A Rumble over Banking Risk

International bankers are divided over new rules

When members of the Basel Committee on Banking Supervision gather for their meetings at the Bank for International Settlements in Switzerland, the talk is of "capital adequacy," "risk-rating systems," and "supervisory review"--arcane financial stuff that doesn't often inspire much passion.

But the complex new rules the committee has proposed to improve the way banks around the world protect themselves from risk are causing a right royal rumpus. Many bankers, regulators, and business owners are up in arms. Even German Chancellor Gerhard Schröder has weighed in, vowing to fight Basel 2, as the proposed regulations are called. They are "unacceptable to Germany," he declared in November.

It's easy to see why so many people are upset. The proposals--all 600 pages of them--may be technical, complicated, and difficult to fathom. But what foes understand is that if they were put into practice, they would have a real impact on the cost of bank loans and how much money companies and countries can borrow. "They could even affect the shape of the business cycle by making booms boomier and recessions more recessionary," says Andrew Hilton, director of the Center for the Study of Financial Innovation in London. "They would directly affect the entire economy."

Put simply, Basel 2 would require banks to pay more attention to the creditworthiness of the countries and companies they do business with. They would have to set aside more capital to cover not only loans to their riskier customers but also their own operational risks--for example, of computer failure or fraud. They would be allowed to assign less capital to good risks. Regulators would take into account the quality of a bank's management when assessing its overall capital needs.

Two and a half years in the making, the proposals elaborate on the 1988 Basel Capital Accord, which obliged banks to back every loan they made with capital equal to 8% of its face value. The trouble is, Basel 1 didn't distinguish between high and low risks, so a loan to a top-rated company like General Electric Co. had to be backed by as much capital as a loan to a start-up.

Most bankers accept that Basel 1's one-size-fits-all approach was crude, but they worry that Basel 2 will create as many problems as it solves. Consider, say opponents, what the new rules would do to the economic cycle. Because lending is riskier when the economy is slowing, banks would have to set aside more capital to cover the loans they make then. That means charging higher interest rates, which would discourage companies from borrowing and further dampen business activity. That's one reason Schröder is so concerned.

More important, the chancellor frets that the rules would make it costlier for Germany's 3 million small and mid-size companies, known as the Mittelstand, to raise money. Few of those outfits are rated by independent agencies. They also tend to borrow money for longer periods than their bigger competitors, which rely on the bond and stock markets for long-term financing. So under Basel 2, which factors in ratings and loan length in assessing risk, banks would allocate more capital to cover such loans, and the borrowers would have to pay more.

To be sure, many bankers support Basel 2. They say the new rules measure risk more accurately, require more rigorous bank supervision, and tell markets more about banks' risk-management procedures. Says Klaus-Peter Müller, CEO of Commerzbank: "It's the key to the global financial system, an absolute must for world financial stability." But a growing number of bankers oppose Basel 2. One reason is the $2.25 trillion of additional capital it would require all banks to put aside. At the same time, many smaller banks say that the proposals discriminate against them because they lend comparatively more money to non-investment-grade customers.

Despite the opposition, most financial experts assumed until just a few weeks ago that Basel 2 would sail through. For one thing, the committee brings together central bankers and banking supervisors from 13 of the world's richest nations, so it has plenty of clout. For another, it is chaired by William J. McDonough, president of the Federal Reserve Bank of New York and one of the most powerful personalities on the central-banking circuit. Besides, both the U.S. Fed and Treasury support the plans. They believe that it will strengthen banking balance sheets and encourage acceptance of Anglo Saxon-style financial standards worldwide.

But Hilton, of the financial innovation center, now thinks Basel 2 has only a 50-50 chance of making it into most countries' statute books. Some 250 banks have commented on the proposals, and "I've been struck by the fundamental and deeply held nature of many of the opponents' objections," he says.

McDonough has gone out of his way to appease the opposition. "I love the Mittelstand," he told German bankers on Jan. 8. "I assume we will solve the small- and medium-enterprise problem. I assure you, I will not allow [the proposals] to be finished until we do." But committee members don't seem to be near a solution yet. And they've delayed the deadline for implementing the new rules by a year, until 2005, giving the opposition more time to organize. This bankers' brawl is far from finished.

By David Fairlamb in Frankfurt

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