Basel Accords - Something somewhere went terribly wrong!

“German regulators seized the ailing Herstatt and forced it to liquidate on June 26, 1974. The same day, other banks had released Deutsch Mark payments to Herstatt, which was supposed to exchange those payments for US dollars that would then be sent to New York. Regulators seized the bank after it received its DM payments, but before the US dollars could be delivered. The time zone difference meant that the banks sending the money never received their US dollars.”

Business Pundit, May 7, 2009

This failure has special place in the history of banking regulation, as the following debates led to introduction of new international regulation. This included well known Basel Capital Accords introduced in 1988, which has mainly focused on banks’ credit risk management, by setting risk-weighted minimum capital requirements. Unfortunately, bank regulators seem to have failed to discipline banks.

OECD analysis shows a significant decline in risk-weighted assets to total assets ratio over time. Historical development of the ratio of 15 largest banks has declined from nearly 70% in 1990 to 35% just before the financial crisis. Systemically important banks started moving to unconventional business practices, which suggests that risk-weighted system of calculation encourages banks to design instruments for bypassing the regulatory regime.

“Commerzbank is to swap junior debt for shares to boost core capital by €1bn and take the German bank closer to meeting European regulators’ demands to shore up its balance sheet.”

Financial Times, February 23, 2012

By engaging in shadow-banking and other unconventional banking activities, banks seem to forget about their core function, which is prudential lending to credit-worthy enterprises and households. The following table shows the percentage ratio of selected banks' loans to their total assets.

Since Basel accords were implemented in 1992, the percentage ratio of bank loans to the total assets in decline gradually throughout past 20 years, causing negative consequences for economic output.

As banks main profit margin is derived from securitisation of loans, they failed to devote adequate attention to prudential underwriting (credit risk assessments) of individual loans. It looks like capital requirements, which are based on risk-weighted assets could contribute to further incentives for financial engineers to bypass the regulatory requirements.