Question

Does the Basel II Accord deserve its share of the blame in the run up to the financial crisis of 2007?

Those who say “no” however point to shortcomings of Basel I Accord as the possible reason. At a time when countries had just begun the implementation of the Basel II Accord, the remnants of the Basel I era, with its lack of sensitivity and inflexibility to rapid innovations, could have created perverse regulatory incentives to simply move risky exposures off balance sheet, without really assessing the adequacy of capital to meet the risk exposures.

Those who say “yes” feel that the financial crisis merely exposed the deficiencies in the “vastly improved” Basel II. What were the limitations of the Basel I?

One, it made a quantum leap from the relatively simple Basel I to include a degree of complexity that proved a challenge to both the regulators as well as the banks.

Two, external ratings provided by rating agencies played a critical role in Basel II. Since ratings agencies were assigned specific blame, for the financial crisis, the basic premises of Basel II were also questionable.

Three, the standardized and advanced approaches operated under certain assumptions may not be applicable to all countries adopting the Accord. Hence, the onus was on the regulator of each country to assess if the risk weights assigned were applicable to the country’s context.

Four, the Accord allocated higher to higher credit risk. This led to the concern that small businesses and the less prosperous sections of society, typically considered high credit risk segments, would attract unaffordable rates of interest. This concern is especially true for developing countries.

Five, the risk modelling approaches in the advanced approaches had limitations. It is unclear whether maintaining capital based on these risk models would ensure adequate amount capital to cover risks.

Six, the level of technological and computational competence that the approach presupposes may not be available with all banks and banking systems.

Seven, aligning disclosures under Pillar III to international and domestic accounting systems will be a challenge.

Eight, effective implementation of Basel II would require tremendous upgrading of skills of both supervisors and banks.

Finally, an issue that has been discussed widely is that of pro-cyclicality. When economies are doing well, the banks will lend more, probably to take more risks for better returns and maintain adequate capital. However, when business cycles take a downturn, banks downgrade the borrowers due to increased likelihood of default and therefore, have to maintain more capital. This leads to capital shortage, as well as restriction in credit and therefor, leads to further deterioration in the economy. The Basel Committee acknowledges that risk based capital requirements could inevitable lead to pro-cyclicality, but this problem could be addressed by different instruments.

In November 2008, the Basel Committee admitted that its proposed Accord had to be more comprehensive to address the fundamental weaknesses exposed by the financial crisis related to regulation, supervision and risk management of internationally active banks. In 2009, the committee had already brought out documents amending Basel II Accord.

REQUIRED:

1. Why is the set of rules like Basel II blamed as the cause for a global financial meltdown?

2. How can another set of rules like the Basel III remedy the situation?

3. How successful will Basel III be in averting future financial crisis?

Answer 1

1. Basel II was blamed because banks and firms financial health was based on the fact that they were rated at a good rate by ratings agencies, which is what Basel II gave inportance for, but these banks ultimately failed even when they were graded at investment levels as per the ratings agencies, this showed deficiency. To summarise, Basel II was formed to ensure credibility in the banking system and as a fullproof mechanism to avoid bankruptcies, but there were several limitations which ultimately led to the fall in the banking system.

2. Basel III addressed the shortcomings which were prevalent in the banking system and the previous accord, the need to raise the quality of capital held by banks which will allow the bank to remain solvent. More strong liquidity requirements such as holding more liquid capital which will be easily convertible to cash. An improved level of risk coverage so that risk weights are assigned wherein they are considered low risk assets during normal conditions and high risk during economic stress, such as trading book, repos. Capital conservation buffer ensured that there is no inappropriate distribution of capital dividends. Introduction of leverage ratio and countercyclical capital charge so that the credit growth rate is measured against the GDP growth rate. Higher levels of stress testing on regular basis. This will ensure timely intervention and providing relief or bankrupty opportunities on timely manner.

3. Basel III addresses liquidity concerns and focuses on global liquidity ratio standards so that global banks don't face headwinds and shocks. But the success depends on whether it is implemented globally and its steps are followed by everyone, there will be country specific inputs which might dent the complete implementation of this accord as several countries don't adhere to it fully. If this is done, then it reduces the chances of its effectiveness, however banks would be able to address liquidity concerns once all banks in the ecosystem follow these procedures and central bank maintains efficacy, which will hopefully avert global financial crisis if not nationwide.