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Straight talking from bankers’ bank Back  
The annual report of the Bank for International Settlements released in early June contained fresh, plain, and even humorous statements about the international economy, rewarding traders, the euro and capital markets. The following are edited highlights.
Using risk-adjusted returns to avoid failures

Financial failures in the 1930s seriously aggravated the economic downturn in many industrial countries, and led to a sharp tightening of the regulations governing financial activity. The postwar period witnessed a progressive liberalisation as the memories of earlier difficulties faded and the potential benefits of freer financial markets became better recognised.

Risk-adjusting rewards for traders, too
Promoting healthy financial institutions, especially banks, is a crucial pre-requisite for financial stability. The largest number of crises still arise, be it in emerging market economies or industrial countries, from financial institutions overextending themselves when times seem good and then retrenching violently afterwards.

Governance would first benefit from a greater internal focus on risk-adjusted rates of return, particularly when rewarding traders and credit officers. The relentless pursuit of shareholder value, without this crucial adjustment, could prove a very dangerous strategy.

To this recommendation might also be added greater attention to the way in which public safety nets may encourage imprudent behaviour, not least through institutions thought to have a state guarantee. The recent explosive growth of such institutions in the United States reinforces long-standing concerns about similar state involvement in both Japanese and continental European banking.

New capital adequacy rules
The proposals put forward by the Basel Committee on Banking Supervision for improving the 1988 Capital Accord, to be modified in the light of the recently concluded consultation process, will link the minimum capital requirements for banks with well developed rating systems more closely to the banks’ own internal assessments of credit risk.

Such a linkage is clearly desirable, provided of course that these assessments are not themselves biased in any way. Eligibility for this approach will thus be subject to sound practice standards and guidelines aimed at ensuring the integrity of the rating system output and process.

The standardised approach being proposed for less sophisticated banks perhaps promises fewer benefits, but may also entail fewer risks. It obviously needs to be well thought through since the vast majority of banks in emerging markets are likely to be governed by it.

The proposed new Capital Accord also recognises that supervisors have an important role to play in ensuring that the need for capital is being adequately assessed and that capital requirements are consistent and comparable across institutions. In this latter regard, simple rules ensuring forward-looking provisioning might play a bigger role than is currently the case.

The Basel Committee has pointed out that market discipline could also contribute to prudent behaviour on the part of financial institutions. Credit spreads and share prices are traditional mechanisms in this regard, but subordinated debt might also be considered. A necessary but not sufficient condition for the application of market discipline is that the market has enough reliable information to allow it to make a sound judgment. Ensuring the provision of such information, along with a clear explanation of the accounting principles on which it is based, should continue to be of the highest priority.

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