Introduction

The Basle Capital Accord of 1988 (Basle Accord) specifies that as a minimum, banks must maintain an 8 percent ratio of recognized capital to risk weighted assets. It applies to internationally active banks of the G-10 countries. The Basle Accord is considered a key element in defining the ground rules for global bank competition within the bounds of safety and soundness. The limitations of the Basle Accord are well known, notably the problems associated with the single focus on counterparty risk. The Basle Committee is considering several modifications to address these issues. ^1/ Nonetheless, the accomplishments of the Basle Accord are not in question. It forced international banks to increase the level of capital and hence contributed directly to a higher level of safety. Furthermore the multiyear process of implementing the Basle Accord helped standardize accounting rules, enhanced the comparability of balance sheets and thereby contributed to levelling the playing field in international banking. For these reasons the Basle ratio appeals to a wide range of national regulators and regional bank regulation groups.

Within the European Union (EU), risk based capital standards similar to the Basle Capital Accord were adopted for all credit institutions. It was recognized that the principles of the risk-based capital ratio were not limited to internationally active banks and that more stringent capital adequacy would benefit national financial market development. Furthermore, harmonized capital adequacy rules throughout the European Union were seen as supporting regional financial integration by facilitating the banks’ cross-border activity.

Many other countries have in recent years adopted risk-based capital standards tailored after the Basle Accord. The Basle Accord has become somewhat of a hallmark for quality banking, and therefore, banks around the world claim adherence to the Basle Accord in their published statements, implying that they have “joined the Club” of top financial institutions. However, the reference to the Basle rules is not necessarily justified. In many cases, in fact, this presumption is unwarranted as the preconditions for a meaningful application of the Basle Accord are not met. Without meeting these preconditions the application of the Basle rules is virtually meaningless.

This paper shows that the Basle Capital Accord is based on several implicit assumptions regarding the micro- and macro-economic environment in which the G-10 banks operate. These implicit assumptions are identified by discussing the components of the capital ratio. The paper concludes that non-G-10 countries wishing to introduce a risk based capital ratio should do so as part of a comprehensive strategy including medium-term transitional arrangements.

Section I describes the background and main elements of the capital ratio, Section II discusses the risk weights (the denominator), Section III addresses the need for provisioning, Section IV focusses on the 8 percent rule and the elements of capital (the numerator), Section V discusses the need for a comprehensive strategy and transitional arrangements, and conclusions are drawn in Section VI.

I. Background and Intention of the Basle Capital Standard

Originally, the Basle capital standard was designed to strengthen the financial soundness of G-10 countries international banks. Simultaneously, however, the Basle Capital Accord was intended to help create a more even basis for global competition among international banks. The previously existing plurality of different national capital standards permitted some banks to derive competitive advantages from less stringent safety requirements, thereby potentially undermining the system’s stability and soundness.

The Basle capital standard constitutes an important part of an ongoing effort on the part of G-10 countries to devise internationally acceptable principles of banking supervision. (See INFOBOX.) The Basle Committee was formed in response to qualitative changes in banking activity such as the increasing use of nontraditional banking products and increasing levels of cross-border operations, in parallel with a tendency to a reduction in banks’ capital base as compared with their level of activity. Product innovation and globalization per se are generally interpreted as reflecting competition and hence benefitting the international economy. However, to maintain the effectiveness of prudential supervision in this changing environment, the regulatory instruments needed adjusting.

The 1988 Basle Capital Accord constituted a breakthrough in international banking supervision. For the first time, regulators of the countries with highly developed financial markets arrived at a substantive consensus on practical steps to strengthen banks’ financial structure. Capital adequacy was chosen as the starting point because of its fundamental importance to banking supervision. While the G-10 countries agreed on the basic principles, the actual implementation responsibilities remained with the national regulatory authorities. The Basle Committee is not itself an agency exercising oversight.

Table 1 lays out a simplified version of the Basle capital ratio calculation. As in the Basle Accord, Table 1 shows two principal categories of capital, tier 1 (core) and tier 2 (supplementary) capital in the numerator. In the denominator the Basle Accord considers five broad categories of bank assets grouped by risk (I. Balance Sheet Items), and off-balance sheet items also grouped by risk (II. Off-Balance Sheet Items). The Basle Accord spells out in considerable detail the assets to be subsumed under each category as well as the components of tier 1 and tier 2 capital.

Table 1.

Simplified Summary of Basle Capital Standards

Table 1.

