The Role of Basel II in Causing Financial Crisis

September 20, 2011

The recent financial crisis called for reforms and revision of regulations and supervision on international and national basis. The regulatory standards in these economies were strengthened through the adoption of Basel II Capital Standards and the Basel Core Principles for Effective Bank Supervision (BCPs). Despite this the crisis emerged in the economies where the regulations and supervision were thought to be the best in the world. This crisis exposed the weaknesses in regulatory and supervisory frameworks and provided the basis of debate about the roles these have played in causing and aggravating the crisis. So this is the top priority for decision and policymakers and many countries are working to upgrade their regulatory and supervisory frameworks, although inevitably this has to be a multilateral arrangement if it is to succeed.

The latest Basel III proposals from the Basel Committee have been put forward to strengthen the banking system and to avoid future financial crises. These proposals require the banking sector to raise far more capital than is presently the case in response to the global financial crisis. Under the new proposals when implemented will generate a funding requirements of more then one trillion euros for European Banks as a whole. The costs will be borne mostly by the relatively undercapitalized banks in Germany, France, Spain and Greece.

The key areas covered by the Basel III proposals are Tier I Capital Base, Minimum Liquidity Standards, Leverage Ratios, Counterparty Credit Risk – Derivatives, Repos and Securities and Countercyclical Capital Buffers. The committee intends to raise therefore both the quantity and the quality of the capital base to enable banks to absorb losses in crisis period. It also introduces a minimum liquidity standard for banks to meet their liquidity requirements for 30 days under any ‘acute’ liquidity situation. Under these proposals leverage ratio introduces additional safeguard against risk and measurement error. The committee also proposed to strengthen capital requirements for counter party credit risk exposures arising from derivatives, repos and securities financing activities. It also proposed building up capital buffers in good times that can be drawn down in periods of stress.

Over past 25 years capital adequacy has been a dominant form of regulation for maintaining the safety of banks. The rational for holding regulatory capital was to provide buffer for banks against expected losses and disincentive excessive risks by banks owners and managers where standards are not tight enough banks will not have sufficient capital to cover their losses and liabilities will outweigh assets rendering the banks insolvent. But holding capital requirements for banks comes at a cost as they have to forgo the profit that they could have earned while investing the funds into profitable avenues.

The 1988 Basel accord set minimum capital requirement of 8 percent of the value of assets. Assets were assigned risk according to the identity of borrowers. Corporate bonds were assigned a risk of 100 percent while government bond was assigned a risk weight of 0 percent.

In 1990s the accord was taken as costly by banks as they identified the gap between economic capital they should keep aside and the regulatory capital assigned to these loans by the accord. For example the risk assigned to Blue Chip Company was same as risk assigned to retail customers’ loan and risk to loan to a large industrial country was same as a risk assigned to loan to a volatile emerging market. This induced the banks to move to risky assets with higher return within a given risk category and to securitise their assets. This eventually resulted in the reduction in the capital levels in the late 1990s.

Basel II introduced the “advanced internal rating based approach” (A – IRB) where banks were allowed to use their own models to review credit risk exposure. The idea was to reduce the regulatory arbitrage and closely align economic and regulatory capital. Basel II also tackled the area of market risk and encouraged the banks to use their own model to estimate ‘value at risk’ (probability that value of given portfolio will decline by certain amount within a specified time period).

In 2006 banks recorded overall capital reduction of 15.5 percent and reduction in Tier 1 capital of 31 percent. Federal Deposit Insurance Company (FDIC) found out in 2003 that average capital reductions in Americans banks fell by 18 – 29 percent with some reduction more than 40 percent. The accord also did not increase the competition among banks as large banks were able to free up capital and allocate it to profitable areas while small banks recorded increase in capital requirements loosing market share and making them more vulnerable to the financial markets.

The A-IRBS had huge impact on level of capital held by banks because internal rating based approach data was derived from historical data. In accordance with historical data capital that should be set aside for certain types of assets was much lower than stipulated byBaselI. Also the past default rates are not a good indicator of future default rates.

Basel II was also lenient in the treatment of asset securitisation in term of assigning a suitable capital charge for asset backed securities tranches to external credit rating. In the initial proposal committee proposed that AAA or AA- would carry a 20 percent risk weight, A+ or A- a 50 percent risk weight, BBB+ to BBB- 100 percent risk weight, BB+ to BB- 150 percent and B+ or below a deduction from capital. But in the final paper risk charge was at very low levels. Risk weight for AAA was 7 percent, AA 8 percent, A+ 10 percent, A 12 percent, BBB 35 percent and BB 60 percent.

This fuelled the lending in the mortgage sector due to low risk weights assigned for residential mortgages. For standardized banks mortgages risks were cut by 15 percent and for A- IRB banks the drop was between 60 percent to 90 percent. Mortgage portfolio was 75 percent of total asset base of Northern Rock.  When Northern Rock adopted advanced rating based approach in 2007 its risk weighted asset almost halved. At the time of collapse of Northern Rock, it has capital amounting to 2 percent of total assets despite complying with Basel II. Basel II also fuelled off balance sheet financing because of low risk associated with Asset Backed Securities.

