Question

the moral hazard problem can be reduced through various actions such as the Basel Agreements. Submit a brief summary of these agreements (Basel I, II, and II). 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

(you can use the Web site of the Bank of International Settlements)

Answer 1

Moral Hazard- Moral hazard is the risk that a party has not entered into a contract in good faith or has provided misleading information about its assets, liabilities, or credit capacity. In addition, moral hazard also may mean a party has an incentive to take unusual risks in a desperate attempt to earn a profit before the contract settles.

Basel III is an international regulatory accord that introduced a set of reforms designed to improve the regulation, supervision and risk management within the banking sector

The three pillars of BASEL agreements are as below;

1. Minimum capital requirement- A capital requirement is the standardized requirement in place for banks and other depository institutions that determines how much liquidity is required to be held for a certain level of assets. 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

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. Furthermore it dictates that the BIS II framework should be an integral part of the banks activities. This means for instance the banks general management should be aware of BIS II and should be involved in the decisions surrounding BIS II.

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. In the absence of direct government intervention in a free market economy, market discipline provides both internal and external governance mechanisms.