The world's financial regulators are hard at work attempting to make sense of what happened to the banking system and put a new framework in place. But will revisions to Basel II or even a Basel III be enough? Robin Amlot reviews developments
All over the world you can hear the sound of stable doors being slammed shut after the horses inside have already bolted! The key international construct governing banks are the Basel Accords, established by the Basel Committee on Banking Supervision (BCBS). The 1988 Basel I rules were designed mainly to ensure adequacy of capital as a defined proportion of risk-weighted assets. What Basel I did not take into account was the potential 'riskiness' of individual assets.
The 'one size fits all' approach of Basel I was seen to be unsatisfactory. Hence the introduction of Basel II in 2004 and a three pillar approach dealing with the measurement of minimum capital, risk-based supervision and market discipline. However, it should be painfully obvious to all that the regulatory environment in place was not as effective as we might have wished.
Speaking at a conference hosted by Dow Jones Islamic Indexes in Dubai on 18 February, Dr. Nasser H Saidi, Chief Economist at the Dubai International Financial Centre Authority, made no bones about his views, claiming, "Basel II and self-regulation have totally failed. Basel II is not going to address the challenges in the crisis being faced by the global banking sector. We need a new paradigm and we need to be looking at a Basel III framework to make a fool-proof mechanism that protects the banking industry during the times of crisis.
"Generally we look towards raising capital adequacy ratios (CAR) during good times and lowering in bad times, but it's not sufficient. The scope for regulation, liquidity market framework should be strengthened. We should develop early warning indicators. We need a Basel III framework in 2009 and key factors such as risk management, liquidity management, CAR need to be incorporated in the new guidelines."
Over-regulate now!
His voice is not alone in calling for a substantial rethink on regulation. Willem Buiter is Professor of European Political Economy at London School of Economics and Political Science; former Chief Economist of the European Bank for Reconstruction and Development and a former external member of the Bank of England's Monetary Policy Committee. In a paper presented to the 6th Annual Conference: Emerging from the Financial Crisis, held at the Center on Capitalism & Society, Columbia University in New York, he said, "It is better to over-regulate now and subsequently to correct the mistakes than to risk another era of self-regulation and soft-touch under-regulation of financial markets, instruments
and institutions."
Within a wide-ranging critique of financial regulation, Professor Buiter also noted that, "Self-regulation stands to regulation the same way self-importance stands to importance. The notion that markets, including financial markets could be self-regulating, by properly incentivising Chief Executive Officers and Boards of Directors, and through market-discipline is prima facie suspect."
Professor Buiter believes there is no substitute for fair value accounting or even mark-to-market accounting. He also said that, "The capital adequacy of the first pillar of Basel II has to be overhauled radically, as it relies for the risk-weighting of assets in part on internal bank models that are private to the banks."
Even at the time the Basel II proposals were initially put forward analysts were cautioning that the new rules could themselves cause more severe business cycles. Writing in The Hindu Business Line in September 2004, Katuri Nageswara Rao, Associate Dean, ICFAI School of Financial Studies, Hyderabad, said, "The Basel II rules convert the probability that a borrower will default, the size and maturity of the loan and the bank's exposure at default into a capital charge. Other things being equal, the higher the probability of default, the higher the capital charges. During recession, there is a higher probability of default and hence the need for higher capital charges, forcing the banks to tighten credit norms, which could accentuate recession."
Moves are already afoot in the US and Europe to strengthen regulations. For example, on 25 February, a group led by former Bank of France Governor and International Monetary Fund Managing Director Jacques De Larosiere put forward recommendations for introducing cross-border financial supervision in the European Union (EU). The European Commission will use the recommendations to formulate proposals to be discussed at a summit of EU leaders on 19-20 March. While the report stops short of calling for a single pan-EU supervisor, EU states have adopted a preliminary reform of the Basel II rules that will introduce a tougher regime for selling securitised products.
The EU has already forced through an easing of the fair value accounting rule used by the bloc's 8,000 listed companies. The European Commission is now considering what other changes could be made to avoid the impact of the credit crunch being exacerbated. One proposal finding favour is dynamic provisioning requiring banks to build up reserves in the good times for use in bad times.
How many pillars of wisdom?
What of Basel II in the meantime? The Financial Stability Institute (FSI), part of the Bank for International Settlements, recently issued the results of its 2008 survey into the international implementation of Basel II. It reveals many regulators have shown signs of deferring Pillar II and Pillar III progress in the short term. Some 49 jurisdictions are offering to implement the advanced measurement approach for operational risk.
