The New Basel Capital Accord: Making it Effective with Stronger Market Discipline

In January 2001 the Basel Committee on Banking Supervision proposed a new capital adequacy framework to respond to deficiencies in the 1988 Capital Accord on credit risk. The main elements or ‘pillars’ of the proposal are capital requirements based on the internal risk‐ratings of individual banks, expanded and active supervision, and information disclosure requirements to enhance market discipline. We discuss the incentive effects of the proposed regulation. In particular, we argue that it provides incentives for banks to develop new ways to evade the intended consequences of the proposed regulation. Supervision alone cannot prevent banks from ‘gaming and manipulation’ of risk‐weights based on internal ratings. Furthermore, the proposed third pillar to enhance market discipline of banks’ risk‐taking is too weak to achieve its objective. Market discipline can be strengthened by a requirement that banks issue subordinated debt. We propose a first phase for introducing a requirement for large banks to issue subordinated debt as part of the capital requirement.