The debate currently going on in the US over the way that the Basel II accord is going to affect bank capital levels is being replicated, in one form or another, all over the world (or at least the parts implementing Basel II).

Regulators realise that the current, Basel I, standards are risk insensitive. This means that banks can indulge in regulatory arbitrage to increase both risk and, hopefully, return without having to be hit by increased capital requirements. Indeed, some of the ways it can be done will both increase risk and reduce capital requirements.

Basel II addresses this, to a great extent, by its more risk sensitive measures. Even in the Standardised version there is an improvement in risk sensitivity, with the more advanced measures being even better.

The problem, from a regulatory view, is essentially down to two competing imperatives. For a regulator there is no real upside to (in their view) “conceding” a lower capital level to a bank – the increased profitability that can follow is of no importance to a regulator – they want either the same or increased capital which, to a regulator, means reduced risk of bank failure.

The banks, however, want to see some upside from the massive spend involved in Basel II compliance projects – if they can prove that they are running less risky portfolios they want to carry a lower capital burden. The regulators, on the other hand, want to see better risk management, but do not want to give up the capital buffer.

If they do not allow a lower capital holding for less risky banks, however, the whole point of the more risk sensitive measures is lost. Why should a bank move to a less risky portfolio, accepting lower profits as a result, if they are not going to get a lower capital burden?

The way the Fed has said in the US to say that the big 12 (or so) must use the advanced measures and then have the Senate worrying about reduced capital shows a misunderstanding of the whole point. As I have stated earlier, the big 12 (and indeed most decent sized banks in the US) should be able to meet the Basel II advanced requirements fairly easily, if expensively. To say that they will not get any benefits from doing so defeats the purpose.

The regulators surely cannot have it both ways. The system’s safety will be improved by the better risk measures. Reducing capital should therefore be the logical consequence – allowing cheaper banking (and/or better service) for all the clients

of the banks.