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?