18 June 2003 • The New Basel Capital Accord (Basel II) from a Macroeconomic Point of View • Franz. R. Hahn

The Basel Committee on Banking Supervision and the EU Commission have submitted – widely harmonised – proposals for reforming the capital requirements for banks and investment firms (Basel II). The object of the reform is to strengthen the stability of the financial market by aligning the regulatory capital requirements of banks more closely with underlying risks, especially credit risks, an objective that is to be achieved chiefly by the greater use of new risk assessment methods to be applied internally by the banks.

Macroeconomic aspects on the regulatory side were, for the time being, almost ignored by both proposals. The reform's implications for the overall economy and financial system have been discussed, however, by academies and politicians, this debate has not yet produced a consensus on the likely macroeconomic effects.

The most vigorous debate has focused on the fear that Basel II, with its more risk-sensitive regulations for capital requirements, might have a greater destabilising effect on the business cycle than Basel I has. The credit cycle followed by the banks, already strongly marked by the business cycle, would be enhanced rather than muted by the new internal risk assessment methods. This objection is based on insights that are well-founded in empirical terms. The cyclical sensitivity of central risk factors in the credit business is rarely given consideration by the banks. Empirical evidence also supports the suspicion that banks base their risk assessment on short periods (one year or less). This implies, i.a., that any static short-term risk assessment, such as is preferred by the banks, may lead to credit risks being undervaluated during a cyclic upturn and overvaluated during a downswing. Such behaviour will strengthen the upturn but may well accelerate the subsequent downswing.

In the course of the consultation process, the Basel Committee has shown itself open to such objections, and is expected to recommend that the banks proceed more cautiously in estimating the default probabilities and follow a more future-oriented and macroeconomically founded approach.

In connection with Basel II, many EU countries, including Austria, have expressed their fears that the new capital requirements regime for banks might make lending to SMEs more expensive. The Basel Committee used such concerns as a starting point to revise the capital requirements for lending to SMEs and to defuse their most serious consequences. Simulations show that due to the substantial reduction of capital requirements for loans to SMEs, banks should incur much lower regulatory costs than when lending to larger companies of an equal credit standing.

Each of these macroeconomic implications of Basel II is important from the Austrian point of view, albeit not to the same extent. The procyclic trend in the internal ratings of banks may produce critical competitive disadvantages for an economy whose businesses are highly dependent on the availability of low-cost bank loans, especially when (as is the case in Austria) key sectors, such as tourism, construction and export manufacturing, are extremely sensitive to variations in the business cycle. Easing up the capital requirements for loans to SMEs should benefit the Austrian economy which is characterised by a preponderance of SMEs.

Once the third consultative stage is completed in late 2003, it will be seen whether the new accord will feature a strong macroeconomic foundation in addition to a sound microeconomic base. This will be the criterion by which to judge whether Basel II will be able to meet the great expectations it has been raising.

Vienna, 17 June 2003.

For further information, please refer to Mr. Franz R. Hahn, phone (1) 798 26 01, ext. 255. For the full text of this article see the Internet under http://www.wifo.ac.at/