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Home > Blogs > Anthony Harrington > Basel II Mark II, better for the bruising?

Basel II Mark II, better for the bruising?

Finance Blogger: Anthony Harrington Anthony Harrington

It has become fashionable to scoff at Basel II, the key regulatory platform for the international banking community, for its failure to prevent or expose the wild excesses of global banks before the sector imploded, triggering the worst global downturn since the Great Depression. The common charge brought against Basel II is that it took far too easy a line in allowing banks to model their own risks, which, as events showed all too clearly, they almost universally massively understated and grievously underpriced. The common verdict is that the banks “gamed” the rule book while the regulators were way too complacent in watching over their charges.

Now we are in the closing stages of the consultation over Basel II, Mark II, revised to take account of the weaknesses of the Mark I version. The consultation period ends in April 2010. What suggests that things will be different this time round?

The answer is quite a bit, though it is still far too early to tell if the final version of Mark II will provide the regulators with sufficient guns to redeem the Basel approach to de-risking global banking. A quick glance down the contents page of the consultative document indicates how much the Basel Committee has extended the net to try to capture much of what the earlier document missed. Apart from obvious changes, signaled by section headings such as “Strengthening the global capital framework,” there is now a section that addresses “pro-cyclicality” directly.

This goes to the argument that, as it stood, Basel II reinforced market cycles instead of working to damp them down. The Basel Committee is now very keen on the introduction of capital buffers and a number of academics around the world have worked on models that would enable the banks to absorb even severe shocks without the kind of meltdown we saw in 2008.

The Committee is keen to insist that the “fundamental reforms” it is introducing to its regulatory framework will include “macroprudential regulation.” This, the Committee says, is designed to address “system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.”

As far as risk coverage is concerned, this time round counterparty credit risk on “exotic” products, including “credit risk exposures arising from derivatives, repos and securities financing activities” will be scrutinized. In fact securities lending and securities financing, as well as repo activity, tends to be fully collateralized and as such provides no great counterparty threat at all.

The real problem with the 2008 meltdown lay in the derivatives space where the trading book had build up enormous risk at laughably low prices. The Basel Committee seems to have in mind a mechanism that would ensure massive capital adequacy penalties for over-the-counter (bilateral) derivatives trading and very modest capital adequacy requirements for derivatives trading that gets put through central counterparties and exchanges, where the volumes and associated risks can be easily seen by all.

There is a very long way to go still before we get the finished draft of Basel II, Mark II. The comments are pouring in and it will be interesting to see the Committee’s response.

Further reading for Basel II



Tags: Basel II , capital adequacy , capital buffers , pro-cyclicality , regulation
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