An Unresolved Basel II Risk When Basel II goes into effect it will be the biggest change in banking regulation in the past twenty years. No only is its impact potentially immense, but its very complexity makes the nature of its impact hard to predict.

One area that causes me some concern relates to the differing capital charges for low rated credits between Standardized Basel II banks and Internal Ratings-based Approach banks. Careful internal ratings-based analysis can yield significantly higher capital charges for low quality credits than would be applied using the standardized approach. Thus, there is a ready-made regulatory capital arbitrage in transferring such credits to banks using the standardized approach from those using one of the internal ratings-based approaches. This has the potential to concentrate such risky assets in smaller less sophisticated banks that are arguably least able to manage them effectively. This issue has been raised by many analysts during the extended deliberations on Basel II, but to the best of my knowledge it has never been effectively resolved.

I am interested in what you think will be the impact of this obvious arbitrage. Will supervisors attempt to limit it impact by quantitative controls or moral suasion? Will such transfers actually lead to undesirable concentrations of risky credits in smaller banks? If so, does it threaten the long-term viability of such small banks? Perhaps most importantly, will it restrict the available funding for new emerging companies by making such lending unattractive for major sophisticated banks? If so, will other less heavily regulated institutions simply step into the vacuum? Will capital market instruments such as CLOs become the major source funding for small emerging company debt? The list of future uncertainties raised by this differential regulatory capital treatment is long indeed.