Basel II: your questions answered

Balance Sheet

ISSN: 0965-7967

Publication date: 1 September 2004


Robinson, B. (2004), "Basel II: your questions answered", Balance Sheet, Vol. 12 No. 4.



Emerald Group Publishing Limited

Copyright © 2004, Emerald Group Publishing Limited

Basel II: your questions answered

Bill RobinsonHead UK Business Economist in Financial Advisory Services at PricewaterhouseCoopers. He is a former Special Adviser to the Chancellor of the Exchequer.

What is Basel II and why are governments taking such an interest in it? What will it do to banks and bank profits? Will it have an impact on the wider economy? PricewaterhouseCoopers assembled a large group of economists and banking experts from around Europe to consider these issues on behalf of the European Commission. Here are some of the main findings.

What is Basel II?

Basel II is a process of reviewing the 1988 Basel Accord on capital adequacy signed by over 100 countries. It is all about the size of the capital cushion used by banks to protect depositors from the failures of borrowers to repay or service loans. The purpose of the review is to link capital requirements more closely to the risks involved in different kinds of lending business and encourage the spread of modern techniques for evaluating those risks.

How might it affect my business?

In two ways: changes in banks' capital requirements may affect their costs of doing business and hence the price of loans. And that in turn could have a significant effect on the macro economy – just like an interest rate change.

Are you saying Basel II might lead to an increase in bank charges?

When the proposals were first mooted there was a lot of concern that lending to small businesses would become more expensive. But the PwC analysis suggests otherwise. Overall there is likely to be a reduction in capital requirements, and hence in the cost of borrowing.

Is that true right across the EU? And across all kinds of borrowing?

No. It is true for the EU as a whole, but there are different effects in different countries. For example there will be a significant reduction in capital requirements in France and a noticeable reduction in the UK. But some countries, notably Greece, will see an increase. As regards different kinds of borrowing, a clear conclusion of the PwC study is that the cost of personal borrowing is likely to fall more than that of company borrowing.

Why is that?

The main risk that banks run is that people default on their loans. But for the banker, risky loans are not necessarily those with a high probability of default. Loan business with default rates that are predictable, even if high, can provide steady income for banks, because the probability of default is factored into the price charged for the loan. The truly risky business is in lending with variable, hence unpredictable default rates.

In general lending to households, where there are large numbers of similar loans, provides a much sounder statistical basis for the analysis of default probabilities than lending to companies, where the numbers are smaller and the business more varied. In this sense lending to households is less risky (i.e. default rates are both less variable and more predictable). So a feature of the Basel II changes is that capital requirements for mortgage and other household lending tend to be lower than before.

Can you give me a feel for the size of these changes, and their likely effect on my borrowing costs?

The short answer is: ''it depends''. There are four broad classes of loans (sovereign, interbank, corporate, and personal) with many sub-categories (secured versus unsecured, large company versus small company) each of which have different capital requirements. And to complicate matters further, banks use three different methods of assessing capital requirements. So the impact of Basel II on a particular banking transaction will depend on the bank, and on the nature of the transaction.

I can see that, but haven't you quantified an average overall effect for the EU?

Yes. Given the numbers of banks in each country using the different approaches, and the proportion of their funds devoted to different classes of lending, we can calculate average changes in capital requirement by country. This information is provided by the Quantitative Impact Studies carried out for the Basel Committee between October and December 2002, supplemented by other official data.

The bottom line of this large statistical modeling exercise can be summed up in a few macro economic numbers. Total bank capital across the EU is some $E1,600 billion. The new approach should lead to a reduction in capital requirements of around 5 percent or $E90 billion. If this capital saving is valued at the banks' cost of equity, it amounts to an annual saving of $E11 billion. This figure represents less than half of 0.1 percent of the total capital base. So there is a potential reduction in interest rates, or increase in banks' margins, of this amount.

Why would the banks pass this cost saving in lower interest rates?

We don't know that they will. It will depend on the competitive pressure within the industry in different countries and for different kinds of loans. It will also depend on the banks' own attitudes to risk.

One of the key features of the banking industry is that banks are conservatively run institutions which have always maintained a larger capital cushion than is required by the regulators. Banking regulation, like fire regulations or speed limits, requires people to do something that many of them would do anyway out of natural prudence, to avoid the risk of a major disaster. This makes it difficult to assess the effect of Basel II on banks' behavior. If you already consider it sensible to drive at 25 mph in built-up areas, do you necessarily drive any faster when the government lifts the speed limit from 30 to 35 mph?

Are you saying the banks may simply not use the new freedom given them by the regulators?

That is one possibility. There are two others: that the banks' reduce their capital requirements but do not pass on the benefit in the form of lower lending rates; or that they do reduce interest rates. In this latter case, it makes a difference whether companies or individual borrowers are the main beneficiaries.

So what is the likely effect on the macro economy of these different scenarios?

Clearly at one extreme, if the banks don't change their behavior at all as a result of Basel II, there will be no macro economic effect. If they pocket the benefit of reduced capital requirements in the form of higher profits, there will also be virtually no long term macro economic effect. But if they pass on the reduction in costs in the form of lower interest rates, there will be a macro economic benefit.

Can you say how big a benefit?

If companies can borrow more cheaply, they will invest more, and this will in the long term lead to a higher level of productive capacity and more output. The macroeconomic analysis suggested a 0.3 percent increase in investment in the long run, and a 0.07 percent increase in the level of output. Because the additional output comes as a result of higher productivity (reflecting the increase in the amount of capital employed), there is no discernible effect on employment.

So Basel II is no big deal at the macro level?

Not necessarily. The macro economic simulations only capture the effect of increase the stock of capital. Arguably a more important result of Basel II is the more efficient allocation of scarce capital. This is a micro economic effect which is unquantifiable, but certainly positive, and probably significantly so.