Simplified Summary of Basle Capital Standards

Tier 1 Capital (must be at least 50 percent of total capital)			+ Tier 2 Capital	= Total Capital (at least = 8 percent of the sum of risk weighted assets)
I.	Balance Sheet Items
	Risk Weight	×	Asset on the balance sheet
	0 percent	×	Cash, loans to governments and central banks
	10 percent	×	Claims on public sector entities
	20 percent	×	Claims on OECD banks
	50 percent	×	Loans secured by mortgage on residential property
	100 percent	×	All other assets including commercial loans
II.	Off-Balance Sheet Items
	Risk Conversion
	Factor x (off-balance sheet item) x (applicable risk weight)

View Table

Table 1.

Simplified Summary of Basle Capital Standards

Tier 1 Capital (must be at least 50 percent of total capital)			+ Tier 2 Capital	= Total Capital (at least = 8 percent of the sum of risk weighted assets)
I.	Balance Sheet Items
	Risk Weight	×	Asset on the balance sheet
	0 percent	×	Cash, loans to governments and central banks
	10 percent	×	Claims on public sector entities
	20 percent	×	Claims on OECD banks
	50 percent	×	Loans secured by mortgage on residential property
	100 percent	×	All other assets including commercial loans
II.	Off-Balance Sheet Items
	Risk Conversion
	Factor x (off-balance sheet item) x (applicable risk weight)

For the numerator, the Basle Capital Accord defines multiple components of tier 1 and tier 2 capital respectively. These are discussed in more detail below. In the denominator, the nominal value of every asset on the bank’s balance sheet is multiplied (weighted) by a given risk factor. The higher the presumed risk of default by the counterparty, the higher the risk weight. Off-balance sheet items are included in a two-step process. First, each type of off-balance sheet item is multiplied by a so-called credit conversion factor. This yields a so-called equivalent amount of balance sheet risk. Second, the equivalent amount of balance sheet risk is multiplied by the weight applicable to the category of the counterparty. The Basle Accord specifies the risk-weight and conversion factors to be associated with each type of asset and off-balance sheet item, leaving some discretion to the national regulators. Any assets that are not explicitly mentioned in the Basle Capital Accord are subsumed under “all other assets” and carry the highest risk factor of 100 percent. In the end, recognized capital divided by weighted risk assets must be equal to at least 8 percent to satisfy the Basle Accord.

The Basle Accord makes reference to OECD members as countries that are considered to be of high credit standing. ^1/

Risk weights laid down in the Basle Accord are ultimately based on default probabilities observed over a period of time in the G-10 countries. To arrive at the risk weights, the Basle Committee members produced broad judgements on the relative risk of each bank asset. In doing so, the Committee chose to exclusively focus on credit (or counterparty) risk. ^1/ The Committee also made a deliberate effort to keep risk weights as simple as possible. Hence, there are only five weights: 0, 10, 20, 50 and 100 percent, as shown in Table 1. Although the scale of risk weights contains subjective elements, it nonetheless reflects the best guess on the relative risks associated with each type of asset and off-balance sheet item. Because the risks associated with any given asset are an empirical factor, tied to the general economic conditions, they vary widely across a larger spectrum of countries and over time. The regional and economic specificity of the risk weights hint at the problems that arise when attempting to generalize the Basle capital standards beyond G-10 banks.

II. Should Non-G-10 Countries Apply Higher Risk Weights?

Many of the non-G-10 countries that adopted risk-based capital standards simply copied the risk weight system laid down in the Basle Accord. The question is whether the same risk weights are justified regardless of the economic environment. An argument can be made that in non-G-10 countries that are more vulnerable to macroeconomic disturbances (a feature of most developing and transition countries) an across the board 100 percent risk factor should be applied to all claims on non-OECD entities. Furthermore, an across the board treatment of all off-balance sheet items might be adopted. This would amount to a simple leverage ratio which was frequently used in G-10 countries before the Basle Capital Accord was reached and which would present a viable option.

Conceivably an argument could be made for introducing risk factors higher than 100 percent to be imposed on some assets. However, introducing risk factors in excess of 100 percent is not advisable as it complicates the interpretation of the capital ratio. Risk weights in excess of 100 percent would counter an important goal of the Basle capital standard, that of comparability of the ratio across banks. Risk weights over 100 percent would lead to a situation where the same asset would require different capital funds depending on which banks held it. Therefore, higher than 100 percent risk weights are not a suitable solution. A more practical option would be for non-G-10 countries to raise some of the risk factors for assets that carry higher risks because of the economic environment in which the banks operate. Along similar lines, the treatment of off-balance sheet items would also have to be reviewed for non-G-10 countries.

The following examples discuss the significance of risk factors in more detail. They illustrate that non-G-10 countries need to review whether the Basle risk weights for different claims are appropriate given the economic environment in which they are to be used.

