Are international capital adequacy rules adequate? The Basle Accord and beyond.

• Author: Tarbert, Heath Price

INTRODUCTION

No institution has shaped the economic development of the world more than the bank.(1) In its most unadorned form, a bank is a "business establishment authorized to perform financial transactions, such as receiving or lending money."(2) Every bank has assets equal to the sum of its liabilities and equity--capital.(3) Bank capital, or bank equity, can thus be described as the bank's residual interest in its assets. Every bank bears the risk that its assets are actually worth less than the stated value on its balance sheet. If asset market values decline, fewer asset dollars will be available to settle the constant liabilities of the bank, resulting in a corresponding decrease in capital. If a bank's capital decreases too much, the bank may be unable to satisfy its obligations and therefore become insolvent. Consequently, governments have sought to reduce bank insolvency through capital adequacy regulation. For bankers, lawyers, and even professors, these combined regulations constitute an overwhelming brain-teaser of financial law.(4) Nonetheless, bankers, economists, lawyers, and legal scholars must understand these regulations because the "capital adequacy regime is the single most important set of rules and proposals in both international and domestic banking law."(5) This Comment seeks to aid those trying to understand this "multibillion-dollar global regulatory scheme promulgated by banking regulators"(6) by examining the architectural role played by the Basle Committee on Banking Supervision, outlining global capital adequacy standards that are currently enforced, and evaluating proposals to change the present regulatory regime.

Part I addresses the nature of banking, the importance of capital within the banking system, and the broader question whether capital regulation is necessary. Part II examines the role, structure, authority, and international influence of the Basle Committee on Banking Supervision. The current Basle Accord of 1988,(7) which has been adopted by the G-10 nations(8) and most other industrialized countries,(9) is the subject of Part III, which also details the current regulations and the policy considerations that led to them. In particular, Part III focuses on why the current regulatory regime has not achieved the various policy goals for which it was designed. Part IV then explains the 1999 proposal by the Basle Committee(10) to amend the 1988 Accord by allowing, inter alia, a system of private rating agencies and internal rating methods to replace the current predetermined asset ratings. This Comment examines the policy rationales behind this new proposal and highlights the strengths and weaknesses of implementing such a regulatory structure. Part V introduces a second alternative to the current regulatory regime, proposed by the U.S. Shadow Financial Regulatory Committee, which would require banks to carry a specific amount of uninsured, subordinated debt.(11) The Conclusion reiterates the seven major flaws of the 1988 Basle Accord, and argues that the Basle Committee's 1999 Proposal to replace the original Accord with the New Capital Adequacy Framework ("New Framework") does little to ameliorate the "seven sins" of the current regime and will even engender additional dilemmas upon its implementation. Operating on the assumption that bank capital regulation is necessary, this Comment suggests that regulators should consider centering such regulation on a subordinated debt requirement that enhances market discipline. Finally, it argues that the prefatory assumption of the necessity of bank capital regulation is itself a seemingly flawed premise that should be scrutinized vigilantly.

1. BANKS, CAPITAL, AND REGULATION

   1. The Importance of Banking to the Economy

      All market economies rely on the voluntary relationships of autonomous individuals acting in their self-interest to create wealth through productive enterprise.(12) For most enterprises, economic inputs fundamental to the entity's success are not initially owned by the enterprise. Entities and individuals contract with one another to form borrower/saver relationships. Savers provide economic inputs to borrowers who use such inputs to generate economic outputs. Borrowers, in turn, promise a return of their inputs, as well as a portion of the net output (i.e., principal plus interest), to savers. By serving as "intermedia[ries] between savers and borrowers," banks have eliminated much of the inherent inefficiency and risk in this process.(13) Banks thus "raise funds by issuing their obligations to savers, and provide these funds to borrowers by acquiring the borrower's obligations."(14) In effect, banks have earned their profits through the interest rate spread between the rate they pay on deposits and the rate they charge for loans.

