1. The Future of International Banking Regulation: A New Beginning or Business as Usual? Presentation at DIIS by Ranjitt Lall 18th of May 2010

2. Basel Accords Set minimum capital requirements for banks Capital (mainly equity) absorbs unexpected losses, but is costly for banks as a source of funding Basel I (1988) Minimum capital requirements based on ratio of capital to risk- weighted assets of 8% Risk weights depend on riskiness of borrower e.g. government bonds (safe) 0% risk weight; corporate loans (riskier) 100% risk weight Provided opportunities for regulatory arbitrage, causing capital levels in the banking system to decline

3. Objectives for Basel II 1.To promote safety and soundness in the financial system 2.To continue to enhance competitive equality 3.To constitute a more comprehensive approach to addressing risks

4. ObjectiveRegulation required to meet objective Basel II 1More refined risk-weights linked to external ratings for all banks? 2 3Regulation of trading book risks No regulation Regulation of market riskUse of VaR models underestimating market risk Regulation of securitization risks Use of excessively low risk weights ObjectiveRegulation required to meet objective Basel II 1 Link risk-weights to external ratings for all banks? 2 3 Regulation of trading book risks ? Regulation of market risk ? Regulation of securitization risks ?

5. the accord would have to introduce rules to capture three previously unregulated types of risks: trading book risks, in particular counterparty credit risk and risks related to over-the-counter (OTC) derivatives; market risk, the risk of losses to on- and off-balance sheet assets arising from movements in market prices; and securitization risks. ObjectiveRegulation required to meet objective Basel II 1 Link risk-weights to external ratings for all banks Internal ratings for large banks; modified version of Basel I for other banks 2 3 Regulation of trading book risks No regulation Regulation of market risk Use of models known to underestimate market risk Regulation of securitization risks Use of excessively low risk weights

6. Impact of Basel II on capital levels Large banks under A-IRB approach experience 26.7% decline in capital levels Small banks under standardized approach experience 1.7% increase in capital levels Consequence: overall capital levels fall (contra objective 1); large banks increase profits at expense of small banks (contra objective 2)

7. Mattli and Woods (2009): Regulatory Outcomes Pure Capture Regulation De facto Capture Regulation Capture but with Concessions and Compromises Common interest regulation Institutional Supply Limited (Closed and exclusive forums, minimal transparency) Extensive (Proper due process, multiple access points) Demand Narrow/ Limited Broad/ Sustained

8. My ‘dynamic’ analytical framework Mattli and Woods flawed: regulatory process takes place over time; some actors arrive before others This is significant because of first-mover advantage: decisions made at an early stage are self-reinforcing Who will arrive first? Those with the best information about the regulatory agenda; usually through personal contacts with regulators Qualification: timing only important when agreements not subject to ‘ratification phase’

9. Applying my framework to Basel II First-movers: large international banks represented by IIF Second-movers: smaller banks and emerging market banks Theoretical prediction: large banks will secure their preferred regulatory outcomes in Basel II

10. ObjectiveInitial proposalIndustry Recommendation Final proposal (Basel II) 1 Incorporate external credit ratings into new framework Recognize internal credit risk models of large banks? 2 3 Introduce capital charge for derivatives risk (‘w factor’); capture counterparty credit risk Drop ‘w factor’; do not apply credit risk capital requirements to trading book ? Standardized methodology based on fixed risk parameters Substitute standardized methodology for market risk (VaR) models ? Link risk weights to external credit ratings Lower risk weights for rated tranches?

11. ObjectiveInitial proposalIndustry Recommendation Final proposal (Basel II) 1 Incorporate external credit ratings into new framework Recognize internal credit risk models of large banks Recognition of internal ratings for large banks; modified Basel I for other banks 2 3 Introduce capital charge for derivatives risk (‘w factor’); capture counterparty credit risk Drop ‘w factor’; do not apply credit risk capital requirements to trading book ‘W factor’ abolished in 2001; no regulation of trading book Standardized methodology based on fixed risk parameters Substitute standardized methodology for market risk (VaR) models Recognition of VaR models in 1996 Link risk weights to external credit ratings Lower risk weights for rated tranches Reduced risk weights for rated tranches

12. The G-20’s demands for capital adequacy reform Washington Summit (Nov 2008): raise capital requirements for structured credit and securitization activities BCBS response: trading book enhancements approved in July 2009 Pittsburgh Summit (Sept 2009): introduce international leverage ratio, more restrictive definitions of capital, countercyclical capital buffers, capital surcharges for ‘systemically important’ institutions BCBS response: preliminary proposals (‘Basel III’) released in December 2009; to be finalized by end-2010

13. Why Basel III will fail Public attention to banking regulation decreases Rule-making returns to BCBS, whose agreements do not require ratification by domestic stakeholders i.e. timing regains its significance Large banks gain first-mover advantage through personal contacts with regulators

14. Strategies for first-movers in Basel III process 1.Using close personal networks to conduct private meetings with regulators: IIF Annual Conference (Oct 2009); World Economic Forum (Jan 2010) 2.Informational ‘scare tactics’: JP Morgan (Feb 2010); Project Oak (Apr 2010); BNP Paribas (Apr 2010)

15. Initial ProposalIndustry recommendation Likely outcome (Basel III) Introduce international leverage ratio in Pillar 1 (i.e. binding) Move ratio to Pillar 2 (i.e. non-binding) Adoption in Pillar 2 Create capital surcharge for ‘systemically important’ institutions in Pillar 1 Drop surcharge or move it to Pillar 2 Removal or adoption in Pillar 2 Introduce ‘forward-looking provisioning’ (to mitigate pro-cyclicality) Adopt in Pillar 1Adoption in Pillar 1 Introduce countercyclical capital buffers linked to credit-to-GDP ratio in Pillar 1 Move buffers to pillar 2Adoption in Pillar 2