02 January 2008

Overhaul 'increases risk of recession'

An overhaul of the way banks are regulated threatens to make the financial sector even more vulnerable to recessions, the Bank of England has warned. Basel II - the revamp of the scheme under which banks arrange their balance sheets - poses "risks to the stability of the financial system", the Bank said in a paper.

On Monday debt collection and finance group London Scottish Bank warned it was considering scrapping its dividend and launching an emergency rights issue after breaching the regulatory rules, which came into effect yesterday.

The Bank argues that the updated Basel rules will make the financial sector more reliant on credit rating agencies for assessing how much risk to apply to its assets and liabilities. Because these agencies' ratings tend to rise and fall depending on the state of the economy, the Bank warned that the new regime threatened to make the banking system more "pro-cyclical" - in other words prone to booms and busts.

The system focuses on how much capital - largely consisting of shareholder money - a bank must raise in comparison to its assets. Whereas the previous Basel system laid down a strict method of calculating how much different types of assets were worth, the updated version leaves this in the hands of the banks - based on recommend-ations from ratings agencies.

The report said: "Under Basel II then, banks' risk-weighted assets, and therefore capital requirements, might rise in a recession scenario as credit risk materialises and borrowers are downgraded." It added that this might force banks to cut back on lending and issue more shares.

Such a phenomenon is already occurring in the current credit crisis, though the Bank said it could be even more severe under the new system. "A systemic tightening in credit supply may in turn increase financial pressures on companies and households and deepen, or prolong, a downturn," it said. It calculated that, in a "global economic slowdown" similar to the UK recession in the early 1990s, banks might lose as much as 40pc of their Tier 1 capital - a figure which would run into tens of billions of pounds.

London Scottish said it had undershot international banking guidelines on the amount of capital that must be set against assets, forcing it to consult with the Financial Services Authority about "actions the company plans to take to address the shortfall".

Peter Spencer, chief economic adviser to the Ernst & Young Item Club warned recently that the capital requirements demanded by both old and new Basel regimes were serving to exacerbate the credit crisis, since they were deterring banks from lending to each other, as this would place further demands on their capital accounts. He warned that governments would soon be forced to relax the Basel rules.

Other experts have warned that even if Basel II had been put into place before the market turmoil of last summer, the credit crunch would still have occurred. Mark Wheaton, head of Accenture's UK risk management practice, said: "Few people believe that, had Basel II already been in place, it would have prevented the current credit crunch crisis, although some of the initial sub-prime lending decisions may have had greater scrutiny."

© Graham Bishop