the right direction toward closer alignment between economic and regulatory capital within firms.

Hence, the Basel Committee has expressed a keen interest in promoting internal methodologies at the expense of standardized methodologies by providing for one-sided incentives in this direction. The problem in such a setup, however, is that the capital relief offered by moving to the more sophisticated internal methodologies is likely to be largest for those institutions that have a relatively low risk profile, whereas banks with a high risk profile may end up with even higher capital requirements, stemming from the use of more accurate risk measurement techniques. Insofar as these higher requirements would discourage the relatively high-risk banks from developing those systems, this is clearly not an ideal situation. One way to resolve this issue would be by even further increasing the gap between standardized requirements and internal measurement-based requirements so that the move to internal methodologies would pay off also for high-risk institutions. Such a remedy could have serious distributional effects, however, as larger banks are more likely to have access to sophisticated methodologies than smaller banks that may have no choice but to stick to the standardized approach.

This brings me to my final point—a point that I think would have merited somewhat more discussion in the paper and that has to do with the “level playing field” or competitive neutrality of regulation. Referring to this concept, two dimensions can be distinguished. First, regulators worry about the level playing field among various firms within a single jurisdiction, an issue that is touched upon in the paper and that I briefly referred to above. Here, I agree with Llewellyn that many allegations about unequal treatment, for instance between small and large firms, can be put into perspective by the notion that treating as equal firms that in practice are not equal is not competitive neutrality.

The second dimension of level playing field, however, is more contentious from a supervisor’s perspective and has to do with the level playing field for similar firms across various jurisdictions. The paper remains silent on the somewhat awkward question of how, once we move away from detailed and prescriptive rules toward contract or perhaps even precommitment types of regulation, a bank in country A supervised by supervisor A, can be assured that its competitor from country B, supervised by supervisor B, will receive equal treatment with respect to solvency and other requirements. The Basel Committee will therefore also have to find ways to deal with this question in a satisfactory manner; otherwise, supervisors will be reluctant to continue on this avenue. In a similar vein, I fear that for the time being the emphasis of most supervisors will safely remain on Pillar 1 of the new Capital Accord.

Reference

    Basel Committee on Banking Supervision, 1999, “A New Capital Adequacy Framework,Basel Committee Publications No. 50 (Basel: Bank for International Settlements).

    Basel Committee on Banking Supervision, 2000, “A New Capital Adequacy Framework: Pillar 3—Market Discipline,Basel Committee Publications No. 65 (Basel: Bank for International Settlements).

    Karacadag, Cem, and MichaelTaylor,2000, “The New Capital Adequacy Framework: Institutional Constraints and Incentive Structures,IMF Working Paper 00/93 (Washington: International Monetary Fund).

See also Karacadag and Taylor (2000) on this issue.

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