Claims on central governments of the OECD countries, whatever the currency of the denomination, carry a zero percent risk factor in the Basle Accord. In applying the rules, this means a bank carrying a loan to an OECD central government does not need to hold any capital against this loan. The assumption is that these loans carry no credit risk, a judgement based on the observation that, in the relevant time frame (over the past several decades), central government loans in OECD countries have never been in arrears, never defaulted or rescheduled. Loans to central governments outside the OECD are subject to an 8 percent capital requirement on the entire value of the portfolio (100 percent risk weight) unless denominated in national currency and funded in that currency (in which case, a zero percent risk weight applies). The implication for banks of non-OECD countries would be that some claims on their central governments would be subject to the 8 percent capital rule.

Claims on (and loans guaranteed by) banks with a residual maturity of up to one year, carry a risk factor of 20 percent. ^1/ As shown in Table 2, if a bank has SDR 30,000 of interbank claims on its balance sheet, only 20 percent of this sum, or SDR 6,000 is subject to the 8 percent capital requirement. The 20 percent risk weight was chosen by the Basle Committee to reflect the fact that interbank loans carry a low credit risk relative to other types of loans. Interbank loans have rarely been in default--at least in the past decades in markets in which the G-10 international banks operate. Moreover, the Basle Capital Accord is based on the assumption that bank’s interbank exposure is well managed in terms of interest risk, that the creditors are well diversified, and that other prudential regulations and guidelines are in place and enforced. It is also assumed that the interbank market is liquid and that available information (and rating services) permits banks to make well informed lending decisions. Only under those circumstances where a developed financial infrastructure is in place is the low risk weight of 20 percent justified. The same condition does not hold for many developing and transition countries and hence higher risk weights, reflecting the counterparty risk would be appropriate in most cases.

Table 2.

How to Calculate the Basle Capital Ratio

Table 2.

How to Calculate the Basle Capital Ratio

Asset	SDR		Risk Weight	=	Weighted Assets, SDR
Cash:	20,000	×	0 percent	=	0
Interbank loans:	30,000	×	20 percent	=	6,000
Business loans:	50,000	×	100 percent	=	50,000
Total of Risk Weighted Assets				=	56,000
Basle Rule
Tier 1 plus tier 2 capital must be 8 percent of 56,000, i.e., 4,480 and Tier 1 capital must be at least 50 percent of total capital i.e., 2,240

View Table

Table 2.

How to Calculate the Basle Capital Ratio

Asset	SDR		Risk Weight	=	Weighted Assets, SDR
Cash:	20,000	×	0 percent	=	0
Interbank loans:	30,000	×	20 percent	=	6,000
Business loans:	50,000	×	100 percent	=	50,000
Total of Risk Weighted Assets				=	56,000
Basle Rule
Tier 1 plus tier 2 capital must be 8 percent of 56,000, i.e., 4,480 and Tier 1 capital must be at least 50 percent of total capital i.e., 2,240

Loans to enterprises are fully subject to the capital requirements. ^1/ Again, there are a number of tacit assumptions made by the Basle Committee. It is assumed for instance, that as soon as a loan is not repaid according to schedule, potential losses are assessed, and an adequate provision is set apart by drawing from the capital base. It is assumed that the banks have implemented well defined provisioning systems, and rigid guidelines on when to write off a loan. It is further assumed that loan quality is subject to continuous and effective internal controls, external audits, and that qualified and experienced bank supervisors have accurate and timely information. While none of these points were made explicit in any documents, the Basle standards implicitly assume at least three sets of safety checks performed by banks themselves, by their auditors, and by the bank supervisors. In most cases, rating agencies provide yet another independent judgement and market participants will discover any weaknesses in banks’ balance sheets. In many countries, these pre-requisites are not in place and therefore, a comprehensive approach to introducing the Basle capital standard must be developed. In line with the underlying principles of the Basle Accord, higher commercial risks should be reflected in higher levels of provisioning. The following section discusses the importance of provisioning in more detail.

III. Implicit Assumptions on Provisioning in the Basle Accord

Banks maintain capital and reserves for general risks inherent in the banking business and make provisions for specific problem assets. Capital is explicitly intended to cover general, unforeseen risks. By contrast, provisioning is intended for losses that arise or are likely to arise during the life of a specific asset. Capital must be kept entirely separate from specific provisions. The Basle Accord does not place great emphasis on this distinction, the underlying assumption being that appropriate levels of provisioning are in place and enforced by each national bank regulator. These levels are not necessarily equal across G-10 countries, but it was felt that they were set and enforced adequately in each case.

