Chapter

IV International Capital Adequacy Standards and Consolidated Supervision

Author(s):
International Monetary Fund
Published Date:
January 1993
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The shifting financial terrain over the past two decades has placed considerable stress not only on banks and other financial institutions, but also on the regulatory regimes in many industrial countries. International efforts to strengthen the regulatory framework for banks have focused on two main areas—the formulation of capital adequacy standards and the consolidated supervision of banks’ foreign establishments. The internationalization of financial markets has meant that a coordinated policy response among authorities was essential in preventing the shifting of financial activity to avoid regulation.

International Capital Adequacy Standards

Concern about the weak capital positions of major international banks in the early 1980s (Table 10) and the rapid pace of change in financial markets provided the backdrop for the work of the Basle Committee on Banking Supervision in formulating comparable standards for bank capital across countries. The Basle accord, reached in July 1988, established for the first time an international framework for measuring regulatory capital and setting capital adequacy standards.77 The main focus of this initial effort was to establish capital requirements proportional to the credit risks undertaken by individual institutions, reflecting the fact that non-performing loans account for the bulk of bank failures. The accord also established capital requirements for the credit equivalent measure of banks’ off-balance-sheet positions in view of the rapid innovations in this area (discussed in Section III above).

Table 10.Capital/Asset Ratios of Banks in Selected Industrial Countries1(In percent)
1982198319841985198619871988198919901991
United States
Commercial banks5.876.006.146.206.196.026.286.216.466.75
Large commercial banks4.724.975.245.355.515.185.585.435.736.11
Japan
Commercial banks2.342.342.242.342.292.482.752.973.183.34
Large commercial banks1.871.901.801.951.912.182.492.702.933.13
Germany
Commercial banks4.044.023.934.244.584.764.584.875.055.09
Large commercial banks4.064.043.984.424.794.994.695.175.185.11
France
Commercial banks and credit cooperatives2.522.392.352.422.432.552.732.833.033.41
Large commercial banks1.991.861.721.911.841.912.162.172.532.78
Italy
Commercial banks5.285.646.257.056.866.356.918.01
Large commercial banks3.854.244.936.135.955.456.267.83
United Kingdom
Commercial banks4.004.525.235.355.665.024.784.59
Large commercial banks6.386.716.297.918.468.288.948.217.597.78
Canada
Commercial banks3.684.124.494.655.205.035.405.465.655.95
Netherlands
Commercial banks3.313.403.473.743.974.304.214.374.014.08
Sweden
Commercial banks4.366.106.066.226.527.086.826.405.645.41
Switzerland
All banks5.995.855.826.116.256.336.336.486.466.40
Large commercial banks5.585.445.385.906.016.096.136.506.346.29
Belgium
Commercial banks2.392.512.522.512.872.933.063.393.403.87
Luxembourg
Commercial banks3.023.203.293.473.483.373.293.203.213.43
Sources: Bank of England; and Organization for Economic Cooperation and Development (1993a).

Owing to differences in national accounting practices, the figures in this table must be interpreted with caution. In particular, provisioning practices vary considerably across countries, as do the definitions of capital. Therefore, cross-country comparisons may be less appropriate than developments over time within a single country.

Sources: Bank of England; and Organization for Economic Cooperation and Development (1993a).

Owing to differences in national accounting practices, the figures in this table must be interpreted with caution. In particular, provisioning practices vary considerably across countries, as do the definitions of capital. Therefore, cross-country comparisons may be less appropriate than developments over time within a single country.

Any piecemeal approach to setting capital adequacy standards, however, regardless of the importance of the individual pieces, could induce a shift in risk taking toward activities not yet included in a comprehensive framework. Position risk in traded equities, exposure to interest rate fluctuations, and foreign exchange risk—generally classified as market risk—have so far been omitted from the Basle capital standards. Moreover, any attempt to impose capital requirements on various types of market risk by bank regulators must be coordinated with securities authorities—otherwise incentives may be created to shift the locus of activities from one type of financial institution to another that does not necessarily reflect the efficient provision of financial services. The systematic inclusion of market risks into the existing capital standards is the aim of ongoing efforts by the Basle Committee, the Technical Committee of the International Organization of Securities Commissions (IOSCO), and individual national authorities. Also, within the European Community (EC), the recently adopted Capital Adequacy Directive (discussed in Section V below) established uniform capital requirements for separately constituted securities firms and for securities trading activities of banks, and contains a consolidation regime for securities firms’ groups.

