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 II 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

(1): The set of rules like Basel II is to be blamed as the cause for a global financial meltdown because of its inherent structural weaknesses that skewed the risk profile and exposure of various banks and financial institutions. There were a number of flaws in Basel II and this provided the atmosphere for the financial crisis that occurred. The risk modelling approach of Basel II was not systematic and this led to a situation in which banks, even after maintaining capital levels as determined by Basel II, were not able to mitigate their risk exposure. The various structural weaknesses of Basel II encouraged pro-cyclicality which finally led to the global financial meltdown.

(2): Another set of rules like Basel III can remedy the situation by ensuring the shortcomings and weaknesses of the Basel II rules were rectified and improved upon. Risk exposure of banks will become systematic under the new set of rules and with proper risk mitigation system in place the entire banking and financial sector will become stronger on one hand and efficient on the other hand. Focus will be on quantity and quality of capital of banks along with stronger supervision.

(3): Basel III will be highly successful in averting future financial crisis. This is because the strong and robust set of risk control mechanisms will ensure that a toxic environment that led to global financial crisis in past does not develop again in future. It will also not allow any financial bubble to develop in the economy and it will also not allow banks and financial institutions to support such bubbles. Stringent risk management and disclosure standards will ensure that Basel III will be highly successful in averting future financial crisis.