The FSI expects 77 jurisdictions will be implementing Pillars II and III by 2015, but says regulators are putting off implementation in the current regulatory climate.
In the Middle East, the FSI survey was sent to 10 jurisdictions and responses were received from nine. Results from the 2008 survey show that all nine jurisdictions implementing Basel II were offering the Standardised Approach for credit risk by the end of 2008 and that eight out of the nine jurisdictions implementing Basel II were offering the Basic Indicator Approach for operational risk by 2008. The Standardised Approach is also being offered by eight jurisdictions, but in the longer time horizon of 2010-15 while the Advanced Measurement Approaches are being offered by 44 per cent of jurisdictions by 2015. The 2008 survey results also indicated that eight out of nine jurisdictions planning to implement Basel II expected to implement both Pillar 2 and Pillar 3 by 2008.
Revisions to Basel II
On 16 January 2009, The BCBS issued three consultative documents to strengthen the Basel II capital framework. Comments on the Revisions to the Basel II market risk framework and the Guidelines for computing capital for incremental risk in the trading book were required to be submitted by 13 March 2009 while comments on the Proposed enhancements to the Basel II framework should be submitted by 17 April 2009.
Revisions to the Basel II market risk framework and Guidelines for computing capital for incremental risk in the trading book set out the Committee's proposed enhancements to the regulatory capital treatment for trading book exposures.
Proposed enhancements to the Basel II framework covers the Committee's proposals to strengthen Pillar 1 (minimum capital requirements - in addition to those covered under the trading book proposals), Pillar 2 (supervisory review process) and Pillar 3 (market discipline).
The proposals are part of a broader effort the Committee has undertaken to strengthen the regulation and supervision of internationally active banks in light of weaknesses revealed by the financial markets crisis. Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank, said that, "The proposed enhancements will help ensure that the risks inherent in banks' portfolios related to trading activities, securitisations and exposures to off-balance sheet vehicles are better reflected in minimum capital requirements, risk management practices and accompanying disclosures to the public."
The proposed changes to capital requirements cover:
trading book exposures, including complex and illiquid credit products;
certain complex securitisations in the banking book and
exposures to off-balance sheet vehicles (i.e. asset-backed commercial paper conduits).
The BCBS is also proposing standards to promote more rigorous supervision and risk management of risk concentrations, off-balance sheet exposures, securitisations and related reputation risks. In addition, the Committee is proposing enhanced disclosure requirements for securitisations and sponsorship of off-balance sheet vehicles, which should provide market participants with a better understanding of an institution's overall risk profile.
The timetable for implementation of the new proposals is for the capital requirements for the trading book to be implemented in December 2010 while the other improvements, including those related to risk management and disclosures, be introduced by the end of 2009.
Shoring up the pillars
The BCBS says since the financial crisis began in mid-2007, the majority of losses and most of the build up of leverage occurred in the trading book. Admitting that the inadequacy of the current capital framework for market risk was an important contributing factor, among a range of suggestions the Committee proposes to supplement the current value-at-risk-based trading book framework with an incremental risk capital charge, which includes default risk as well as migration risk, for unsecuritised credit products.
In addition to the IRC and other trading book proposals, the Committee is proposing other Pillar 1 enhancements that focus on strengthening risk capture of the framework. The credit crunch has clearly shown that collateralised debt obligations comprised of asset-backed securities (i.e. CDOs of ABS so-called "resecuritisations") are more highly correlated with systematic risk than are traditional securitisations.
Supplemental Pillar 2 guidance is being formulated to address flaws in risk management practices revealed by the crisis, which, says the Committee, in many cases were symptoms of more fundamental shortcomings in governance structures at financial institutions.
After a careful assessment of leading disclosure practices, the BCBS has developed proposed revisions to existing Pillar 3 requirements that are intended to complement the other two pillars of the Basel II framework by allowing market participants to assess the capital adequacy of a bank through key pieces of information on the scope of application, capital, risk exposure and the risk assessment process. The Committee believes that these proposed enhanced disclosure requirements will help to avoid a recurrence of market uncertainties about the strength of banks' balance sheets related to their securitisation activities.
The question remains, however, once the new proposals are put in place, will they be enough to head off crisis the next time?
"It is better to over-regulate now and subsequently to correct the mistakes than to risk another era of self-regulation and soft-touch under-regulation of financial markets, instruments and institutions."
© Banker Middle East 2009