Harmonization of Capital Standards for Banks and Securities Firms

Whereas the Basle accord focused primarily on credit risk, the ongoing desegmentation of banking and securities activities has prompted efforts by both banking and securities supervisors to ensure that the risks associated with portfolios of traded securities are equivalently backed by adequate capital. In Canada, France, Italy, and the United Kingdom, banks now can, and increasingly do, own the larger securities firms. Japan has recently passed legislation that will allow banks to engage in securities activities, and in the United States banks’ permissible securities activities have expanded somewhat. In universal banking countries such as Germany, securities transactions for customers can only be conducted by banks.

Existing differences in capital adequacy standards for banks and securities firms reflect the traditional activities performed by the two types of institutions and, in particular, the holding period and liquidity of their core investments. Banks typically hold loans on their balance sheets until maturity, funding them with deposits. A major reason for this relatively long-term perspective is the illiquidity of commercial loans, which had accounted for the bulk of banks’ assets. Securities firms, in contrast, tend to turn over assets rapidly in connection with their underwriting, market making, and trading activities. Thus, the main business risk faced by banks is credit (default) risk, whereas that for securities firms is market (interest rate, currency, or price) risk.

Differences between the traditional activities of banks and securities firms in turn have important regulatory consequences. Because many bank assets are illiquid, the criterion used by banking authorities to set capital standards for banks is their ability to absorb most losses given historical experience with loan performance. The aim is to avoid a forced sale of illiquid assets by allowing a troubled bank time to raise new capital, and to strengthen management to sustain it as a going concern. In contrast, standards for securities firms are set with a view to winding down troubled institutions while protecting their customers. These standards aim to provide adequate protection against adverse market movements during a typical liquidation period (one to three months).

Not only are the criteria used to judge capital adequacy for banks and securities firms different, but so are the regulatory definitions of capital. For banks, the emphasis is on permanent capital (for example, paid-in equity and retained earnings) that serves to forestall liquidation. Subordinated debt counts only as secondary capital and is subject to strict limits. In contrast, regulatory capital for securities firms is more temporary, reflecting their ability to scale down rapidly in response to difficulties. As a result, securities firms can rely heavily on subordinated debt as a source of regulatory capital. It is important to note, moreover, that securities firms typically operate on a capital base far above the regulatory minimum because of their fluctuating need for capital.

The Basle accord sets out the key elements of existing bank standards in most industrial countries.78 However, there is as yet no common international standard for securities firms. One approach to the regulation of capital adequacy is that adopted in the United States and Japan. (An alternative approach followed in the EC is discussed in Section V below.) U.S. regulations require a minimum 2 percent ratio of regulatory capital to total customer receivables, a proxy for the size of customer-related business.79 For small broker-dealers, these receivables can represent a majority of their assets. However, for most large broker-dealers that are not retail oriented, these items usually constitute less than 25 percent of total assets. Recognized capital includes shareholder equity, subordinated debt with a maturity of at least one year, and short-term subordinated debt that can be used to fund underwriting and other extraordinary activities. The standard also requires deductions from capital to reflect the liquidity or market risk of assets held by securities firms. An illiquid asset requires a 100 percent capital charge, while marketable assets that are not hedged attract fractional charges, or “haircuts,” that reflect their historical price volatilities. The haircuts range from 0.5 percent for three-month U.S. Treasury bills to 15 percent for corporate equities.80

With the aim of leveling the playing field between increasingly competitive banks and securities firms, the Basle Committee and the IOSCO Technical Committee held a joint meeting for the first time in January 1992 to consider harmonization of minimum capital standards for the two types of institutions. Departing from the traditional capital adequacy standards for securities firms that capture both credit and market risk in a single comprehensive haircut, the Technical Committee agreed to back the Basle Committee’s “building-block” approach that treats credit risk and market risk separately to formulate minimum standards. The two committees also committed themselves to narrowing the differences in their definitions of capital.

For holdings of traded debt securities, the Basle Committee’s proposal follows market practices for the measuring exposures to interest rate risk. Basically, these practices involve grouping institutions’ interest earning assets and liabilities according to their maturities and calculating the net interest income for each group. A number of large net income positions, whether positive or negative, tends to indicate a considerable exposure to interest rate risk. To obtain a summary indicator, each net income position receives a risk weight; the weighted positions are then aggregated with either full or partial offsets between positions of opposite signs.

With respect to position risk in traded equities, the Basle Committee’s approach attempts to capture both the risk in a specific equity and that of a broad market movement. For gross portfolio positions (longs and shorts), the proposal calls for 50 percent risk weights, while a 100 percent weight would apply to the net position of diversified portfolio of liquid equities.81

The Technical Committee agreed to limit the use of short-term subordinated debt in the regulatory definition of capital for securities firms to 250 percent of equity capital, in an effort to achieve a more uniform definition of capital than currently exists. At the same time, a majority on the Basle Committee indicated a willingness to define capital held against the market risk of banks’ trading portfolios in a way that would closely approximate the approach followed by securities regulators.

