Has Basel II backfired?

March 5, 2008

basel.jpgBasel, one of Switzerland’s largest cities,  is known as the home to such drugmakers as Novartis AG and Roche Holding AG, earning the old Swiss canton the unofficial moniker of “biotech Silicon Valley.”

Increasingly the metropolis is also known as the birthplace of international capital adequacy banking accords — Basel I and Basel II.

The banking rules were devised as a one-size-fits-all capital adequacy standard for global financial institutions. However, critics are now asking if Basel II has backfired by allowing firms to lower capital requirements, leaving them in a crunch now that some investments have soured.

At issue is whether the new rules allowed some European firms — where Basel II regulations had already begun to be rolled out — to put less capital into loss reserves for highly-rated debt, including U.S. mortgage-backed securities, exacerbating a crunch that at first seemed contained in the United States.

Swiss-based UBS on Friday estimated that the credit crisis that has been roiling markets, and putting a chill into M&A markets worldwide, is far from over, forecasting losses that could exceed $600 billion globally.

Abby Joseph Cohen, chief U.S. investment strategist at Goldman Sachs speaking at a New York business conference last Thursday said, based on anecdotal evidence, it appeard that the subprime mortgage crisis had caused a higher degree of problems for non-U.S. financial firms.

 The write-downs that European financial institutions have had to take on bad U.S. mortgage debt was something that Cohen attributed to Basel II, as the regulations gave firms some wriggle room when it came to putting up capital for top-rated securities.

The snag? “The ratings were wrong,” said Joseph Cohen, who added it was not yet clear how the crisis will play out. “The final chapter has not been written,” she said.

In the meantime, Basel II’s potential flaw is starting to get a lot of attention. “Mortgage fallout exposes holes in new bank-risk rules” read a page 1 story in Tuesday’s Wall Street Journal. And an earlier Financial Times op-ed was titled “Turmoil reveals the inadequacy of Basel II.”

 Federal Reserve Vice Chairman Donald Kohn stepped up to defend Basel II  on Tuesday, calling the rules an “important step forward to make capital requirements more risk sensitive.”

But if critics of Basel II are on to something, Basel — which is also home to UBS, the European bank hardest hit by the credit crisis — could find itself with a bad headache, one that none of its drug firms are likely to have a cure for.       

(Photo: Firefighters in Basel watch as a burning wooden wagon passes the old city tower of Liestal during a festival. Source: Reuters, 10 February 2008)


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How Basel II allowed the banks to get it wrong

The number of shocks to the banking system in advanced economies recently such as the nationalisation of Northern Rock Bank in England; the losses by a rogue trader from SocGen; the reconstruction of two smaller German banks after over-exposure to the subprime crisis; the increase in short term interest rates as banks are increasingly reluctant to lend to each other in money markets; the increase rates of interest on business and mortgage loans in excess of official central bank changes. The biggest one of all was the sale of Bear Sterns, a prominent New York investment bank and a leader in the sub-prime mortgage securitisation, to JP Morgans in a bargain basement sale officially supported by the Federal Reserve.
All this take together is indicative of a banking system which has misjudged risks, has mispriced risk, has been unable to assess the creditworthiness of other banks.
Is this just a case of banks having overextended themselves and made poor calls at critical points?. On the contrary I would argue that changes in international banking regulation brought about under the auspices of Basel II have allowed banks systematically to underestimate risk and loss allowances and to make inadequate provision of capital reserves to meet unexpected losses. Banks have been implicitly encouraged to place growth ambitions ahead of prudent management of their affairs.
There are two changes under Basel II which deserve consideration. The first is to allow banks to employ credit ratings to measure individual banks’ credit risk.
The second is to allow banks to use advanced statistical models to determine risk of default or failure in the event of external shocks.
Concerns about credit ratings are not new; they were previously raised during the Enron scandal of 2002 and the Asian Financial Crisis of 1997. But under Basel II banks have been allowed to use credit ratings to determine the risk attaching to their loans and hence to calculate minimum capital requirements. An example of how this worked is: banks sell mortgages off their balance sheet to a securitisation vehicle which is rated AAA. In consequence, the bank needs to keep minimal capital reserves against this. If the bank lends the securitisation vehicle the funds to complete the purchase, the bank needs to make minimal, if any, provisions for capital reserves. When the securitisation loses its AAA rating the bank is then required to make substantial provisions for capital reserves up to eight per cent of the loan. If the loan to the securitisation vehicle is considered doubtful, then the bank must make explicit provisions for the expected loss. What started out as a clever piece of financial engineering has put the bank in difficult circumstances. The position is made worse if the sale of mortgages was not a “clean sale” i.e. the bank provided implicit undertakings to purchase loans back.
Also banks have been allowed to carry out their own risk assessment of other parts of their operation by using sophisticated statistical techniques which aim to calculate the risk of loss in the event of some external shock e.g. a rise in market interest rates, a shock to financial markets or a recession in the economy. As one might expect, banks used assumptions which cast their assessed risks in the best possible light. The general effect has been to allow banks to come up with models showing they face a lower risk which means they have to hold smaller amounts of capital. Banks like to hold less capital because it doesn’t dilute control it increases leverage (able to use more borrowed funds) and hence profits when things are going well. However, when things are not going well, as they are in 2008, banks have to overcompensate by holding higher than the minimum capital reserves. Since they are unable to raise new capital on the open market (think how an issue of shares would be regarded when the price of existing bank shares have taken a severe tumble), banks have to cut back on new loans and try to increase their profit margins i.e. increase interest rates by more than official increases.
The process is contagious. Banks become unwilling to transact with other bank because each suspects that the others have been up to the same tricks as they have so that balance sheets lose transparency. The interbank market come to a halt and liquidity dries up especially as banks now need to hoard cash.
Is this analysis speculation? Well, the President’s Working Group on Financial Markets on March 11, in a classic case of shutting the stable door after the horse has bolted, has made extensive recommendations for the reform of the credit rating industry, the use of statistical risk models and has called for certain of the Basel II to be sent back to the Bank for International Settlements for another look.

Posted by Jon Stanford | Report as abusive

hey guys dont know if you can help but my organisation has to comply with the Basel II act, so im looking for somewhere that offers training for Basel II? do you have any ideas? im monitoring the blog so let me know?

Posted by Austin | Report as abusive