"Turmoil reveals the inadequacy of Basel II"

This comment in the Financial Times by Harald Benink and George Kaufman, discusses a major shortcoming in Basel II, the new bank capital standards promulgated by the Bank of International Settlements, namely, that banks can use their own risk models to set minimum capital levels. That procedure allows them to tell the regulators how much equity they need to hold, putting the inmates in charge of the asylum.

This practice dates back to the mid 1990s, when derivatives started to become popular. The Fed adopted a “let a thousand flowers bloom” approach, allowing dealers to create and refine their own risk metrics, rather than having the central bank develop an independent understanding of the downside exposure. Admittedly, the Fed has tried to encourage banks to adopt what it considers to be best practices, but since it has little expertise in this area, it is hardly in a position to judge whether more sophisticated approaches are more effective, or merely create an illusion of greater understanding.

From the Financial Times:

Instability and the design of financial regulation, including the new Basel II capital adequacy framework for banks.

The implementation of Basel II coincides with massive losses reported by some of the world’s largest banks, requiring large-scale recapitalisations. The risk models that anchor Basel II are basically the same as the ones many of these banks have been using in recent years. Sheila Bair, chairman of the Federal Deposit Insurance Corporation in the US, recently noted that these models had important weaknesses which, in the light of today’s market turmoil, were a flashing yellow light to drive carefully.

Basel II aims to address weaknesses in the Basel I capital adequacy framework for banks by incorporating more detailed calibration of credit risk and by requiring the pricing of other forms of risk. Under the Basel II framework, regulators allow large banks with sophisticated risk management systems to use risk assessment based on their own models in determining the minimum amount of capital they are required to hold by the regulators as a buffer against unexpected losses.

However, recent events challenge the usefulness of important elements in the Basel II accord. The need to recapitalise banks reveals that the internal risk models of many banks performed poorly and greatly under-estimated risk exposure, forcing banks to reassess and reprice credit risk. To some extent, this reflects the difficulties of accounting for low-probability but large events.

A more fundamental problem is that Basel II creates perverse incentives to underestimate credit risk. Because banks are allowed to use their own models for assessing risk and determining the amount of regulatory capital, they may be tempted to be overoptimistic about their risk exposure in order to minimise required regulatory capital and to maximise return on equity.

Bank capital-asset ratios are near historically low levels, typically at about 7 per cent of total assets (on a non risk-weighted basis). During the past five years, several so-called “quantitative impact studies” (QISs) have been conducted under the auspices of the Basel Committee on Banking Supervision to explore the consequences of shifting from Basel I to Basel II for large banks. These studies show that bank capital requirements will fall further for many banks when the Basel II rules are fully implemented. In the US, the QIS results indicate potential reductions in required capital of more than 50 per cent for some of the largest banks.

The turmoil on financial markets, which has caused large banks to take substantial losses and search for significant new capital, indicates that Basel II should not be implemented, if at all, without first making a number of important changes. We advocate the following improvements in order to correct some of its deficiencies.

First, we urge the Basel committee to conduct another quantitative impact study using observations from the recent turmoil before allowing banks to use their internal models for calculating regulatory capital.

Second, we advocate the additional adoption of a meaningful non risk-weighted leverage ratio requirement, as currently applicable in the US, to supplement Basel II risk-weighted capital requirements. Consistent with the FDIC chairman, we believe that it is important to have a minimal capital cushion in the banking system, even when risk-based Basel II capital rules indicate lower risk. Strong capital allows banks to recognise losses and put problems behind them in times like the ones we are now experiencing. And strong capital gives banks the flexibility to serve as shock absorbers to our economy during difficult times.

Third, we recommend that the Basel II approach using banks’ own risk models should be complemented by a credible and effective form of market discipline. While Basel II contains information disclosure requirements, at the same time it fails to create incentives for professional investors to use this information in an optimal way. As long as professional investors holding bank liabilities have the perception that large banks are too big to fail – or that all deposits will be fully protected against loss, as in the Northern Rock case – they will have the idea that their money is not really at stake. This will mitigate their incentives to use the disclosed information. A mandatory requirement for large banks to issue credibly uninsured subordinated debt as part of the regulatory capital requirement could enhance market discipline, thereby mitigating banks’ incentives to reduce capital.

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  1. a

    Hey I was saying this in comments about a month ago.

