Question

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 II?
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

(1): The set of rules like Basel II is being blamed as the cause for a global financial meltdown because of the inherent flaws and weaknesses of the rule which set the ground for a financial meltdown to occur. Basel II had underlying weaknesses with regards to its regulation, supervision as well as risk management framework. As pointed in the article above BASEL II was weakened by various inherent flaws and one of the main reasons was its regulatory capture i.e. de facto control of the regulatory agency by some regulated interests. This enabled large international banks to reduce their capital levels and hence risks that were important for systematic financial stability were largely ignored. This combined with other factors like non-standardization of risk weights, limitations of risk modelling approaches, etc. all lead to pro-cyclicality. In pro-cyclicality when the economy takes a downturn then banks change their business model and this leads to capital shortage and hence the economy takes further battering.

(2): Another set of rules like Basel III can remedy the situation by plugging in the gaps and removing the inherent flaws in the Basel II set of rules. For starters Basel III should have a stricter definition of capital and this will improve as well as raise the quality of capital that is held by banks. Secondly focus should be on improving as well as enhancing the level of risk coverage for banks. Thirdly the liquidity requirements of banks will have to be strengthened and banks will have to be required to hold more liquid capital. Thus another set of rules like Basel III will have to ensure that the rules are enhanced and given more teeth so that there is a structural control of banks and their risk exposure.

(3): Basel III can be highly successful in averting a future financial crisis. This is because it has put in place a framework that is comprehensive and fills in all the gaps that previously existed. It has taken steps to ensure that the problem of pro-cyclicality do not occur going forward. It has also put in place distribution policies that are largely consistent with sound capital conservation principles. The systematic risk is dealt with aptly through introduction of various macro-prudential measures and all this will make Basel III capable of being successful in averting a future financial crisis.