Basel, and how it has never worked

The regulatory justification for introducing the Basel Accords would, in retrospect, appear to have been no less valid in 1988, when Basel I was issued, than it is today — which is that failure of big banks portends systematic trouble.

Else, it is likely that banks would have been allowed to set their own levels of equity — known as economic capital — and let the market read the riot act to them.

LEVELS OF RISK

Authored by the Basel Committee on Banking Supervision (BCBS), the Basel Accords seek to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses.

They provide recommendations on banking regulations in regard to capital risk, market risk and operational risk, and also determine how much equity capital — known as regulatory capital — a bank must hold to buffer unexpected losses.

For a traditional bank, loans are assets, while customer deposits are liabilities. If assets decline in value, the equity can quickly evaporate.

So, the Basel Accords require banks to have an equity cushion in the event of asset decline, providing depositors with protection.

In the year 1988, Basel I Accord set minimum capital requirements based on two ratios: a ratio of tier one (mainly equity) capital to risk-weighted assets of 4 per cent; and a ratio of tier one plus tier two (undisclosed reserves, loan-loss provisions, subordinated debt) capital of 8 per cent.

Assets were risk-weighted according to the credit risk of the borrower — that is, the risk that the borrower will default on his loan. Government bonds, for example, had a zero per cent risk weighting, which entailed that no capital needed to be held against them.

Traditional corporate loans, meanwhile, had a 100 per cent risk weighting, which entailed that capital constituting the full 8 per cent of the value of the loan must be held against it.

By the late 1990s, the accord had come to be seen as ‘useless for regulators and costly for banks', with bankers lamenting the gap between the actual risk inherent in assets and the regulatory capital assigned to them under the accord.

This created perverse incentives to engage in regulatory arbitrage: exploiting the difference between ‘economic' risk and regulatory requirements to reduce capital levels, without reducing exposure to risk.

The consequence of these activities was that overall capital levels in the banking system, which had risen sharply after Basel I came into effect in the early 1990s, were now beginning to decline.

FLEXIBLE RULES

In September 1998, the Basel Committee announced that it would officially review the 1988 accord with the aim of replacing it with more flexible rules. In June 1999, it released its first set of proposals for the new framework.

After five years of negotiations, the Committee finally announced that it had agreed on a new capital adequacy framework, the Basel II Accord.

The new accord rested on three ‘pillars'. In addition to specifying minimum capital requirements (pillar 1), the new accord provided guidelines on regulatory intervention to national supervisors (pillar 2) and created new information disclosure standards for banks with a view to enhancing market discipline (pillar 3).

Under the ‘advanced internal ratings based (A-IRB) approach' in pillar 1, banks were permitted to use their own models to estimate various aspects of credit risk.

This, it was thought, would more closely align regulatory capital with underlying risk and thereby reduce the incentives for arbitrage.

Banks without the resources to operate such models would adopt the ‘standardised approach', in which fine-grained risk categories were linked to external credit ratings provided by commercial rating agencies.

Finally, Basel-II focus on credit risk sought to address the previously unregulated area of market risk, ‘the risk of losses in on and off-balance sheet positions arising from movements in market prices'.

Here, banks could use sophisticated mathematical models to produce estimates of ‘value-at-risk' (VaR) — or, the probability that losses on a portfolio of financial assets will exceed a certain amount within a specified time horizon.

Economists and regulators are of the view that the Basel Committee may have erred here grievously, since the market turmoil in the late 1990s had shown VaR models to vastly underestimate the probability of ‘extreme' events.

No wonder, a growing consensus has since emerged suggesting that Basel II may have played a key role in precipitating the year 2008 financial crisis.

BASEL-II BLAMED

The story of the financial crisis 20 years after Basel I Accord became operational would now appear to have been one of deregulation, complex financial products and greedy financiers. It is being argued that the reason for the failure of Basel II lay in ‘regulatory capture', i.e. de facto control of the regulatory agency by some of the ‘regulated' interests.

A small group of large international banks succeeded in rewriting the Basel II rules to their own advantage, at the expense of their smaller and emerging market competitors.

Basel II hence ended up reducing the capital levels in large international banks, ignoring some of the risks most crucial to systemic financial stability.

A 2006 survey of more than 300 banks by Ernst &Young had found that 75 per cent believed Basel II would benefit the largest banks, employing the most advanced risk modelling systems, at the expense of those unable to adopt them.

Beginning in the subprime mortgage market in the US in the summer of 2007 and quickly spreading to Europe and the rest of the globe, the financial crisis has passed, perhaps, the most damning verdict of all on Basel II, critics say.

Something of a consensus has arisen in policymaking circles that a new approach to capital regulation is essential to the future stability of the global financial system. A ‘fundamental review' of Basel II was demanded on the grounds that it ‘underestimated some important risks and overestimated banks' ability to handle them'.

REFORM PACKAGE

In response to this growing recognition, the Basel Committee has since put forward a set of proposals for a revised Basel II framework — tougher than many expected, prompting controversy and resistance in many quarters.

Dubbed Basel-III, the reform package has unsettled the finance industry and in some eyes heralded a new period in the history of banking regulation.

But critics have made the point that once again it is the large international banks that have seized control of the regulatory process, potentially closing the window of opportunity for far-reaching reform.

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