Question

5. Outline the features of Basel 1 and Basel 2 which in your view contributed to the financial crisis.

Answer 1

Basel I and Basel II - These are the agreements on frameworks for assessment of the bank's capital adequacy, which helps in ensuring the strength and soundness of banking systems and in equalizing the cross-border competition between banks. It provides an effective framework that helps banks in assessing their capital adequacy.

At the time of financial crisis, it was triggered by inadequate control of risks, malpractice and regulatory failures, and also shows the failings in the supervision and regulation of the international financial system, so Basel II act against different bank risks by enhancing banks to hold the minimum capital adequacy ratio. It also includes standards for the management of banks’ liquidity risk.

Basel I-

1. Capital serve as a buffer against credit risk and the capital constitute 8 percent of the risk-weighted assets of the banks. The weights reflects the credit risk of different classes of counter party.

2. Covers market risks- It allows banks to use their own models to measure the market risk. Under this banks uses the internal data in estimating the required capital to meet the market risk.

3. Strengthens the soundness and stability of the international banking system.

4. Reduces the competitive inequality among international banks.

Basel II-

1. It calculates the minimum regulatory capital requirements for credit risk that are based on the standardized and the Internal ratings approach.

2. Standardized Approach of Basel II-Credit risk is measured based on ratings that are provided by external credit assessment institutions.

3. Internal Ratings-Based approach-Banks use their own rating systems for the measurement of the credit risks.

4. Contains regulatory capital requirements for operational risks.

5. Concerns minimum capital requirements- promotes the adoption of minimum capital adequacy standards.

6. Has a powerful supervision-empowering supervisory agencies

7. Have an effective market discipline.