The level of provisioning must follow closely each step in the progressive deterioration of the quality of a given asset. As soon as a loan is flagged as a problem, provisions should begin to accumulate, increasing as needed when its quality further deteriorates. By the time a loan is considered a loss, provisions should be built up to 100 percent less the value of realizable collateral. Therefore, when proper provisioning is in place, writing off the loan as a loss will not affect the capital base. On the other hand, in the absence of sufficient provisioning, write-offs directly reduce the bank’s capital base.

Without or with substantially inadequate provisioning, a bank’s capital ratio takes on an entirely different meaning. Among the G-10 banks it was understood that capital is a buffer to be used to absorb losses only when provisions are marginally insufficient. This also means that when a G-10 bank resorts to its capital base, it signals to the market that major unforeseen problems have occurred. The general economic environment in which the banks operate is hence reflected in the level of provisions on the banks balance sheet. For banks that operate in environments where borrowers frequently default, provisioning needs to be higher than in more stable economies with lower default rates.

In many countries, provisioning has been a neglected area. Often, provisioning rules are not clearly spelled out or they are not strictly enforced. Furthermore, in most countries, banks do not disclose provisions or publish figures where provisions are netted off against the assets, so that outside observers are unable to determine the extent to which provisions are in place. Therefore, most non-G-10 countries adopting risk based capital rules, should explicitly include rules for appropriate provisioning, reflecting the risks on the banks’ balance sheets as observed over time.

Applying the Basle 8 percent rule without adequate provisioning distorts the informational value of the capital ratio. Worse than that, compliance with the 8 percent capital rule without adequate reserves for loans of doubtful quality renders the ratio meaningless as banks may boost capital ratios at the expense of provisioning.

IV. Is Eight Percent Capital Coverage Enough?

The Basle Accord sets a common minimum standard ratio of capital to weighted exposures of 8 percent. Some non-G-10 countries have voluntarily set higher ratios to compensate for less stable economic environments. However, even before deciding on the appropriate ratio, the question of what should be included in the capital base is controversial, owing to the large number of hybrid financial instruments that are used by banks. The Basle Committee therefore decided to separate capital in two categories, called tier 1 and tier 2. Tier 1 capital, has a very restrictive definition: it only includes the elements which are considered to be pure capital in all countries, and that are wholly visible in the accounts: paid capital and disclosed reserves. Tier 1, or core capital is therefore the highest quality capital.

Tier 2, or supplementary capital, includes several elements such as revaluation reserves and hybrid debt capital instruments that the Basle Committee considered to be legitimate additions to the core capital. However, their inclusion is subject to specific conditions and limitations. The main limitation is that tier 2 cannot exceed tier 1, or in other words that tier 1 must be at least 50 percent of the total capital base.

A special problem arises for banks operating in high inflation environments. They need to replenish their capital on a continuous basis. Under these circumstances, appropriate accounting and tax rules need to be developed to keep up with the Basle capital standard. For instance, the Basle Capital Accord contains a stipulation that revaluation reserves can be part of tier 2 capital but that they are subject to a 55 percent discount. It was assumed that revaluation reserves would be used sparingly by G-10 banks. High inflation countries need to design additional rules to facilitate the process by which banks can transform revaluation reserves into tier 1 capital to avoid the erosion of the capital base that would otherwise occur.

Table 2 contains a numerical example of how to calculate the Basle capital ratio of a bank. The table shows that the various assets add up to an unweighted total of SDR 100,000. For simplicity the example does not include an off-balance sheet item. After all weights are applied, the total risk weighted assets amount to SDR 56,000. The Basle capital standard specifies that the bank must have at least 8 percent of this total in capital and that at least half of that must be tier 1 capital. The bank must keep 8 percent of SDR 56,000 or SDR 4,480 in capital and at least SDR 2,240 must be tier 1 or core capital.

In determining whether or not higher ratios are advisable for non-G10-countries, the question is whether a higher capital ratio indicates that the bank is safer. To some extent, the Basle Committee suggests that this is so, and therefore underlined that 8 percent was considered a minimum. ^1/ The Basle Accord permits national authorities to require higher standards than those proposed by the Basle Committee. This option is open to any country even under the existing Basle Capital Accord. It may be advisable for countries that are more vulnerable to macroeconomic disturbances to establish capital ratios somewhat above the minimum level for an interim period. Furthermore, individual banks seeking access to international markets may choose aim at higher levels of capital.

