Basel II to encourage smaller banks to invest in risky assets

The new Basel II capital rules will encourage smaller banks to invest in riskier assets, according Peter Plaut, a managing director in fixed income research at Bank of America in New York.

The rule change could prompt a major shift in asset allocation during the next two years as smaller institutions buy up the lower quality assets being sold off by the large banks, Plaut told RiskNews.

Unlike its predecessor, Basel I, Basel II allows larger institutions to use internal ratings-based (IRB) approaches based on their own figures, default probabilities and historical loss experience to assess how much capital to lay against perceived risk.

But smaller banks without such resources will have to abide by the standardised approach, which sets a single capital requirement according to the credit rating of the individual asset. This is often at much lower levels than those calculated by the larger banks for riskier assets, making them much cheaper to offset. Plaut said these riskier assets typically have a credit rating lower than double-B.

“There will be no incentive to provide more capital,” he said. “Instead, they have a perverse incentive to invest in low quality exposures, and that presents a concern to me as a credit analyst. They just won’t have the systems or historical data.”

Smaller banks will also be put at a “competitive disadvantage” higher up the ratings pecking order, where it is cheaper to use the IRB approach to calculate the capital requirement of an asset, Plaut said. For example, they will need to hold a minimum 4% of capital against assets rated single-A, whereas larger banks using the IRB approach will typically need to hold significantly lower capital, he said.