Question

It is suggested that the initial exclusion of market risk from capital requirements and high regulatory costs in the Basel I Accord, encouraged banks to shift their risk exposure (via securitisation) from priced credit risk to unpriced market risk. Do you agree? Discuss with examples.

Answer 1

Yes, I do agree and in fact strongly agree with the proposition that the initial exclusion of market risk from capital requirements and high regulatory costs in the Basel I Accord, encouraged banks to shift their risk exposure (via securitization) from priced credit risk to unpriced market risk.

As Basel I did not have any provisions for market risk it was basically ‘unpriced’. Absence of market risk from capital requirements encouraged banks to seek comfort in the process of securitization and then eliminate its high quality loans and replace it with low quality loans on their books. The risk management process and risk mitigation tools were ignored and so banks indulged in regulatory capital arbitrage to maximize their gains. This approach was hollow and not a foolproof approach.

To give an example banks developed financially engineered products lime MBS (mortgage backed securities). In this method sub-prime assets were repackaged as securities and this eventually led to the financial crisis of 2007-08. To further elaborate on the example banks failed to systematically differentiate between high quality and low quality commercial credits because there was no capital charge for market risk exposure.