Logic of Lower Returns: Why Basel III Matters and More Needs to be Done (Part I)

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APR

Most people are not worried about the finesse of financial regulation, but I will give here a brief explanation of the three Basel Accords. As expected it is the trilogy of some accords created in the sterile inter-governmental buildings in Basel designed to regulate finance. As most film aficionados will confess, trilogies often get progressively worse: Star Wars, Blade, Matrix (does anyone understand the ending?), Die Hard, Pirates of the Caribbean, Transporter (yes they made three!). Occasionally you get a great trilogy: Toy Story and Back to the Future come to mind. Basel III, although not as cute as Toy Story or as thought provoking as BttFs time travel is nevertheless a franchise that has improved with each chapter -but the work is far from finished.

Basel by Twen, shared under Creative Commons

Basel I
Basel I was drafted as a response to the savings and loans crisis that enveloped 1980s and was implemented in 1988. The Basel Committee of Banking Supervisors, housed at the Bank of International Settlement, determined a minimum amount of capital to be held by banks. What was significant about this accord was it defined bank capital for the first time and assessed the importance of risk in relation to capital. Capital, under the accord was defined into two categories: Tier one capital the core capital of the financial institution, the equity make-up such as retained profits and shareholder equity 2. Tier two capital the supplementary capital, which includes more risky assets such as derivates and foreign currencies. Certain assets carry more risk than others. For example, cash and government gilts are considered risk free, whereas property loans, corporate loans and foreign currencies carry more risk. So, tier two capital is considered more risky than Tier one 1.

Basel I set out an 8% capital ratio, meaning banks have to hold at least 8% of their capital against any risky assets. Should anything go wrong, there is the capital in reserves to back them up. The accord also indicated to work out the risk associated with an asset. To see this in action, in the table below I show you roughly how to calculate risk for my fictional bank. Bank of We Left Marks Asset Cash Government Gilts Property Loans Amount 1bn Risk weightings 0 Risk 0

2bn 2bn

50% (50% x 2bn) 1bn 100% (100% x 3bn)

Corporate Loans Total

3bn

3bn 4bn

The Bank of We Left Marks has a total of 4bn worth of assets exposed to risk. The bank must hold 8% of capital to cover any losses, therefore a total of 640m needs to be set aside for the 4bn risk, and the capital ratio is 125:2. In its simplest form the bank needs to hold 1 of capital for every 62.50 pound of (credit) risk. Capital ratio, therefore, allows a bank to carry out transactions provided they can absorb any losses. In this fictional example, 640m will cover these losses. However, the approach was too simplistic and did not consider future counterparty risk, i.e. the risk that debts will not be paid as we have seen in thesubprime crisis. A further ailment was the inability to distinguish between different types of risk. For example, it employed a blanket policy and treated all currencies the same whether they were deemed risky or a relative safe haven. This means that the bank would be required to hold 8% capital to all currencies no matter how safe they were, and it did not distinguish between the different types of risk within a specified asset category. This static 8% was a weakness. Basel I will always be a breakthrough accord in financial regulation, but it is important to emphasise two key flaws (1) Basel I was only concerned with one type of risk: credit risk; (2) it did not distinguish between different types of risky assets. Next came, you guessed it, Basel II

Basel II
The shortcomings of Basel I were noticed early but were not rectified until the adoption of Basel II in 2007. Basel II was enshrined in law under the EU Capital Requirements Directive and was fully implemented in January 2008, America delayed implementation until January 2009, making it impotent in affecting the current financial crisis. If it had been adopted earlier could it have lessened the impact of the financial crisis? Realistically though, what government wants to impose further restrictions on financial institutions when they are performing exceptionally well? If anything, governments were rushing to remove regulation, a good example of which is the 1999 repeal of the Glass-Steagall Act separating retail and casino banking. The languor of governments is somewhat understandable in the euphoria of the boom years, but wholly undesirable in the hindsight of subsequent economic fallout years. Moving away from just credit risk as outlined in Base I, the second accord created the concept of three pillars to deal with financial regulation: (1) Minimum capital requirements,

(2) Supervisory tools for regulators, and (3) Market transparency. Pillar One: Minimum capital requirements The first pillar separated risk into three types: credit, operational and market, allowing more risk to be included than Basel 1. The accord put risk management at the heart of a financial institution, giving the institution the opportunity to carry out their own internal ratings based approach (IRB) on a number of assets. Other assets would be classified by a ratings agency. This was the key remit of the first pillar allowing lenders to use their own models of risk and move away from the standardised approach set out in Basel I. There were two major problems with this: Credit Rating Agencies (CRA) CRAs have more recently been highly criticised for the role they played in the financial crisis particularly in giving impossibly good credit ratings to subprime mortgages. A further criticism was that they received payment from the institutions that they provided credit ratings for. Therefore it was in the CRAs interest to give a favourable rating in order to increase return business from the institution a clear conflict of interest. For more information on the role the CRAs played during the financial crisis see the work of the Financial Crisis Inquiry Commission . Internal Ratings Based Approach (IRB) IRB institutions would opt to create their own risk management models, provided they were a large enough institution to be able to afford it. These customised risk models often produced lower capital ratios than would have been the case if the standardised approached was used. Gaining a lower capital requirement was only useful if the lender was able to cover their costs of developing the risk model. Although not the intention of Basel II, it did leave room for lower levels of capital to be held in the banking system. In hindsight, this was a mistake. Pillar Two: Regulation Under the second pillar the accord attempted to internationalise regulation, but there was no appetite among nations to implement extra burdens on a sector that was performing beyond expectations. This was all before the fall-out 2007. National regulators were given more tools to carry out investigations. However, this proved problematic in practice as different jurisdictions would apply regulation differently. Therefore, two similar banks operating in two different jurisdictions may result in two very different outcomes The differences could emerge from differing interpretations of the regulations, a particularly sensitive area and difficult for agreement to be reached. The Committee of European Banking Supervisors (replaced by the European Banking Authority in January 2011) produced guidelines for national supervisors but this did not help ease the banks frustrations. Regulation remained problematic. Pillar Three: Market transparency Finally, Basel II compelled banks to be more transparent in publishing information on their approach to risk management under the third pillar. The idea was that lenders risk models would be subject the market discipline and scrutiny. Theoretically if banks actions are exposed to the scrutiny of daylight, risky behaviour would be discouraged. Greater transparency was the safeguard provided under the third pillar to protect against possible abuse of the first pillar.

Conclusions
The three pillars of Basel II are the key requirements of the regulation, but were seemingly functionless come the crisis as the accord was implemented too late.

The position towards risk management was weak, and helped contribute to a loss in market confidence, leading to a drop in the price of securities. Also, the risk associated with mortgage-backed securities was completely baseless and played a big role in the subprime crisis, the catalyst to the financial crisis. The failure to deal with counterparty risk was also felt during the crisis as many failing institutions affected others one by one. The contagion in the banking system spread quickly. So, we arrive at the Basel III accord, which was drafted in order to correct these problems. Inadvertently opening a route for banks to create levels of capital ratio lower than the minimum requirement of 8% proved catastrophic. Have we learned our lesson? In Part II of this piece I shall examine the merits and weaknesses of Basel III