Friday, December 23, 2005

Why banks hold the highest-risk corporate debt possible

1998 -
By this time, shortcomings with the original accord's treatment of credit risk were becoming evident. The simple system of risk weightings provided an incentive for banks to hold the 0% risk-weighted debt of G-10 governments (a fact viewed with some cynicism, since those same governments were largely responsible for the original accord). However, such debt tended to be unprofitable. Far more profitable for banks was corporate debt, which was weighted 100%. With all corporate debt being weighted equally, it made sense for banks to hold the most risky corporate debt. Higher quality corporate debt incurred exactly the same capital charges but was less profitable.

During this period, markets for credit derivatives and securitizations grew explosively. It was an open secret that banks were employing these to take advantage of shortcomings in the 1988 Accord's crude system of risk weights. This practice is called regulatory arbitrage.

Another issue during this period was operational risk. Operational risk poses significant risk for banks. It includes a variety of contingencies including fraud—and fraud is routinely a factor in bank failures. Neither the original Basel Accord nor the 1996 Amendment required capital for operational risk.

In January 1999, the Basel Committee proposed a new capital accord, which has come to be known as Basel II. There followed an extensive consultative period, with the committee releasing additional proposals for consultation in January 2001 and April 2003. It also conducting three quantitative impact studies to assess those proposals.

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