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6 J. Banking Reg. 6 (2004-2005)

handle is hein.journals/jlbkrg6 and id is 1 raw text is: Editorial Why banks hold capital in excess of regulatory requirements: The role of market discipline In June 2004, the proposed amendments to the Capital Accord (Basel II) were agreed and are scheduled to take effect in January 2005. An overriding objective of Basel II is to allow market forces to play a more important role in setting capital standards in order to enhance the risk sensitivity of banks' capital allocation. In G10 countries, however, banks already hold capital signifi- cantly in excess of regulatory capital requirements. If an important objective of Basel II is to make a bank's capital more risk sensitive, it appears that banks may already be meeting this objective and that reform of international capital standards may be misguided. This essay suggests that excess capital levels in the banking sector may be due to market failures and inade- quate regulation. Indeed, it is argued that excessive reliance on market discipline may result in inefficiencies in the banking sector and may also pose a threat to financial sta- bility. What are the implications for regu- latory reform? EXCESSIVE RISK-TAKING BY BANKS GIVES A ROLE FOR MINIMUM CAPITAL STANDARDS The experience of the Basel Accord demonstrates that regulators have accepted that an important way of building confi- dence in the banking sector is to require banks to hold minimum levels of capital against their risk-based assets. Bank capital requirements are based on the notion that banks have an incentive to underprice financial risk and therefore create too much of it in financial markets. The economic costs incurred by banks when they under- price risk are far less than the social cost such risk poses for society at large, as demonstrated by recent banking crises. In the 1970s and early 1980s, most coun- tries did not have minimum capital requirements for banks. After several bank- ing and financial crises in the early 1980s, the UK and USA initiated the drive for minimum capital standards by adopting a bilateral capital agreement in 1985 that provided the basis for the G10 country negotiations that eventually led to the 1988 Basel Capital Accord. The Accord estab- lished the first minimum international capi- tal standards for banks operating in G10 countries. Its 8 per cent minimum capital standard consisted of 4 per cent tier one capital (equity and reserves) and 4 per cent tier two capital (subordinated debt and general provisions). This capital standard was much higher than the capital main- tained by most banks prior to the Accord's adoption and resulted in a dramatic increase in capital levels for most banking systems. Although the Accord was not binding as international law, its 8 per cent capital ratio became an international benchmark that has been implemented into the national law and administrative code of over 100 countries. The binding effect of the Accord under national law resulted in Journal of International Banking Regulation, Vol. 6, No. 1, 2004, pp. 6-9 © Henry Stewart Publications, 1358-1988

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