Although the Basle Committee and the Technical Committee agreed to formulate minimum capital standards for banks and securities firms using the above approach, their agreement allows those authorities that have long successfully applied the haircut methodology for traded equities to continue this practice. Any authority using the haircut methodology, however, would need to show that its application yields a standard that is consistently equal to or greater than that required under the building-block approach.

A final agreement between the Basle Committee and the IOSCO Technical Committee has so far proved to be elusive, however. A key stumbling block has been the lack of consensus among members of the IOSCO Technical Committee regarding the appropriate minimum amount of capital to be held against a portfolio of equities. The debate, which came to the fore at IOSCO’s annual meeting in October 1992, centers around two issues—the extent to which long and short equity positions should be netted for this purpose and the minimum floor of capital to be held against a diversified portfolio of equities. Some areas of disagreement also remain between the two committees. The Basle Committee, for example, has proposed excluding banks’ holdings of bonds for investment purposes—as opposed to holdings for trading purposes—from capital requirements. IOSCO has opposed this distinction and recommends that capital should be required for all bond holdings.

The Basle Committee, on May 3, 1993, released for comment a set of proposed revisions to the Basle Capital Accord. These changes focused on the areas of market risks of debt and equity securities and foreign exchange positions, measurement of interest rate risk, and bilateral netting of OTC derivative positions. The proposals were formulated with a view to work undertaken in this area by the EC Commission and by securities regulators in the IOSCO Technical Committee.

The Committee recommended for tradable securities risk weights for both gross and net positions (that is, the building-block approach), which would substitute for the credit risk weights. Also, to reach an agreement with securities regulators, the Committee proposed a third tier of regulatory capital that would include short-term subordinated debt. On foreign exchange risk, the Committee proposed a measure for the net open position in each currency and two methods for estimating foreign exchange risk in a portfolio of positions—a shorthand method and simulation method. With respect to interest rate risk, it proposed a measure of the sensitivity of banks’ on- and off-balance-sheet positions to fluctuations in interest rates. Although this risk measure would not attract a capital charge, it is designed to alert regulators of possible excessive exposures to interest rate risk. With respect to bilateral netting, the Committee proposed to recognize for capital adequacy purposes most bilateral netting agreements that are enforceable in the event of default.

Interest Rate Risk Proposal of U.S. Bank Regulators

The Federal Deposit Insurance Corporation Improvement Act of 1991 required the federal banking agencies to revise their risk-based capital guidelines to ensure that the standards take adequate account of interest rate risk. This legislative mandate came at a time of significant shifts in the asset portfolios of U.S. commercial banks. The ratio of banks’ holdings of U.S. Government securities increased to 22 percent of their total loans and securities in 1992 from 15 percent in 1988 (Chart 19). Moreover, this ratio has increased above levels witnessed in previous business cycles.

Chart 19.United States: Ratio of U.S. Government Securities Holdings to Total Loans and Securities of Banks

Source: Data Resources Incorporated.

In August 1992, the federal bank regulatory agencies proposed a set of rules to implement the interest rate risk requirement of the FDIC Improvement Act.82 Several considerations shaped this proposal. First, a certain amount of interest rate risk is inherent and appropriate in commercial banking. Also, interest rate risk is difficult to measure precisely and has played a relatively minor role in U.S. banking troubles relative to that of credit risk. Accordingly, the proposal seeks to identify banks with substantial levels of interest rate risk and to require those institutions to allocate additional capital to support their relatively high levels of measured risk.

The proposal focuses on estimating the impact that changes in market interest rates might have on an institution’s net worth, including both on-and off-balance-sheet positions. Specifically, the scheme would seek to estimate the change in the net present value of institutions’ assets, liabilities, and off-balance-sheet positions, for an assumed 100 basis point shift in the yield curve both upward and downward. The calculation would involve assigning assets and liabilities, both on- and off-balance-sheet, to six maturity or repricing categories. The dollar amounts in each cell would be multiplied by corresponding interest-sensitivity weights that represent measures of the time to repricing of each category.83 The values in each cell would then be summed to obtain an aggregate difference between risk-weighted assets and liabilities. This difference would be divided by the bank’s total assets to obtain a measure of its overall interest rate risk.