Basel principles were one of the main contributing factors in causing the crisis. Basel III proposal will increase the capital requirement of the banks’. This will  lead to more lending cut by the banks that will hamper economic growth.


The Consumption and Saving Trend of the UK Households’

September 14, 2011

I wrote this article for Positive Money. It was first published on the Positive Money Website on September 14, 2011. You can also read it on I am publishing this on my blog so that people who access to my blog read this as well.

Households saving is the proportion of disposable income that is not spent on consumption, or alternatively the difference between current income and current consumption. Households’ decisions to save or spend plays a key role in the determination of aggregate demand and their willingness to spend on final goods and services. It has a key effect on economic outlook of the UK because 60 percent of contribution in the consumption of the UK is by consumer sector. The saving ratio of the UK fell steadily from 1995 – 2007 but increased by the end of 2008 and 2009. The output of the UK also fell over 5 ½ percent in 2007.

Berry and Williams in their paper “Household Saving” explained that either saving or debt can be used to accumulate assets by households. They used the following equation to explain this:

S+D = A+H


S= Saving


A=Financial Assets (deposits and shares)

H= Housing Assets

This means that households can acquire financial assets or housing assets by saving or by obtaining debt. In practice some of the households will be obtaining debt to increase the amount of funds for consumption and some of the households will be saving. But during the last decade saving ratio of the UK households has decreased and household debts have increased markedly.

Saving ratio in the UK has declined since 1992 as the household sector increased its consumption expenditure. The increase in rate of consumption was greater than the increase in disposable income which means that households acquired huge debt to finance their consumption expenditure. Following figure shows the decline in consumption of households in 2007.

The households saving ratio declined from around 10 percent in the mid – 1990 to around 2 percent in mid 2007 and then -0.7 percent in 2008. It then increased to 4 percent in 2009. The following figure shows the actual saving ratio and inflation adjusted saving ratio.

 The households saving ratio declined over last decade due to low interest rates, low inflation, excessive lending by banks to households sector, loose credit conditions, high asset prices and an economic boom (naturally fuelled by debt).

According to the modern consumption theory, which is based on Friedman’s “life-cycle permanent income” model, households decide on their current spending on their expected future income. If they expect the income to be higher today than in future than they will save today and if they expect the income to be lower now than expected future income than households will ‘dis-save’ (by borrowing or using ‘saving’ assets for consumption). [Of course, this theory is very much open to dispute – ed.]

The ‘risk-free real interest rate’ is also one of the key determinants of the households consumption and saving. In economic conditions with low interest rates, the saving ratio is also low because the households are able to borrow  easily to fund their consumption (because increase in house prices provide more collateral against which they can borrow more). A higher real interest rate encourages consumers to spend less at the moment to maintain their real value of money by saving higher interest receipts.

Over a last decade long term interest rate of the UK was at historically low levels making possible for households to obtain credit easily. The spread between bank rate and mortgage rates narrowed to around 50 basis point from 100 basis points at the end of 2006. This encouraged the households to increase their consumption and reduce savings.

The increase in consumption and decrease in saving of households was not a result of their expectation of high future income but due to easy availability of credit. Banks played a crucial role in influencing consumption and saving pattern of the households. The excessive lending by banks  in the form of secured (mortgage) and unsecured (credit cards, overdrafts etc) encouraged the borrowers to increase their consumption and decrease saving over last ten years period. The consumption and saving trend reversed during economic slowdown.

Households decisions to save or spend are dependent on their expectation of future economic growth and easy availability of credit. Households increased their saving during the financial turmoil because they were uncertain about future positive growth prospects, non-availability of credit in the economy, increased job uncertainty, decrease in net financial wealth, and lower expected future income.

Increase in unemployment and low future expected income was major causes that encouraged households to increase their savings and cut consumption. Unemployment in the UK increased sharply during the financial crisis. Unemployment rate rose over 2 ½ percentage points over the past two years. Households expected increase in unemployment and prolonged period of economic slowdown so they cut their spending. Following figure shows the households expectation of unemployment.


GDP growth of 0.2 percent in the second quarter caused households to revise their expected future income. Following figure shows that households are expecting to have low future income.

Due to financial turmoil and uncertain future economic conditions consumers responded by cutting back their consumption / spending. Households are now trying to save for debt repayment and to maintain their real value of money. This adjustment in saving will have important consequences on the economic outlook keeping in mind the role of households spending in the aggregate demand.

Reduction in consumption by households will push down economic outlook and eventually households income because businesses will cut their capital spending that leads to low job creation in the economy. The drag on households income will make it harder for them to increase their saving which mean that we don’t see increase in consumption by households in near future.

If banks continue to invest in mortgages and speculative investments we will soon be witnessing another economic boom and bust. Banks should invest in productive sector of the economy particularly to Small and Medium Businesses that contribute to the economic development, create employment opportunities, increase saving of households, lead to stable consumption and spending in the economy and reduce vulnerability of output in the economy and for businesses.