      The advent of banks resulted in an "efficient payment system"(15) that financed the Industrial Age.(16) Today, banks are much larger and more complex than they were a few hundred years ago, yet their main function as intermediaries between savers and borrowers remains, and they continue to flourish. The most significant trend in banking is "globalization."(17) For the past decade, American banks have been establishing branches, subsidiaries, agencies, and representative offices in foreign countries at astonishing rates, and other nations' banks are doing the same in the United States.(18) Bank customers are no longer only individuals and entities from the bank's home country. For example, an American bank (intermediary) may loan a British corporation (borrower) money that was initially deposited by a Japanese bank (saver). International banking centers have emerged, creating more competition among banks and expanding the parameters of commercial payment systems.(19) The current legal systems of individual nations, however, are more or less insufficient to address the tumultuous changes arising from globalization.(20)

   2. The Importance of Capital in Banking

      The bank's role as a financial intermediary involves many specific risks, of which the most predominant is credit risk--that a borrower will default on a loan.(21) On a bank's balance sheet, a loan is classified as an asset, because it is an entitlement of the bank to receive a certain amount of money (plus periodic interest payments) on a given date from a borrower. The main liabilities on a bank's balance sheet are its deposits, or obligations to reimburse savers on a specified date or upon demand. The amount of net assets (assets minus liabilities) is thus the bank's capital.(22) Capital is generally "a financial cushion that absorbs banks' losses and thus protects depositors--or any entity that insures depositors--from loss."(23)

      Consider the following hypothetical balance sheet:

      Assets (Loans) $100,000,000 Liabilities (Deposits) $90,000,000 Equity (Capital) $10,000,000 Total: $100,000,000 Total: $100,000,000 In this case, the bank has $100,000,000 in loans that it is entitled to receive from its borrowers. It concurrently has an obligation to pay its savers $90,000,000 upon withdrawal of their deposits. The $10,000,000 in capital serves as a 10% default cushion against the outstanding loans. What would happen if a downturn in the economy or reckless management caused the borrowers to default on 15% of the loans? The realized credit risk would then be 15% of total assets. Consider the revised balance sheet:

      Assets (Loans) $85,000,000 Liabilities (Deposits) $90,000,000 Equity (Capital) ($5,000,000) Total: $85,000,000 Total: $85,000,000 The bank now has the possibility of recovering only $85,000,000, but its obligations remain $90,000,000. The net worth of the bank is negative $5,000,000. The test for bank insolvency is simple: "[b]anks fail when their losses exceed their capital."(24) Applying this test, the negative $5,000,000 net worth is again evident since losses were $15,000,000 and bank capital was only $10,000,000. In this simplified hypothetical, the bank only had a 10% capital cushion, a capital ratio that was inadequate. Capital adequacy(25) laws are created to prevent this very situation.

      While the technical function of capital is to ensure that net liabilities do not exceed net assets, capital also functions in more dynamic ways:

      [B]ank capital serves four primary functions. First, it inspires public confidence in the bank's viability by absorbing unanticipated losses. Second, it protects uninsured depositors in the event of bank insolvency. Third, it pays for the acquisition of physical plants and other resources necessary to operate the bank. Finally, it serves as a regulatory restraint on unjustified asset growth.(26) Since adequate capital is a necessary condition for solvent banks, and solvent banks are fundamental to the world economy, adequate bank capital is thus essential for a sound economy. Many assert that "[a] sufficient level of capital backing can cushion the most serious shocks to the banking system as well as forestalling systemic failure."(27) Because adequate bank capital is a vital component of economic stability, it has become a subject of concern for financial regulatory bodies around the world.

   3. Capital Adequacy: Why Government Regulation?

      Capital adequacy is not a phenomenon exclusive to banks. Every business, from a corner snowcone stand to a Fortune 500 company, possesses the inherent risk of incurring losses that exceed capital. Government, however, does not interfere with the balance sheets of operating companies by mandating specific ratios of capital to assets. Firms are expected to maintain adequate capital the old-fashioned way--through self-imposed, prudent management. Businesses that misjudge risks and the capital needed to serve as a buffer against them either become entirely insolvent or suffer punishment by acquiring reputations for not paying their debts. Individuals or businesses may refuse to enter into contractual obligations with a company known to be lacking in...