Question

One of the most important concepts discussed in the text is the moral hazard problem. Even though this problem cannot be eliminated completely, it can be reduced through various actions such as the Basel Agreements.

Submit a summary of these agreements (Basel I, II, and II) using the Web site of the Bank of International Settlements. Briefly explain the moral hazard concept and summarize the three pillars of the Basel Agreements, which are:

a. Minimum capital requirement

b. Supervisory review process

c. Market discipline

Answer 1

Moral Hazard- Moral hazard is a situation in which one party gets involved in a risky event knowing that it is protected against the risk and the other party will incur the cost. It arises when both the parties have incomplete information about each other.

In a financial market, there is a risk that the borrower might engage in activities that are undesirable from the lender's point of view because they make him less likely to pay back a loan. It occurs when the borrower knows that someone else will pay for the mistake he makes. This in turn gives him the incentive to act in a riskier way. This economic concept is known as moral hazard.

The three pillars of BASEL agreements are:

1. Minimum Capital Requirement- A capital requirement is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent. Under Basel III, the minimum capital adequacy ratio that banks must maintain is 8%.

The capital adequacy ratio is calculated by adding tier 1 capital to tier 2 capital and dividing by risk-weighted assets. Tier 1 capital is the core capital of a bank, which includes equity capital and disclosed reserves. This type of capital absorbs losses without requiring the bank to cease its operations; tier 2 capital is used to absorb losses in the event of liquidation.

2. Supervisory Review Process- The second pillar considers the method in which banks and central banks should review the implementation and usage of BIS II. This pillar requires banks to develop their risk management beyond the minimum requirements set out in pillar one. Additional risk types such as interest rate risk should be incorporated in this more comprehensive risk management system.The supervisory review process of the Framework is intended not only to ensure that banks have adequate capital to support all the risks in their business, but also to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.

3. Market discipline- Market discipline is the onus on banks, financial institutions, sovereigns, and other major players in the financial industry to conduct business while considering the risks to their stakeholders. Market discipline is a market-based promotion of the transparency and disclosure of the risks associated with a business or entity. It works in concert with regulatory systems to increase the safety and soundness of the market. New market discipline mechanisms have taken root, including enhanced reporting measures, audits, better internal governance (including a diverse mix of independent board members), higher collateral and margin requirements, and more intense supervisory actions.