The Role of Basel II in Causing Financial Crisis

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.

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