Watching the watchers

Market turmoil since August has highlighted several potential shortcomings in the financial system, some of which may be exacerbated by the very parties that are there to ensure market stability and a level playing field: financial regulators.

Take the Basel II capital rules. This new accord - first discussed more than a decade ago - was developed to more closely align regulatory capital requirements with economic capital-allocation techniques then used by the world's most sophisticated banks. It was designed for G-10 countries, with the aim that regulators in other jurisdictions could voluntarily adopt the framework.

Unquestionably, Basel II has proven a force for good. Banks in a number of Asian countries have benefited from a regulatory requirement to overhaul their outmoded risk management practices. Risk managers effectively gained support from bank boards to establish the data capture, systems and staff to develop vastly improved risk management they may not have secured otherwise.

A core feature of the accord was to break down credit risk into more granular buckets, so that banks would allocate different levels of capital based on the riskiness of their exposures. This means a loan to a AAA-rated company would require less capital reserved for regulatory reasons than a loan to a BBB-rated entity.

Initially, this appeared to penalise Asia's banks - many companies in Asia are unrated and so require far higher capital reserves. As our article on page 16 explains, agency ratings, notably in structured credit products, look unsound anyway. Which might explain why some of the region's most sophisticated banks view Basel II as an expensive compliance programme that they will run alongside their internal economic capital risk management systems.

Another concern raised by Basel II is that banks with increasingly similar risk management processes will behave in a similar fashion in the event of a financial shock and that this could exacerbate dislocations - something regulators call 'procyclicality'. But with so many Asian countries yet to implement Basel II, it's still too early to tell if the new rules will increase procyclicality or not. Nevertheless, it's an area that regulators might want to focus on more.

As our cover story suggests, regional regulators may also want to look more closely at Asia's structured product market. There is now evidence that structured product position hedging is affecting equity cash markets. With structured product concentrations greater here than elsewhere in the world, supervisors may need to develop solutions for this issue and, this time, export them to Europe and the US.

Christopher Jeffery.