times leverage suggested by the 100% risk weight?<sup>4</sup> In any event, does even a 12.5 times leverage really do much to protect depositors in those transition economies populated by extremely sick state-owned enterprises? In addition, for most transition economies, it would be a fundamental error to classify bank loans to other banks in the moderate (20%) risk class although some set of inter-bank loans might sensibly be classified in this way.<sup>5</sup> The classification of all loans to the private sector as equally risky is also suspect in light of the uncertain environment for private business, as well, for example, as the fundamental differences between private start-ups and privatized enterprises. In general, even if one were able to fully and precisely implement the Basle recommendations for most transition economies, one would have little confidence that banks which met the recommended minimum were particularly "safe." And yet this is precisely what is done in almost all Banksupported credit lines where a Basle-type level of capital adequacy is the first of the eligibility criteria which participating banks need to meet.

7. **Practical Problems with Balance Sheet-based Regulation.** The problems of applying Basle guidelines to the transition economy banking sectors involve far more than the "correct" size of the capital adequacy ratio or the correct risk weightings. On the _assets_ side of the ratio, the valuation of bank assets is subject to a series of intractable difficulties, including the highly unpredictable fortunes of enterprises, excessively volatile taxation regimes characterized by the retroactive application of changes, shallow asset markets and unclear property rights, as well as the ongoing privatization programs. State-owned enterprise profitability is largely dependent on unpredictable political decisions, including the allocation of subsidies and the decision of whether, how and when to privatize.' And political as well as financial disincentives to recognizing loan losses provides a powerful inducement to avoid the proper characterization of bad and questionable loans.

8. Irreducible uncertainty applicable to the _capital_ component of this key ratio is no less troublesome. Large loans to insiders, (at times used to finance the purchase of shares as, for example, in the Russian FIGs), combined with inappropriate accounting procedures, leading to unjustified dividend payments, raise serious additional questions about the utility of capital as a cushion for loan losses. Even where capital is properly accounted for, excessive insider loans and violations of the large exposure

> ' Steinherr and Gros suggest amending the measurement of capital and of risk-weighted assets to raise the risk weight for long-term claims on banks (from 20% to 100%), for claims on the domestic central government (from 0% to 20%) and for long-term claims on the corporate sector (from 100% to 150%)

> 5 Banks in both Russia and Ukraine learnt from mini banking crises in 1995 that inter-bank lending in an environment of poor quality information was extremely risky. Hence in both countries there were major losses in the inter-bank market and a subsequent significant decline in its size and importance.

> **6** It should be noted, in this regard, that the European Bank for Reconstruction and Development's 1996 Transition Report estimates that more than 50% of the medium- and large-scale enterprises in the FSU have not yet been privatized. And this figure does not reflect the substantial residual interests retained by governments in many "privatized" enterprises, an interest which raises the specter of continued political interference in these enterprises' operational decisions, and thus their profitability. _See generally_ EBRD, _Transition Report 1996 -- Infrastructure and Savings_ (1996), page 11.

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