Credit Risk Measurement In and Out of the Financial Crisis: New Approaches to Value at Risk and Other Paradigms, Third Edition

CHAPTER 13

Capital Regulation

INTRODUCTION

The 1988 Basel Capital Accord (Basel I) was revolutionary in that it sought to develop a single capital requirement for credit risk across the major banking countries of the world.^1,2 A major focus of Basel I was to distinguish the credit risk of sovereign, bank and mortgage obligations (accorded lower risk weights) from nonbank private sector or commercial loan obligations (accorded the highest risk weight). There was little or no attempt to differentiate the credit risk exposure within the commercial loan classification. All commercial loans implicitly required an 8 percent total capital requirement (Tier 1 plus Tier 2), regardless of the inherent creditworthiness of the borrower, its external credit rating, the collateral offered, or the covenants extended.^3,4 Since the capital requirement was set too low for high-risk/low-quality business loans and too high for low-risk/high-quality loans, the mispricing of commercial lending risk created an incentive for banks to shift portfolios toward those loans that were more underpriced from a regulatory risk capital perspective; for example, banks tended to retain the most risky tranches of securitized loan portfolios (see Jones [2000] for a discussion of these regulatory capital arbitrage activities). Thus, the 1988 Basel Capital Accord had the unintended consequence of encouraging a long-term deterioration in the overall credit quality of bank portfolios.⁵

The proposed goal of the new ...