The awakening of environmental awareness and the strengthening of environmental legislation in the industrialized world in the 1970s and 1980s led to increasing public resistance to hazardous waste management, as IT is called NIMBY (Not In My Back Yard) syndrome – and to escalating disposal costs. This has led some operators to seek low-cost hazardous waste disposal solutions in Eastern Europe and developing countries, where environmental awareness was much less developed and rules and implementation mechanisms were lacking. It was in this context that the Basel Convention was negotiated in the late 1980s, and its objective, when it was adopted, was to combat “toxic trafficking,” as it was called. The convention came into force in 1992. The Basel Agreements, the most influential plan for international banking reform, provide both a key framework and a controversial framework for managing credit risks for global banks. Agreements offer opportunities for regulators and bank management to expand to mitigate and possibly prevent credit risks. To what extent do the Basel agreements provide guidance on how bankers can properly manage credit risks? How effective are credit risk management methods under the auspices of the Basel Agreements? These are the central issues that are addressed in this chapter. Basel I had indirectly led international banks in allocating financial resources. Banks were clearly and strongly encouraged to invest in government bonds (zero at very low risk charges), regardless of the actual risk profile of these exposures, and were encouraged to be exposed to the mortgage market rather than to the SME and unskilled segments. These regulatory treatments have triggered bad incentives and sowed the seeds of major problems in the future in the mortgage market in the United States and in the government bond market in Europe. The simplified and partial “on” approach inherent in its architecture only takes into account credit risk, voluntarily leaving out many other risks that are more important in today`s banking activities. With respect to credit risk, the use of four distinct categories to weigh credit risks for capital charges does not provide sufficient granularity to assess or distinguish the various credit risks and other risks inherent in bank portfolios, including to respond to the activities of the most complex organizations. This limited differentiation between risk levels means that calculated capital ratios are often informative and can provide misleading information about a bank`s capital adequacy relative to its actual risk profile.
The limited differentiation between risk levels has prompted banks to participate in “gaming” by creating regulatory arbitrages through asset securitization and other innovative financial instruments such as credit derivatives (credit swaps, secured debt, loans, bonds, bonds, etc.). The general idea behind these new instruments is to allow banks to act on their credit risk positions in order to transfer risk to other financial players in the market.38 In other words, with these new instruments, banks tend to act against any regulatory capital requirements greater than what the market requires.