    Anyway, here’s really what needs to be done. Regulators need to assign the amount of capital that banks hold. Period. Having the banks decide is laughable. I happened to have a hand in discussions about implementation of Basel II at a bank a few years back; it was – of course – how to create the models so they were in the bank’s favor and capital requirements were minimal. What else should regulators expect? The bank’s CEO is paid in stock; you think he’s going to want to hold lots of capital for risks he doesn’t even understand?

    Regulators need to decide. A corollary is that they need to be able to understand every product in a bank’s books, in order to be able to assign a risk rating. Or, if they can’t understand it, an extremely punitive amount of capital needs to be held.

    This will naturally be the end of IBing as we know it, but that will be a good thing.

  2. Anonymous

    What kind of idiots would let the banks determine their own capital requirements (by allowing them to rig their own risk models)?

    These idiots would have allowed many of the big banks (which were already undercapitalized as a result of CDO/MBS losses) to lower their capital requirements by more than 50%.

    The regulators’ logic (or lack thereof) behind this is:

    “I don’t know (or don’t understand) what’s on the books of the banks—therefore let them set their own capital requirements”.

    I totally agree with the last comment.

  3. Anonymous

    The commentators in this string are obviously part of communist sleeper cells who seek to undermine free market capitalism. If regulators set capital requirements, then markets go from being free to being enslaved. The markets know best. And, a quick — and honest — look at the current crisis confirms this. As Countrywide’s Mozillo told us nearly a year ago, the subprime business only moved into crisis territory because regulators started to threaten to act. The better, wiser and truer free market approach would be to shut down the Federal Reserve, get rid of the SEC, terminate all regulatory agencies at all levels of government, and let the markets be free.

    Luckily, free market capitalism continues to gain market share in government itself. The free marketeers clearly have the ear of Bernanke, Paulson et al. And, both the administration and congress are working closely with free marketeers to ensure we get free market, voluntary innovations in response to the securitization and slow growth patch of choppy waters.

    Personally, I’m with John McCain. If it takes a hundred or a thousand years, we need to stay the course to make sure free markets become even freer.

  4. Ginger Yellow

    It’s worth remembering the Pillar 2 of Basel II gives national supervisors the right (and indeed responsibility) to impose additional capital charges when they feel the minimum requirements under Pillar 1 do not adequately cover risks. Also, only banks operating under the IRB approach (the larger, internationally active banks) will be able to use internal models.

    The real debate on Basel 2 at the moment is over the way it enshrines credit ratings at the heart of the capital adequacy rules right at the moment the credibility of those ratings is in question. But nobody wants to do over the whole thing, since it took 10 years and countless millions of dollars to get this far.

  5. Anonymous

    I’ve seen many comments like those of anon 8:07, blaming our current financial problems on regulation and arguing that free, unregulated markets are the solution (and presumably the preventive). The most cursory review of 19th-century US history will reveal repeated banking crises and real-estate bubbles in an unregulated market, often leading to lengthy, painful depressions. These problems help explain why we now have a regulatory apparatus.

  6. Anonymous

    I love free markets.

    I feed free market corn to my parakeet and the residuals rain down on free market paper shreds. I ask free markets for a pension and one is delivered, just like pizza. I get ill and go to free market and he sells me expensive drugs and cheap cigarettes. I went to free markets for a house and got a loan for 800K, even though I pick strawberries for a living.

    Then I tried marrying free markets. WOW. Talk about being taken to the cleaners!

  7. h2odragon

    Anon 8:07 was being sarcastic, right?

    Yes. And not realizing that the unregulated market in loans exists and usually functions very efficently: Somebody (often with a name like “Vinny the Squirrel”) makes sure loans and interest get paid, instead of whining about “should the regulators allowed us to loan other people’s money out on unpayable terms” or bailouts.

    If the regulated market for loans wasn’t so poorly regulated, and/or the goals the regulators were attempting to serve were more sensible; perhaps the unregulated market wouldn’t be so ugly.

    I’d really like to see what the loan sharks’ business has been like the past decade, though: I suspect their legally operating competition has encroached on many of their traditional customers.

  8. doc pepper

    Re: Communist sleeper cells:

    “Look at what they call sleeper cells,” he says. “That’s a fantastic idea. Now we have to create a structure of volunteers, of sleeper cells, all around the country. In case of disaster, you just wake up the sleeper cell, and they’ll know what to do.”


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