Size may have been the main motivation for greater consolidation in the banking and other sectors but the new financial architecture, known by the name Basle II, is likely to provide further impetus as it goes into effect next year and 2008. Moreover, this new complicated set of rules to be incorporated into national law has the potential to make the good corporate borrowers happier and the many firms assigned lower credit ratings less happy. A look back in history is useful in understanding what the new rules dubbed Basle II are all about. To ensure a more stable banking system, the large industrialized countries asked the Bank for International Settlements (BIS) to come up with a set of prudential rules to attain this goal. The first accord on international banking regulation was reached in Basle, the headquarters of BIS, in 1988 and was called Basle I. Of course, not all countries in the world adopted the rules. Even in the US, many institutions such as Savings and Loans, do not abide to Basle I, making some Europeans furious. After all, the stability of the banking system is good but having greater flexibility to make more money, even at the expense of taking higher risks, is precious. Having said that, one has to note that the large US banks with international operations adopted the Basle I accord. Loopholes The 1988 agreement was hailed as a milestone toward a safer international banking system but the quickly changing financial landscape rendered it less potent afterward as more and more banks started taking advantage of the loopholes, according to critics. The Basle I accord was based on a one-size-fits-all approach, focusing primarily on credit risk, wherein banks set aside 8 percent of their own capital when extending loans to creditors, distinguished between sovereigns, banks and corporations and their geographical origin. Under the Basle I accord, supranationals, such as the European Investment Bank (EIB), and countries belonging to the OECD (Organization for Economic Cooperation and Development) were not weighted. On the other hand, banks were assigned risk weights of between 20 percent and 50 percent, depending on their location, whereas corporations were weighted at 100 percent. So, a bank loaning 100,000 euros to a corporation would have to put aside 8,000 euros of its own funds, representing 8 percent of the total loan. This would imply banks extending loans to OECD countries, such as Greece, would not set aside capital for doing so because these countries had a zero risk weighting. However, banks would have to set aside their own funds when loaning to countries that did not belong to the OECD even if some of them had better sovereign credit ratings. The latter were weighted at 100 percent. In addition, bonds issued by banks in OECD countries were weighted at 20 percent. Under the new accord, termed Basle II, this is going to change since banks will calculate minimum capital requirements by assigning a risk weight to assets, taking into account each customer’s credit risk profile. In the new scheme, risk weights will be derived either from the credit ratings of borrowers assigned by international rating agencies, such as Standard and Poor’s, Moody’s and others, or rely on complex formulas provided by the Basel Committee. Moreover, banks will now charge for operational risk referring to human errors or fraud. The new financial architecture recognizes that some banks may not have the technology and the know-how to measure and account for the money, credit and operational risks. It gives them therefore the option to stick to the less sophisticated, so called «standardized» method which relies a lot on the previous Basle I scheme, except for linking capital set aside with the credit rating of debtors instead of their geographical origin. Small Greek banks are expected to take this option because they are not yet ready. On the other hand, the large banks are expected to opt for a more sophisticated method, called «the internal ratings based» (IRS) approach which relies on internal risk appraisal systems. This method gives them the advantage to price a risk more leniently provided they convince the Bank of Greece. Large banks benefit Bankers who are aware of the mechanics and the pros and cons of the two methods say the application of the new financial architecture will favor large banks over small banks. This is so because large banks adopting the IRS method will be able to compensate for the extra charges of the newly introduced operating risk by lowering the risk weight for loans extended to highly rated customers. Overall, operating risk is expected to account for about 15 percent of total risk with credit risk accounting for the bulk 70 percent and the rest being market risk. According to their rationale, large banks will focus on good, highly rated customers, pushing bad credits to smaller banks which will have greater problems keeping their good clients because it will be difficult to match the loan rates of the large banks since they use the «standardized approach.» Facing this reality, small banks will have to think about either being acquired by another bank or merging with another. So, the new Basle II rules are expected to speed up consolidation in the banking sector. Nevertheless, even the large Greek banks will not be immune to the changes brought about by the new accord. In the short term, they may be winners in the home turf over their smaller counterparts. In the medium to long term, however, they may also be victims to foreign large banks with more sophisticated technology systems and people in place. But winners and losers from the Basle II will appear in the sector of small and very small Greek firms. Those firms with lower credit ratings will probably see their cost of borrowing increase, making them more vulnerable to competition. Moreover, some smaller firms may see, to their surprise, banks taking more easily the rug from under them for failing to service their loans.