Rules published this week by the Basel Committee on Banking Supervision in its third and final consultative paper will replace a set of rules from 1988, so-called Basel I.
Basel I enshrined a way for banks to assess credit risk, which many now consider primitive. Crucially, it draws no distinction between the amount of capital a bank needs to allocate for different types of corporate loans, regardless of risk level. An unintended consequence of this has been to encourage banks to make more risky loans. These necessarily carry better terms to compensate the bank for the greater chance of default but the amount of capital required is no different than on a safer loan. The return to the bank is therefore more attractive but the riskiness of the loan portfolio has increased.