Under the proposal, an institution with a measured interest rate risk exposure in excess of a threshold level would be required to allocate additional capital equal to the dollar amount of the estimated change in its net worth in excess of this level. This additional capital would provide complete coverage of any incremental exposures above the established threshold.84

Consolidated Supervision of Banks’ Foreign Establishments

The internationalization of financial markets poses a particularly significant challenge for supervisors by undermining the ability of domestic jurisdictions to regulate domestic institutions. The closure of Bank of Credit and Commerce International (BCCI) in July 1991 is the most recent in a series of international bank failures that has exposed gaps in the regulation of cross-border banking establishments.85 The earlier failures of Franklin National Bank in 1974 and of Banco Ambrosiano Holding in 1982 led to the agreement on the Basle Concordat and its subsequent revision. The Basle Concordat allotted responsibility for supervising banks’ foreign establishments: home-country supervisors were to assume responsibility for supervising the solvency of foreign branches, while host-country authorities were to supervise foreign subsidiaries and joint ventures. The 1983 revision to the concordat included the principle of consolidated supervision and emphasized the importance of ongoing contact and collaboration between supervisors in bridging regulatory gaps. A supplement to the concordat in April 1990 aimed to implement those aspects of the agreement that require information flows between authorities and, in particular, to strengthen consolidated supervision. The supplement outlined the information needs of both home-and host-country authorities and urged them to engage in continuous collaboration from the time that permission is initially given.

In the wake of the collapse of BCCI, the Basle Committee has sought to reinforce the principles of the concordat and to ensure that they can be applied in practice. To this end, the Group of Ten supervisory authorities have reformulated four of these principles as minimum standards, although the extent of information sharing was left to be determined on a case-by-case basis.

The minimum standards are as follows: First, both international banking groups and international banks should be supervised by a home-country authority that capably performs consolidated supervision. To meet this standard, the home-country supervisor should receive consolidated financial and prudential information on the bank’s or banking group’s global operations and confirm its reliability through on-site examinations or other means. The supervisor should also be able to prevent the bank from creating banking structures that work to undermine consolidated supervision.

Second, the creation of a cross-border banking establishment should receive the prior consent of both the host-country supervisor and the bank’s (or banking group’s) home-country supervisor. In reviewing proposals for inward and outward expansion, the host-country and home-country authorities should, at a minimum, give weight to the strength of the bank’s and banking group’s capital and the effectiveness of their risk management procedures.

Third, supervisors should have the authority to gather information from the cross-border banking establishments of banks and banking groups for which they are the home-country supervisor. Thus, consent for outward expansion by the home-country authority should generally be contingent upon there being an understanding with the host-country authority regarding the ability to gather information from the cross-border establishment.

Finally, if the host-country authority determines that any of the above minimum standards are not met to its satisfaction, that authority can impose restrictive measures necessary to satisfy its prudential concerns, including prohibiting the creation of banking establishments. If the host-country authority grants permission for the creation of a cross-border banking establishment without these minimum standards being met, that authority must accept responsibility for supervising the bank’s or banking group’s local establishments consistent with these minimum standards.

A detailed discussion of the provisions and implementation of the accord is contained in Goldstein and others (1992).

The details of this accord are discussed in Goldstein and others (1992).

To qualify for this capital standard, a securities firm must maintain a segregated cash reserve against its net liabilities to customers in excess of that required under the Securities and Exchange Commission’s (SEC) Consumer Protection Rule.

Although the U.S. capital standard is based on a proxy for size, it is not tied directly to the assets of a securities firm. In fact, for a sample of larger broker-dealers at end-1986, the minimum 2 percent ratio converted to ratios of capital to total assets ranged from 0.1 percent to 1 percent. However, it is the deductions from capital that form much of the effective requirements under the U.S. standard. These deductions for the sample of large broker-dealers averaged 5.1 percent of total assets and ranged from 1.6 percent to 16 percent of total assets (see Haberman (1987)).

For example, a long position in a highly diversified portfolio of equities would require a 12 percent capital backing (4 percent for the gross position plus 8 percent for the net position). However, for a fully balanced position of longs and shorts, the capital requirement would amount to only 8 percent (4 percent for each of the two gross positions).

This measure of time to repricing is often referred to as duration. Duration is used for this purpose because it represents the elasticity of the market value of a debt instrument with respect to the interest rate.

For example, if the critical level of measured interest rate risk was 1 percent of total assets, an institution with a measured interest rate risk of 1.5 percent of total assets would be required to allocate a dollar amount of capital equal to 0.5 percent of total assets.

An assessment of the regulatory framework in which BCCI operated is provided by the Bingham Report—Inquiry into the Supervision of the Bank of Credit and Commerce International (London: Her Majesty’s Stationery Office, October 1992).

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