Executive Summary
This article examines:
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Why Basel II is now seen as too pro-cyclical.
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The unfortunate timing which saw the implementation of Basel II taking effect just as the global recession took hold.
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The Basel Committee is already reshaping Basel II to take account of the weaknesses discovered so far.
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The future of securitization in the post crash world is now under consideration.
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The shape of regulation to come.
Introduction
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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