Question

QUESTION 1

Does the Basel II Accord deserve its share of the blame in the run up to the financial crisis of 2007?

Those who say “no” however point to shortcomings of Basel I Accord as the possible reason. At a time when countries had just begun the implementation of the Basel II Accord, the remnants of the Basel I era, with its lack of sensitivity and inflexibility to rapid innovations, could have created perverse regulatory incentives to simply move risky exposures off balance sheet, without really assessing the adequacy of capital to meet the risk exposures.

Those who say “yes” feel that the financial crisis merely exposed the deficiencies in the “vastly improved” Basel II. What were the limitations of the Basel I?

One, it made a quantum leap from the relatively simple Basel I to include a degree of complexity that proved a challenge to both the regulators as well as the banks.

Two, external ratings provided by rating agencies played a critical role in Basel II. Since ratings agencies were assigned specific blame, for the financial crisis, the basic premises of Basel II were also questionable.

Three, the standardized and advanced approaches operated under certain assumptions may not be applicable to all countries adopting the Accord. Hence, the onus was on the regulator of each country to assess if the risk weights assigned were applicable to the country’s context.

Four, the Accord allocated higher to higher credit risk. This led to the concern that small businesses and the less prosperous sections of society, typically considered high credit risk segments, would attract unaffordable rates of interest. This concern is especially true for developing countries.

Five, the risk modelling approaches in the advanced approaches had limitations. It is unclear whether maintaining capital based on these risk models would ensure adequate amount capital to cover risks.

Six, the level of technological and computational competence that the approach presupposes may not be available with all banks and banking systems.

Seven, aligning disclosures under Pillar III to international and domestic accounting systems will be a challenge.

Eight, effective implementation of Basel II would require tremendous upgrading of skills of both supervisors and banks.

Finally, an issue that has been discussed widely is that of pro-cyclicality. When economies are doing well, the banks will lend more, probably to take more risks for better returns and maintain adequate capital. However, when business cycles take a downturn, banks downgrade the borrowers due to increased likelihood of default and therefore, have to maintain more capital. This leads to capital shortage, as well as restriction in credit and therefor, leads to further deterioration in the economy. The Basel Committee acknowledges that risk based capital requirements could inevitable lead to pro-cyclicality, but this problem could be addressed by different instruments.

In November 2008, the Basel Committee admitted that its proposed Accord had to be more comprehensive to address the fundamental weaknesses exposed by the financial crisis related to regulation, supervision and risk management of internationally active banks. In 2009, the committee had already brought out documents amending Basel II Accord.

REQUIRED: 1. Why is the set of rules like Basel II blamed as the cause for a global financial meltdown?  

2. How can another set of rules like the Basel III remedy the situation?              

3. How successful will Basel III be in averting future financial crisis?                

                                                                                                                            

Answer 1

Answer :

1)

The Basel Committe made an accord to regulate the international banking system in 2004. This was made to decide the amount of funds the bank needed to keep in its reserve at all times to ensure its safety. The higher the risk the bank is willing in terms lending money to the people the higher capital it needs to have to maintain the economic stability of the bank. The accord has made an attempt to solve these problem. The three pillars on which this accord stands are: Minimum Capital Requirements, Supervisory view, market discipline.

The reason for recent of collapse banks is attributed to the average level of capital required which was inadeqaute.

Remarkable losses were caused due to the interaction with fair value accounting in intermediaries portfilios

Business cycle flucuations were reinforced because of the capital requirements being cyclical

Non banking institutions were given he duty to assess the credit risk of the money the bank was about to lend

A widely accepted fact that internal models of bank are the best at running risk rates efficiently and accurately was proven wrong

2)

Basel II received a lot of criticism from the world of economics as a failure and the reason for the financial global crisis of 2008. To the complains the response of Basel Commitee was to establish a new accord to slove the problems known as Basel III to remedy the damage caused. The five significant points were:

a) Better quality of regulatory capital

b) Better liquidity management and supervision

c) Better risk management

d) Promoting transparancy through balance sheets

e) An international supervisory cooperation

3)

The third Basel accord was made to remove all the short comings of the second accord and also to deal with the financial crisis prevalent after 2008. This accord was earlier implemented in 2013 and due to its success it was reimplemented uptill 2020.

Based on the succes of this accord certain assumptions can be made about the future use of this accord. The main purpose of this accird was to strengthen banks against the risks invloved with lending , by requiring the details about liquid assets holding and funding stabiliy. The Basel III accord will not be a good option to avert the future financial crisis.

If we see the current economic condition in the lock down due to the pandemic the world needs an economy that is easy going and where money is flowing smoothly. But the accord makes the banks rigid in their lending policies. The leverage ratio set in the accord restricts the expansion of banks and equity limits the assets. The effect is slower economic growth on a global level.

The slow economic growths cause deep wounds on the economy. sometimes making it impossible for the global economy to heal itself from the damage caused. When the progress was slowed in a healthy and working world. The damage in the economic lockdwon will only increase and the accorcd has no provisions to handle the situation.