However, higher capital ratios cannot be used as compensation for deficits in the other prudential norms, particularly regarding proper provisions. In many non-G-10 countries flaws exist in accounting and regulatory frameworks and these should be addressed as part of introducing risk-based capital ratios. Within a comprehensive approach to introducing capital adequacy, a slightly higher capital ratio might be considered as a target. Other options that might be pursued by non-G-10 countries introducing risk-based capital standards would be to adopt more restrictive definitions for the elements of tier 1 and tier 2 capital or to reduce the share of tier 2 capital in total capital.

V. Comprehensive Strategy and Transitional Agreements

Developing and implementing the Basle capital standards entailed an intensive learning process for all supervisory authorities and for the banks themselves. Within the G-10 countries, major difficulties arose as financial institutions with widely varying lending policies, accounting, and tax rules attempted to define their business practices in international terms. The need for designing detailed transitional targets demonstrates that the Basle standards were not easy to implement. In fact, many of the G-10 banks made considerable adjustments in their corporate strategy in order to meet these new standards.

These transitional arrangements were custom tailored for the G-10 major banks’ initial positions in 1988 and proposed a schedule on how to build up the capital ratio agreed upon by bank supervisors. The transitional period lasted from 1988 until the end of 1992, to allow enough time to integrate the Basle standards into domestic supervisory legislation and for the banks to build up the required level of capital.

This experience suggests that non-G-10 banks may find it at least equally if not more difficult to meet these same standards. The need for transitional arrangements is often underestimated and given the extent to which adjustments must be made, transition periods may require considerably more time than was needed for the international banks in the G-10 countries.

One reason for designing a transition program is that in most cases, when an 8 percent capital rule is introduced banks must increase their capital funds. In designing transitional arrangements, the authorities must take into account the extent to which banks can raise additional capital internally, by setting aside bank profits, or externally, by issuing new equity or hybrid debt capital instruments. Access to capital markets is key in helping banks meet higher capital standards, as banks can securitize assets and raise new equity and thereby work on both the numerator and denominator to meet the new capital ratio requirements.

The financial infrastructure needed to accommodate these steps may not be available to all banks outside the G-10 countries. The transitional arrangements would have to take this into account. Any non-G-10 country introducing an eight percent risk-based capital standard should indicate transitional arrangements over a reasonable time frame which would probably range from five to ten years. Announcements of decision to adopt such standards within a short time period are therefore likely to be unrealistic and misleading.

Given the need for non-G-10 countries to review the Basle capital rules in light of the existing financial infrastructure and in light of the overall economic profile (the vulnerability to macroeconomic disturbances and historic default rates of borrowers), a comprehensive strategy must be devised. In particular, the distinction between loan loss provisions and capital must be well established and enforced. While risk-based capital rules can be at the heart of such a strategy, capital rules taken out of context will fail to produce a more competitive, more efficient and more stable banking sector.

VI. Conclusions

The general framework of the Basle Capital Accord constitutes a good basis for defining a single capital standard among a more global group of countries. A single set of standards adhered to by all international banks, is an important ingredient of global competition and global banking soundness and would hence be a desirable goal. A well designed capital requirement can also serve as an effective instrument for leveling the playing field on the national level.

However, it must be recognized that the details of the Basle Capital Accord were developed specifically for a small group of countries characterized by stable economic conditions and a developed financial infrastructure. As shown in this paper countries with less stable economic environments and less developed financial infrastructures must make adjustments to account for their specific economic circumstances.

Many of the non-G-10 countries that have proclaimed adherence to the Basle Capital Accord, failed to consider the necessary adjustments leading to ineffective applications of capital rules. This paper identified the following areas, where adjustments are needed when the economic conditions are less stable.

1. The Basle Accord risk weight system must be reviewed in light of prevailing risks in non-G-10 banking environments.

2. A clear distinction must be drawn between capital as the reserve for unforeseen losses and provisions as reserves for calculable losses. Applying the Basle 8 percent rule without adequate provisioning, as is frequently done, distorts the informational value of the capital ratio and in fact renders the ratio meaningless.

3. The 8 percent mandated by the Basle Accord should be regarded as a minimum, and non-G-10 countries might consider slightly higher levels. However, it should be understood that higher capital requirements can not compensate for generally unstable economic conditions.

4. A comprehensive strategy for introducing capital adequacy is necessary including appropriate transition arrangements. The establishment of risk-based capital standards in the short term is unrealistic.

Several regional associations of international bank supervisors have begun to work on establishing regional guidelines of banking supervision including rules on capital adequacy. As discussed in this paper, a comprehensive strategy strengthening the banks’ accounting and regulatory framework would be the most promising avenue to introduce capital standards that are effective in promoting market efficiency and safety.