Question

Looking at the below article, answer the following:

What flaws in Basel I did Basel II attempt to remedy and what provisions did it make for doing so? What short-comings in bank capital regulation remain?

The Rise of Basel II
Soon, a variety of inherent flaws in Basel I’s treatment of
capital became apparent. First, the relationship between
assets’ actual revealed default risk and their risk weights
proved to be less reliable than had been thought. For
instance, all bonds issued by countries that were members of
the Organization for Economic Cooperation and
Development (OECD) were given the same weight even
though doing so might have downplayed the very real
differences in the risk of defaults among these countries or,
conversely, possibly overstated the difference in default risks
between OECD and non-OECD countries.
Second, the Basel methodology was too crude. It simply
summed the risk weights to construct a measure of overall
capital risk, but that is a poor proxy for actual risk. Doing so
does not take into account the overall portfolio risk of
the bank and the formula made no room for management strategies that could reduce that overall risk. Abank portfolio
can indeed be more or less risky than the mere sum of
its parts might indicate because of the correlation among
assets.
Third, the broad categories were lumped together, and
assigned a single weight to a variety of assets that in reality
exist along a spectrum of risk profiles. A loan to a startup
company, for instance, was treated the same as one to an
established Fortune 500 company. As such, banks investing
the same share of their portfolio in either asset would have
identical mandatory capital set aside. This creates an incentive
for a bank to invest in high-yielding assets in the risky
end of the spectrum without having to make a corresponding
expansion of their capital cushion. This sort of activity
could over time increase the overall risk of a bank’s portfolio
although it would still meet Basel I standards.
In January of 2001, a second set of Basel standards —
called Basel II — attempted to remedy these problems.
(The implementation by the Federal Reserve began in the
fall of 2006.) The first big change altered the risk weight. By
using the ratings issued by credit rating agencies like
Standard and Poor’s and Moody’s to determine the potential
risk of default, Basel II set up a system by which assets within
each broad “risk bucket” could be further classified.
The second big change was a new method by which risk
profiles could be measured. Instead of forcing all banks to
abide by the specific numeric standards set forth in Basel II,
certain banks could opt out. In place of the top-down
approach, the “internal ratings based” approach — available
only to sophisticated banks with the resources and knowledge
base to develop an internal rating with a mathematic
model — allowed some banks to estimate the necessary size
of their own capital cushion.
Both changes were aimed at answering the critics who
stated that the original Basel standards did not integrate any
market-based mechanisms for evaluating risk. Yet these
changes seem to have proven flawed as well. The grades
awarded by the ratings agencies for some mortgage-backed
securities, for instance, have been shown to be less reliable
than originally hoped. Some argue it’s hard to make a case
that a handful of firms which are largely insulated from competition
by the Securities and Exchange Commission, as the
“Big Three” ratings agencies are, could be considered a sufficient
market-based mechanism. (For a detailed analysis, see
this issue’s cover story on page 14.) In addition, allowing banks to set their own capital
requirements doesn’t seem to acknowledge the current state
of the science of risk management. It has become apparent
that the models of risk used by many banks may not have
been sufficiently robust to anticipate the potential default of
complex new asset-backed securities.
There has been some discussion within the Federal
Reserve about how to overcome the incentive a bank would
have to lowball their capital requirement estimates. One way
to create an incentive for banks to be as honest as possible is
to require them to precommit to a maximum loss exposure and corresponding capital buffer. If the bank’s losses exceed
the declared maximum, the bank supervisor would levy a
fine on the bank.
A criticism of the precommitment approach centers on
the ability and willingness of a regulator to assess fines. For
the fines to be a credible threat, they must be large enough
to spur action by the bank. But if an economic shock were to
reduce a bank’s soundness, a regulator might feel compelled,
if he believed the shock to be temporary, to avoid assessing
the fine if doing so would result in the bank’s failure. Yet the
failure to issue a penalty, especially if it is sufficiently steep
for the precommitment regime to work, would severely
restrict the credibility of the regulatory threat in the future.

