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.

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The Future of Basel III

August 22, 2011

The financial crisis called for reforms and revision of regulations and supervision on international and national basis. The regulatory standards in the 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 policy makers 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 reduce risk of future financial crises. These proposals require the banking sector to raise far more capital in response to the global financial crisis. Under the new proposals the banks will have to maintain core capital ratio of 6 percent (formerly 2 percent before). Now the question arises would the increase in capital ratio would prevent financial crisis in future? Is the current crisis due to decrease in core capital ratio? 

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.

Capital standards designed to fortify the global financial crisis are eroding due to the debt crisis in the Euro zone, and the US. The U.S.economic growth for the first quarter was revised down to 0.4 percent, while the second quarter’s initial figure was 1.3 percent. In Europe, gross domestic product fell from 0.8 percent in the first three months of the year to 0.2 percent in the second quarter. . Concerns about   payments, and debt problems of Italy and Spain also darkened the prospects of Basel III. European Commission estimated that European Banks will have to raise about $500 billion in new capital to meet new capital rules that will hamper their ability to lend. The cost will be borne mostly by the relatively undercapitalized banks in Germany, France, Spain and Greece.

The European banks cannot raise required capital as required by Basel III and the US banks have also reversed course. Another question is regarding the quality of capital that would the quality of capital be able to meet the basic objectives of the implementation of Basel III to reduce the risk of future crisis. EU’s implementation proposals allowed the inclusion of securities (such as hybrid securities), if they meet specific criteria, in the calculation of capital ratios.

Bloomberg reported that At Landesbank Hessen-Thueringen, a state-owned lender based in Frankfurt known as Helaba, silent participations account for more than 50 percent of the bank’s 6 billion euros ($8.6 billion) of capital. Helaba withdrew from the Europe-wide stress tests in July after regulators refused to count some of those hybrid instruments as capital.  

Another issue is the double counting of capital in the insurance subsidiaries in European economies. The proposed rules do not require banks to deduct investments in these subsidiaries from capital. The EU proposals are also lenient on the liquidity standards tha require banks to hold enough cash or easily sellable assets to meet short- and long- term liability. It  modifies the rule covering debt payments coming in next twelve (12) months for thirty (30) days to allow counting covered bonds as liquid assets. Denmark, Sweden and Spain supported this as their banks have large holdings of the bonds that are backed by the cash flows from pool of mortgage loans.

With the current international economic condition it is highly difficult for banks to raise the required capital as per required by Basel III. Also the flaws in the Basel III need to be looked into and revised before proper implementation of Basel III. Central banks should also tightly monitor and supervise the banks’ credit activities to reduce the risk of future crisis.


Turmoil to Continue in Global Financial Markets

August 20, 2011

Investors’ Losing Confidence on Future Growth

This week was very important for the investors and private companies as they waited to see the forecast of world economic growth to make investment decisions. Last week witnessed turmoil in the international financial markets. This started at the end of July when the US economy recorded flat line growth in the first quarter and 1.3 percent growth in the second quarter. On the other hand Euro zone and the UK just recorded a GDP growth rate of 0.2 percent.

Things are not gloomy for third quarter as well, with the contraction of the US economy, financial distress on the UK households’ and the sovereign debt crisis in the Euro zone leading to uncertainty in the global financial markets.

Private companies are facing output and profits cuts due to decrease in the households’ consumption. With the ‘air of fear for future growth’, the companies are cutting their investment plans and households’ are deferring their spending decisions.

In the Euro zone, European banks are cutting their lending due to high cost of funding that will drag down the economic growth. European banks are finding it difficult to obtain overnight funding as the banks prefer to deposit their liquidity with the Central Banks rather than lending it to other banks due to counter party risk. Financial Times reported that the foreign bank branches in the US  increased their cash assets from $758 billion for the week ending August 3 to $813 billion.

Banks are finding difficulty in obtaining finance from the wholesale market and commercial paper issuance by the financial group decreased by 16 percent from mid June. If the contraction in the credit in the financial market continues and banks’ cut their lending further, we will not be witnessing increase in growth rate in the US, the UK and the Euro zone despite the European temporary bank funding guarantee scheme and ECB’s overnight “deposit facility”.