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Regulation Best Practice

Revising Basel II—But at What Cost?

by Vishal Vedi

Executive Summary

This article examines:

  • Why Basel II is now seen as too pro-cyclical.

  • The unfortunate timing which saw the implementation of Basel II taking effect just as the global recession took hold.

  • The Basel Committee is already reshaping Basel II to take account of the weaknesses discovered so far.

  • The future of securitization in the post crash world is now under consideration.

  • The shape of regulation to come.


Pro-cyclicality and Its Issues

The future regulation of banking is currently a major area of focus for supervisors and policy-makers, in particular, with the G20 recently committing to strengthening how banks are regulated. There seems to be consensus among stakeholders that additional capital, of the right quality, is required in the system. There is also concern that the existing Basel II requirements are too pro-cyclical to continue to act as the blueprint for bank regulatory capital guidance, without some revision. This is not a new insight. A number of senior figures in the industry have long been concerned that the models behind Basel II might well be pro-cyclical.

A pro-cyclical measure has the unfortunate effect of reinforcing the direction of a particular cycle. In boom times, for example, the models perceive less risk, with banks having to hold a lower amount of regulatory capital for a typical exposure. This, in turn, frees up capital, which allows the banks to pour more credit into the financial system. Other things being equal, this process will continue as long as the economy remains in upswing. Similarly, when the cycle turns negative, at precisely the point when bank lending is freezing and governments are trying to restart economies, the models perceive higher levels of risk and suggest that banks should hold higher reserves, exacerbating lending difficulties.

Because of this, the Basel Committee took action to try to manage the pro-cyclicality of the Basel II framework, for example, by stressing loss-given defaults and probability of defaults to see how these parameters would potentially behave in a downturn, and to suggest corrections. However, the extent of the pro-cyclicality issue was, nevertheless, difficult to gauge, and, with hindsight, it is now clear that the implications are potentially far more severe than was thought when Basel II was originally being implemented.

A Case of Bad Timing

One of the peculiarities of the global crisis, in the context of Basel II, is the timing. After a lengthy gestation, beginning 10 years ago, the regulations began to be implemented in the European Union in 2007, with full implementation the following year. The United States, by contrast, only introduced Basel II on a mandatory basis for its 10 or so largest banks, reasoning that as these banks accounted for the vast majority of overseas business done by US banks, and, as the Basel Committee designed Basel II primarily with internationally active banks in mind, it made sense to restrict implementation to these. Implementation costs were also a major consideration. US implementation commenced on a phased basis this year.

At the same time, the credit crunch began in summer 2007, which means that Basel II had not been implemented to any great extent beforehand. This is an important point to grasp, because the events that brought about the present global financial slowdown were in preparation for many years prior to 2007. Basel II, then, is not responsible for the crash, and it is not a failure because of the crash. However, its continued implementation and adoption has now become much more problematic. It is clear that there are a number of areas, for example, the way risks interact, that the models did not fully capture, and which Basel II arguably did not encompass, not least because of its focus on individual firms rather than, in addition, considering system-wide effects.

There were also issues with credit-rating agencies. The difficulties with the rating agencies are now well documented. The ratings for a range of structured credit products were shown to be unreliable in the credit-crunch environment, and some form of international regulation of rating agencies now seems inevitable. However, in defense of the rating agencies, it could be argued that the credit default swap market was commonly understood as being relatively safe, and we now know that the instruments were incorrectly premised, that the exposures they brought with them were not fully understood, and that the hedges that banks put in place turned out to be ineffective when they were needed, not least because of the extent of the movement in the underlying asset (US property prices) on which so many of them were based.

At the time, though, a bank with a large CDO book, all of which was AAA-rated by leading rating agencies, and where any exposure the bank had was hedged out, or thought to be hedged out, did not look risky. With hindsight, it is clear that the risks were significant, and furthermore, because of the linkages between exposed positions, the hedges were being backed by organizations which themselves were massively exposed. The result was a freezing of liquidity right across the market.

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