Answer 1

SOLUTION =

IN BREIF WHAT IS BASEL >

BASEL COMMITTE ON BANK SUPERVISION , WHICH DECIDES RECOMMENDATIONS ON BANKING REGULATIONS IN RESPECT OF CAPITAL RISK, MARKET RISK AND OPERATIONAL RISK.CAPITAL ADEQUACY IS THE MAIN FOCUS OF THE COMMITTEE. IT RECOMMENDS THE MINIMUM REQUIRED CAPITAL TO MINIMIZE THE CREDIT RISK. ONE OF THE IMPORTANT MOTIVE OF BASEL NORMS IS TO STANDARDIZE THE BANKING ACROSS ALL COUNTRIES.BANKS THAT OPERATE INTERNATIONALLY ARE REQUIRED TO MAINTAIN A MINIMUM AMOUNT (8%) OF CAPITAL BASED ON A % OF RISK WEIGHT ASSETS.ITS MAINLY DEPENDS UPON CREDIT RISK BY CREATING A BANK CLASSIFICATION SYSTEM. THERE ARE 0%, 10%, 20%, 50% AND 100% RISK CATEGORY BASED ON DEBTOR'SCATEGORY.

EXAMPLE > BANK WITH RISK WEIGHTED ASSETS = $1000 MILLION

REQUIRED CAPITAL ( TIER I AND II) = 8% OF $1000 MILLION I.E. AT LEAST $80 MILLION.

FLAWS IN BASEL I AND RESPECTIVE REMEDIES IN BASEL II >

A) THE RELATIONSHIP BETWEEN ASSETS ACTUAL REVEALED DEFAULT RISK AND THEIR RISK WEIGHTS PROVED TO BE LESS RELIABLE THAN HAD BEEN THOUGHT. THE RISK WEIGHT ARE ONLY CONSIDERING CREDIT RISK AND IGNORED OTHER I.E. MARKET RISK , LIQUIDITY RISK AND OPERATION RISK WHICH ARE PLAY MAJOR ROLE IN INSOLVENCY EXPOSURE FOR BANKS. SECOND , THE BASEL METHODOLOGY WAS TOO CRUDE . IT SIMPLY SUMMED THE RISK WEIGHTS TO CONSTRUCT A MEASURE OF OVERALL CAPITAL RISK, BUT THAT IS A POOR PROXY RISK. THIRD THE BROAD CATEGORIES WERE LUMPED TOGETHER, AND ASSIGNED A SINGLE WEIGHT TO A VARIETY OF ASSETS THAT IN REALITY EXIST ALONG A SPECTRUM OF RISK PROFILES FOR EXAMPLE LOAN FROM BIG SUCCESSFUL COMPANY IS EQUALLY AS START UP COMPANY.

REMEDIES BY BASEL II>

THE BIG NEED TO CHANGE THE BASIS OF RISK WEIGHT.BASEL II HAS MORE REFINED GUIDELINES FOR CAPITAL ADEQUACY AND CONSIDERING RISK MARKET RISK AND OPERATIONAL RISK WITH MORE DISCLOSURE REQUIREMENTS.RISK WEIGHTS DECIDED BY THE EXTERNAL CREDIT AGENCIES ARE USED FOR CORPORATES AND BANKS ETC. THE SECOND BIG CHANGE WAS A NEW METHOD BY WHICH RISK PROFILE COULD BE MEASURED.SOME BANKS COULD OPT OUT USE OF CERTAIN SPECIFIC NUMERIC STANDARDS SET FORTH IN BASEL II AND GO WITH INTERNAL RATINGS BASED APPROACH (ONLY FOR SOME SELECTED BANKS.

SOME SHORT COMINGS WITH ABOVE NORMS>

RELIABILITY ON WORK OF EXTERNAL CREDIT RATING AGENCIES , THE RATING AGENCIES FOR SOME MORTGAGE BACKED SECURITIES FOR INSTANCE HAVE SHOWN TO BE LESS RELIABLE , HOWEVER IT STATED THAT THE DATA BASE OF THREE BIG CREDIT RATING AGENCIES COULD BE CONSIDERED SUFFICIENT. SECONDLY ALLOWING BANKS TO SET THEIR OWN CAPITAL REQUIREMENTS DOES NOT SEEM TO ACKNOWLEDGE THE CURRENT STATE OF THE SCIENCE OF RISK MANAGEMENT.THIS WEEKNESS WERE ACCOMPANIED BY POOR GOVERNANCE AND RISK MANAGEMENT, RESULT OF THESE FACTORS = 1) MISPRICING OF CREDIT AND LIQUIDITY RISK 2) EXCESS CREDIT GROWTH.

CREATE AN INCENTIVE FOR BANKS TO BE AS HONEST AS POSSIBLE IS TOREQUIRE THEM TO PRECOMMIT TO A MAXIMUM LOSS EXPOSURE AND CORRESPONDING CAPITAL BUFFER AND THE BANK FAILS THE BANK SUPERVISOR SHOULD LEAVY A FINE ON BANK FOR SECURE FUTURE OF BANKING.