The goals of Basel 1 were basically two. The first goal was aimed at bringing to the same level the playing field for internationally competing banks. The second one sought to minimize the possibilities of such competition causing bidding down of the capital ratios to extremely low levels. Surprisingly, the 1998 accord successfully witnessed impressive milestones towards the achievement of these two goals, equitable grounds for competition were attained and capital standards were tremendously strengthened within and even beyond the G-10. Compared to what had come before, this was a huge breakthrough, especially considering the general acceptance as well as implementation of the capital needs beyond the Basel committee membership. To a large extent, the biggest problem has been the extremely limited sensitivity of the accord to the risks involved. The idea of classifying debtors into several risk buckets was obviously a milestone in 1988. On the other hand a gap was created between the regulatory measurement if risks involved in a given transaction and the real economic risk, leading to counter intuitive outcome. For example, a system requiring more regular capital to grant a non-investment grade Mexican bank, a 1 year loan compared to a 10 yea loan, is more discriminating than it should actually be.
The most disturbing disadvantage of the gap created between regulatory and actual economic risk has always been the negative disruption of financial decision making which include huge amounts of arbitrage or instances of investments being made on the grounds of regulatory limitations instead of truthful economic opportunities. On one hand, this out rightly suggests a significant cost of regulation relative to enjoying an efficient market. On the other hand, one can easily conclude that the very reason for the existence of the standards is being undermined because measurement of the risk might result to insignificant relation to the level of risk involved in the underlying transfer.
Talking in favor of Basel 1, it must be remembered that every strict rule-based approach to the regulation is eventually bound to get in the risk of changing activities in unforeseen ways and also encouraging regulatory arbitrage. Here, for one to firmly acknowledge that a system is far better that what was there before is not a small achievement. Unfortunately, with the modern economic and financial transactions becoming more and more complex, the scope for distortions is also growing. This appears to have caused a shift in the debate which seems to be in favor of principle rather than the rule-based approaches. This is not only happening in banking supervision but also in financial regulation to a large extent. A perfect example for this scenario is the response to the Enron case and numerous other latest accounting scandals.
Impact on the emerging market for financial system
Numerous international initiatives were behind the reasons why governments and supervisors...