loss reserves) should be sufficient to “absorb estimated credit losses.” However, loan
loss reserves may be distorted by the stipulation that they are considered eligible for
Tier 2 capital up to a maximum 1.25% of risk-weighted assets.^14 That is, if expected
credit losses exceed 1.25% of risk-weighted assets, then some portion of loan loss re-
serves would not be eligible to meet the bank’s capital requirement, thereby requiring
excess capital to meet some portion of expected losses and leading to redundant capi-
tal charges. In November 2001, the BIS proposed modifications that would relax these
constraints and permit the use of “excess” provisions to offset expected losses. While
capital requirements for credit and operational risk can be satisfied by Tier 1 and Tier
2 capital only, part of the market risk capital requirement can be satisfied by Tier 3 cap-
ital which includes subordinated debt of more than two years’ maturity.^15
The new capital requirements in BIS II are applied on both a consolidated and un-
consolidated basis to holding companies of banking firms.^16 When BIS II is com-
pletely adopted, overall regulatory capital levels, on average, are targeted (by the
BIS) to remain unchanged for the system as a whole.^17 However, recent tests con-
ducted by 138 banks in 25 countries have led to a downward calibration of the capi-
tal levels required to cover credit risk (under the Internal Ratings–Based Foundation
Approach) and operational risk (under the standardized model, basic indicator model
and advanced measurement approach).^18
3.2 STANDARDIZED MODEL FOR CREDIT RISK. The Standardized Model follows
the same methodology as BIS I, but makes it more risk sensitive by dividing the com-
mercial obligor designation into finer gradations of risk classifications (risk buckets),
with risk weights that are a function of external credit ratings. Under the current sys-
tem (BIS I), all commercial loans are viewed as having the same credit risk (and thus
the same risk weight). Essentially, the book value of each loan is multiplied by a risk
3 • 4 BIS BASEL INTERNATIONAL BANK CAPITAL ACCORDS(^14) Moreover, accounting rules differ from country to country so that oftentimes the loan loss reserve
is a measure of current or incurred losses, rather than expected future losses. See Wall and Koch (2000)
and Flood (2001). Indeed, Cavallo and Majnoni (2001) show that distorted loan loss provisions may have
a pro-cyclical effect that exacerbates systemic risk. In particular, many Latin American countries require
large provisions for loan losses (averaging 8% of gross financing), raising the possibility of excessive
capital requirements in these countries due to double counting of credit risk [see Powell (2001)].
(^15) BIS II makes no changes to the Tier I and Tier 2 definitions of capital. Carey (2001b) suggests that
since subordinated debt is not useful in preserving soundness (i.e., impaired subordinated debt triggers
bank insolvency), there should be a distinction between equity and loan loss reserves (the buffer against
credit risk, denoted Tier A) and subordinated debt (the buffer against market risk, denoted Tier B). Jack-
son, et al. (2001) also show that the proportion of Tier I capital should be considered in setting minimum
capital requirements.
(^16) The one exception to this is with regard to insurance subsidiaries. Banks’ investments in insurance
subsidiaries are deducted for the purposes of measuring regulatory capital. However, this distinction ig-
nores the diversification benefits from combining banking and insurance activities; see Gully, et al.
(2001).
(^17) Capital requirements are just the first of three pillars comprising the BIS II proposals. The second
pillar consists of a supervisory review process that requires bank regulators to assess the adequacy of
bank risk management policies. Several issues, such as interest rate risk included in the banking book,
have been relegated to the second pillar (i.e., supervisory oversight) rather than to explicit capital re-
quirements. The third pillar of BIS II is market discipline. The Accord sets out disclosure requirements
to increase the transparency of reporting of risk exposures so as to enlist the aid of market participants in
supervising bank behavior. Indeed, the adequacy of disclosure requirements is a prerequisite for supervi-
sory approval of bank internal models of credit risk measurement.
(^18) See BIS (2001c, d).