Basel II seeks to align capital regulations more closely to banks’ current practices – it will not change the way that banks actually evaluate risk to decide whether to invest in emerging market economies. To understand this answer, we must first understand the issue that may have triggered this debate. One of the valid criticisms of the 1988 Accord concerns its rather arbitrary treatment of country risk. The 1988 Accord assigns risk weights, and hence capital charges, to sovereign governments and related borrowers, as well as to banking organisations, based on whether the country in question is a  BIS Review 33/2004  3  member of the Organisation for Economic Cooperation and Development. The “OECD Club Rule,” as it has become known, assigned a zero percent risk weight to exposures to sovereign government borrowers that were members of the OECD, which means that no capital had to be held against such sovereign exposures. In contrast, exposures to all other countries were assigned the standard 100% risk weight, which is equivalent to an 8% capital charge. The Club Rule was meant to help distinguish between higher and lower risk sovereign borrowers and their banks. In retrospect, it seems to be an unfair way to divide the world. Indeed, some OECD member governments have experienced serious economic shocks that threatened their repayment abilities, while several non-OECD member governments have performed extremely well in the international debt markets.
When the Committee set out to revise the 1988 Accord, we wanted to resolve the arbitrary treatment of country risk that the Club Rule introduced. Our solution in Basel II was to assign risk weights, and hence capital charges, to exposures to sovereign borrowers and to banks that reflected a measure of their credit risk. Banks on the standardised approach to credit risk will determine the risk weights on their exposures to sovereigns and to banks based on those borrowers’ external credit ratings. Banks adopting the internal ratings-based approach to credit risk will rely on their own sense of the credit risk involved. Basel II eliminates the arbitrary distinctions imposed by the Club Rule and sets capital requirements based on external or internal measures of credit risk. Yet some observers have assumed that a more risk-sensitive approach might drive up not just capital requirements, but also the pricing of credit for loans to emerging market countries and banks. This assumption is where the debate breaks down. Indeed, the arguments suggesting that Basel II will reduce flows of capital into emerging markets requires us to accept the view that regulatory capital drives loan pricing – something that has not been proven in any research. In fact, research and the Committee’s own discussions with banks suggest that something else drives loan pricing. When determining the price of a loan, banks consider all of the economic risks associated with a particular borrower.