Financial stability and the New Basel Accord

This study outlines how proposed changes to international capital adequacy standards – commonly referred to as “Basel II” – will reinforce financial stability. Basel II is designed to contribute to the prevention of individual bank failures by making minimum capital standards more flexible and aligning them more closely with actual risks and changes in the level of risk. By bringing regulatory capital closer to the concept of economic capital that banks use in their internal management, and by going to the core of banks’ financial information systems, the proposed changes will foster better control of risks. By reducing credit disruptions, the changes should help to limit the severity of macro-economic and sectoral downturns and thereby improve financial stability. Concerns have been expressed about the potential “procyclicality” of the new standards, and the possibility of sharp swings in regulatory capital requirements leading to dramatic shifts in the availability of credit. These concerns, while theoretically appealing, do not appear warranted in practice. The Basel Committee took steps early on to ensure that cyclical effects would be moderated, while still achieving the goal of making capital ratios more risk-sensitive, more closely related to the bank’s management of its “risk-return” tradeoff, and therefore more useful as an internal control tool. In contrast with Basel I, which is external to banks’ methods of management, Basel II incorporates an advanced IRB approach. It can therefore figure as a central element in banks’ strategic planning. The success of the proposed changes will depend on how they are applied by bank managers and on the vigilance of bank supervisors in overseeing their implementation. Numerous contacts and on-site examinations carried out to date are encouraging in this regard. A hoped-for reform in the rules on provisioning, consistent with the new capital standard – factoring in ex ante the impact of expected but unrealized credit losses over the credit cycle instead of concentrating them at the lowest point of the cycle – would contribute significantly to financial stability.