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Home > Regulation Best Practice > Revising Basel II—But at What Cost?

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.

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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.

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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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The Basel Committee Rethink

Where things stand at present is that the Basel Committee is working to revise its accord. Some areas of focus include the trading book, treatment of securitization and resecuritization, pro-cyclicality, and the quality of capital. Basel II, of course, is not a legislative body, but a committee of national supervisors, historically from the G7 plus a handful of other countries, but recently expanded to include countries such as China, India, and Russia. It will be down to national governments to implement the new regulations. Within the European Union, this will be driven at a European level.

Already, as we have seen in the United Kingdom from the report on the banking crisis from Lord Turner, the head of the Financial Services Authority (FSA), which was released in mid-March, the UK regulations on liquidity and bank capital requirements are likely to be toughened up. Whereas previously a degree of “gaming” of the rules by banks was apparent, it is likely that in future there will be less tolerance for this. Already, commentators are talking about the need for greater simplicity in regulatory mechanisms, on the grounds that complexity makes the system inherently more difficult to monitor and understand. The difficulty with this, though, is that simplicity is potentially achieved at the cost of setting much higher capital ratios for banks, as well as curbing their activities.

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Recovery for Banks Could Be More Difficult under New Rules

While the latter might be viewed as desirable to some market commentators, it will mean that banks may become less profitable and may, therefore, take longer to repair their balance sheets. Holding additional regulatory capital will have an impact on banks’ ability to lend, just as governments are doing their utmost to free up frozen credit markets. There is also an issue about the effectiveness of simple rules, which will not be well aligned to differentiations in risk, and may, therefore, encourage “gaming”, albeit perhaps in new forms.

The depth of the difficulties the market is now in is also related to the way in which some banks moved a great deal of their risk portfolio off their books, and into special investment vehicles (SIVs), perhaps as a means of funding positions in a more capital-efficient fashion. During the crisis, a number of banks were faced with either having to bring some of these portfolios back on balance sheet, or providing support to off-balance-sheet SIVs. Going forward, one can see much stricter regimes coming into play around SIVs, and banks in general will be focused much more closely on off-balance-sheet risk, even when this takes the form of exposures that they are not legally obliged to meet.

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The Future Regulation of Securitization

It has to be remembered that while offering high loan-to-value mortgages to those of limited means was one cause of the US subprime mortgage collapse, the problems were exacerbated by the fact that banks and financial institutions went on to leverage this risk through the securitizations that they put in place on residential mortgages. In all of this, it is very difficult to distinguish between what was intrinsically a bad business model, and what was the bad execution of an intrinsically sensible idea.

In principle, collateralized debt is a good thing for the sector, in that it frees up capacity on the originator’s books and stimulates investment. However, lending on the assumption that markets can only ever go up is not good business, and, if the originators then write CDOs on the back of these, the resulting creation can be a tremendously toxic asset, if its risk/return characteristics and vulnerabilities are not fully understood. It seems clear that once the dust has settled, securitization will not be abandoned by the market entirely, even if it, in future, follows a different path. For the originator, it is a very useful tool to have available and there are sound, prudent ways of dealing with the objection that securitization creates moral hazard by moving risk away from the originator.

The rethinking of Basel II is likely to mean that regulators will demand that banks hold more and better quality capital, particularly in good times, although they will only be asked to increase their capital ratios slowly, as the world works its way through the recession. The overall framework is likely to remain largely unchanged, but the treatment of particular product types and risk classes will change, particularly so far as the trading book is concerned, into which too many positions were placed that did not, in the event, have sufficient liquidity to be treated in this way.

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The Shape of Regulation to Come

What the industry has today is some visibility on the direction of the elements of change in the Basel II framework. Charges for market risk will increase. Additional capital will be set aside as the world economy recovers. There will be much more rigorous stress testing of the elements that go to make up capital adequacy. And liquidity guidelines will be seen as an essential complement to the capital regime. The FSA, for example, has issued liquidity guidelines that it wants to see implemented by early 2010. These are major proposals and have the potential to have impact on governance models, business models, and bank business activities. There is some cloudiness because these proposals and their implications are still being worked through, but it is clear that the industry agrees that liquidity merits more detailed regulation, although there remains much debate about the specific details of the regulation.

It is also clear that banks are going to need to revisit some essential components of their strategy and business models. The changes being proposed may well result in pressure for more restricted business models than we have seen for banks, and for operating models that offer less incentive for risk-taking. It must be said that these models are not really geared to encouraging more lending, which is what governments want, at least in the short term.

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In conclusion, we can already see the nature of the coming changes, but what is also clear is that while they should ultimately make for a banking system that is less prone to systemic liquidity and capital issues, the changes do little in and of themselves to get the economy out of the present recession. Other policy tools are needed to achieve this.

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