Basel 2: what it is and what changes for businesses

Introduction

“Basel 2” is the new international agreement on banks’ capital requirements. On the basis of this, the banks of the member countries will have to set aside portions of capital proportional to the risk deriving from the various credit relationships assumed, assessed through the rating instrument. In this section of the site we give a brief, but we hope, exhaustive information on the history of the agreement, its authors and stakeholders, on the aims and expected consequences of the agreement itself.

Subjects

The Basel Accords on the capital requirements of banks are the result of the work of the Basel Committee, set up by the governors of the central banks of the ten most industrialized countries (G10) at the end of 1974. The current members of the Committee come from Belgium, Canada, France , Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States.

The Committee operates within the BIS, the Bank for International Settlements, based in Basel, an international organization which aims to promote cooperation between central banks and other equivalent agencies in order to pursue monetary and financial stability.

The Committee has no supranational authority and its conclusions have no legal force. The guidelines, standards and recommendations of the Committee are formulated in the expectation that individual national authorities can draw up operational provisions that take into account the realities of individual states. In this way the Committee encourages convergence towards common and common standard approaches.

The first Basel Accord – 1988-

In 1988 the Basel Committee introduced the capital measurement system commonly called the Basel Capital Accord. It is the first Basel Accord. To date, the central authorities of over 100 countries have joined it. In summary, this document defined the obligation for banks to set aside capital to the extent of 8% of the capital disbursed, in order to guarantee solidity to their business.

The 1988 agreement had some particularly significant limits. The 8% of provision can be judged too much for a low risk counterpart and too little for a counterpart judged risky: the amount of capital absorbed was judged too insensitive to risk, despite some corrective measures introduced in subsequent years.

Basel 2 – The New Basel Accord

In January 2001, the Basel Committee published the document “The New Basel Capital Accord” (see the section “official documents”), a consultation document to define the new regulation on banks’ capital requirements. After a long phase the confrontation with the supervisors of the various countries and a series of quantitative investigations, a definitive text was reached in June 2004, while the implementation of the agreement, scheduled for the end of 2006, is still in the initial phase and with significant differences between the various countries.

The three pillars of Basel 2

The content of the New Agreement is divided into three pillars:

  1. The minimum capital requirements
    It is the part of the new Agreement that matters most to us. It is, in essence, a refinement of the measure provided for in the 1988 agreement which required an 8% provision requirement. Firstly, operational risk (fraud, fall of systems; measure partially revised in June 2002) and market risk are now taken into account. Secondly, for credit risk, banks will be able to use different methodologies for calculating requirements. The most advanced methodologies allow the use of internal rating systems, with the aim of guaranteeing greater sensitivity to risks without raising or lowering the overall requirement on average. The differentiation of the requirements according to the probability of insolvency is particularly wide, especially for banks that will adopt the most advanced methodologies.
  2. Control of Central Banks
    Taking into account the company’s capitalization and risk-taking strategies, the Central Banks will have greater discretion in assessing the capital adequacy of the banks, being able to impose a hedge that exceeds the minimum requirements.
  3. Market Discipline and Transparency
    Transparency rules are provided for public information on capital levels, risks and their management.

The “critical” aspects of Basel 2

Numerous criticisms were made on the original document of Basel 2 which led to changes which, while not eliminating doubts, should mitigate the negative consequences expected from the application of the agreement. What are these negative consequences? There are at least three:

  1. Discrimination between banks (small ones will not be able to use the most advanced methodologies, therefore they will suffer a greater capital burden than large groups);
  2. The penalization of financing for small and medium-sized enterprises (SMEs) induced by the internal rating system;
  3. The problem of financial procyclicality (in periods of economic slowdown, the Agreement would have the effect of inducing banks to reduce lending, due to the growing risk, with the potential consequence of exacerbating the crisis itself).

Here we do not investigate the issues referred to in points 1 and 3, but focus our attention on the problems concerning SMEs linked to the introduction of the agreement.

Basel 2 and small and medium-sized enterprises

Tying the capital requirement more closely to the risk underlying a loan or investment inevitably implies that the price of that loan or investment will become more sensitive to the risk implicitly contained. Following the implementation of the new regulatory provisions, the link between internal rating and pricing will become more solid, more structured and more transparent. This could induce a restrictive effect on companies, in particular SMEs, as borrowers of lower credit quality (typically small and medium-sized enterprises) would see their conditions worsen with a compression effect on their debt capacity and reviewing debt opportunities.

In practice, according to a large part of the observers, banks would be induced to reduce the credit destined for SMEs and at the same time increase interest rates.

The pressure from the Bank of Italy and the Bundesbank, aimed at defending the specificity of the respective economic systems characterized by the presence of thousands of small businesses, led to a partial revision of the draft agreement which now provides for reduced minimum capital requirements for exposure of banks towards small and medium-sized enterprises.

These measures may reduce, but not eliminate, the impact of Basel 2 on SMEs.

New scenarios for small and medium-sized enterprises

The change is therefore decided. With this, the next move is up to businesses. We want to conclude these notes with a reflection by Reiner Masera, President of the Sanpaolo IMI Institute.
“The diffusion of internal rating models therefore represents a far-reaching change also in the relationship between banks and companies, intervening in redefining the boundaries of the respective information and operational relations.” … “For medium and lower quality companies, the rating determined by the banks will become a strategic variable to regulate the cost and efficiency of their choices regarding the financial structure and investment financing, as well as a tool for assessing the possibility of growth and diversification. The rating may represent a useful indicator to support the definition of management objectives for management, contributing to a more efficient capital policy. ” “The strategies with which companies deal with this competitive environment cannot be financially deficient. It is necessary to seek continuous consistency between the structure of the sources and more general objectives of growth, innovation and market positioning. Corporate finance will therefore assume a a central role, often decisive when external growth opportunities are also at stake. This will probably determine a greater importance of the financial functions within companies and greater attention to the programming of resources and development processes. A fundamental step is outlined for businesses: the finance function will become as important as the commercial, organizational and technological one. “

The Basel 2 calendar

When will all this begin? It has already begun.

• After a long phase of refinement on the contents of the agreement, which made it possible to improve, also thanks to the impact studies, the first draft of 2001, the Basel Committee released the final document in June 2004;
• now the agreement, which, we remind you, does not have the force of law, has been transposed into law in the individual states (in Europe it has been transposed with the community directives 2006/48 / EC and 2006/49 / EC which in turn have been in the Italian legal system by Legislative Decree 267 of 27 December 2006);
• the new agreement therefore entered into force on January 1, 2007 for banks that adopt the Standard system and the Base IRB system and will come into force from the following year for those that adopt the Advanced IRB approach. In reality, the former have also chosen to take advantage of the derogation provided for by the EU directive which allows the regulatory capital to be calculated with the previous rules until 1 January 2008.

Do businesses still have time to adapt? Absolutely not!

Banking groups that aim to use internal rating systems (IRB) must demonstrate that they have used rating systems in line with the requirements of the agreement for at least three years, before obtaining authorization.

In fact, the Agreement, for banking groups that aspire to use the IRB approach, has already entered into force, having to comply with at least three years of operational, instrumental and organizational compliance in order to qualify for the most advanced approaches.

For rating procedures, 2008 will therefore be the year of definitive break-in in all banks. Therefore, the ability to access bank credit and the cost of money will shortly be increasingly closely linked to the creditworthiness of each company objectively calculated by the banks and expressed by the rating.