6720441 – Anish Padalkar

Briefing Note

For the European Banking Authority (EBA), regarding the reform of the Basel accord, from the United
Kingdom

Context (Historical/Legal/Political Background)

The Basel Accords were introduced with a clear goal of implementing and creating an international
regulatory framework for managing credit risk and market risk (CFI Team , 2017). The primary
function is to make certain that private and public sector banks hold enough cash reserves to meet
their financial obligations and survive in a financial crisis or an economic downturn. There is also an
importance given to the strengthening of corporate governance, risk management, and transparency.
The Basel Accords are broken into Basel I, Basel II, and Basel III.

Basel I was first formed in 1988 after the collapse of the Bretton Woods system. The first part of the
accord was brought in to facilitate the large increase of international banks and the rapid increase in
integration and global interdependence of financial markets. Regulators found that throughout
several banks, that there were not enough cash reserves and because the international market at
this time was becoming strongly integrated, if one of the banks or one of the countries was to have a
financial crash or a major crisis, this would in turn cause a domino effect across multiple countries.
The framework was put into place to help manage credit risk through the risk-weighting of different
assets. Banks that have a stronghold on the international level needed to hold 8% of their risk-
weighted assets as cash reserves. They were also instructed to allocate capital to lower-risk
investments as well as being incentivised to invest their capital into sovereign debt and residential
mortgages in opposition to corporate debt.

Basel II was then further introduced in 2004 and brought along a few modifications to the first
accord. This accord was focused on improving three key issues – minimum capital requirements,
supervisory mechanisms and transparency, and market discipline. The second accords framework
provided a much more efficient and thorough risk management solution as well as a much more well
rounded and regulated measures for credit, operational, and market risk. It was critical that the
banks got to terms with these measures as they needed to identify their minimum capital
requirement as this was one of the main limitations of the first accord. The only identifier that had
been used was measuring credit risk. Basel II helped form a more generalised measures for
measuring operational risk. There was also a focus on market values, not necessarily looking at book
value when looking at credit exposure. Moreover, there was additional fortification to the
supervisory mechanisms and market transparency by advancing disclosure requirements to oversee
regulations.

The 2008 Global Financial Crisis was able to expose the faults of the international banking and
financial system, in turn leading to the newer accord, Basel III. They were created in 2010 and its full
implementation was introduced in January 2023. Basel III’s implementation transpired due to these
key failures of the previous accord which was, poor corporate governance and liquidity management,
over-levered capital structures due to insufficient regulation restrictions, and incentives which were
not aligned with Basel I and II. Coming off Basel I and II, there was also a strengthening of the
minimum capital requirements. As well as this, there was the introduction of various capital,
leverage, and liquidity ratio requirements. Regulations also stated that banks needed to adhere to
the following financial ratios: (figure 1 (CFI Team, 2022)).
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Basel III also introduced new capita reserve requirements and counter cyclical measures to increase
reserves in periods of credit expansion, and to ease requirements during periods of decreases
lending. Under the new accords, there was a requirement set by the regulations that larger banks
needed to have a greater amount of cash reserves as they had greater importance to their respective
economies.

Pros of the current policy

One of the major benefits that came out of the Basel Accord was the leverage ratio constraint. The
key benefit that came out of this was that banks that had a high leverage ratio, or in other word had
taken upon large levels of debt relative to the other financial metrics within the bank, have lower
loss-absorbing capacity and can argue are less resilient to shocks. This is a worry as we have the
example of the financial crisis as we saw a great deal of leverage across the entire banking sector.
Therefore, by capping the amount of leverage banks can hold, a leverage ratio constraint means that
larger banks that hold a great deal of low risk weighted assets are able to deal with losses during a
crisis without having to fall below the required and regulated minimum for capital. Therefore, the
leverage ratio will be a better tool for measuring the containment of average risk and making sure
that there is a good level of protection against further crises in the financial market.

In the Basel Accords, the model does also point towards a positive GDP (de Bandt & Chahad, 2016).
This mainly holds for the Eurocentric and United States economies. However, to begin with this may
not show through due to the transition from Basel II to Basel III and the stricter implementation of
Monetary policy and therefore there may be a bit of a slowdown before the positive impact starts to
show. This is very much a long-term benefit and the reason for it is that banks would be much better
suited to battle an economic crisis like the one in 2008. They will be able to become more resilient
and when the wider economy needs funding and other financial aid, these major banks will be better
suited to offer the help.

Cons of the current policy

As we have seen above there are reasons to suggest that the Basel Accords do give a good reason to
believe that the objectives that have been put forward can indeed by met, however at times the
actual implementation of the resolution can be found to be problematic at times. One of the reasons
to this was the standardised approach that was taken when dealing with these banks and countries,
and with its casual risk weights. In the original accord, all countries that were members of the OECD
were given a risk weighting of 0%, meaning that all OECD government debt is perfectly safe (Dowd,
et al., 2011) (CFI Team , 2017). As well as this, the original accord also stated that all corporate debt
was as risky as the other. The reason this was set in place was to encourage banks to invest their
money in low quality assets instead of investing in high quality assets.

Another weakness that came out of the Basel Accords is that there is a major reliance of the system
on external ratings. The hope with the ratings system is that those agencies are reliable as their
business works only when they can be trusted and their reputation, if they do not have a good
reputation, they will not have a good reputation within the industry (Cantor & Packer, 1994). This
means that if there is competition, then this will be a fair, efficient, and good quality. However, the
reality is a little different, we find that the issuers are the ones who are paying for ratings instead of
the investors who traditionally would be paying for the ratings of the issuer. The reason for this is
simple, the issuer wants a favourable rating whereas the investor wants an honest rating, which puts
pressure on the agencies to try and accommodate both the investor as well as the issuer. A ratings
company which is stringent will find that the issuers will go to an agency which is a little bit more
lenient, therefore losing their business. Along with this, the theme of issuers telling the ratings
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agencies what ratings they need and the ratings agencies informing the issuers how their debt
securities can be handled for these ratings to be achieved. These types of practices highlighted the
intensifying pressure on the ratings industry and would put them in bad light.

The final stumbling point of the Basel Accords is one which effects the entire banking system. The
Accords have been put into place to stop any type of financial crisis from happening again, however,
it is clear to see that the rules that have been put into place will most probably create systemic
instability (Dowd, et al., 2011). In other words, if there are any faults within the regulations and the
systems and they get exposed, this will leave adversely effect all the banks within the Basel system,
however, one company’s problems will not have the same systemic impact. Then this leads to the
issue of if one single firm can deal with the situation and the market cannot called a fallacy off
composition (Dowd, et al., 2011). This is where the single company can sell securities to get out of
the difficult position, they find themselves in, however the market cannot do the same sending the
prices of these securities sharply down which will end up creating a viscous circle. When these
companies have incentives and encouragement given to them by government officials or any other
advisors, this will end up destabilising the market and the market needs firms to all be using different
strategies and investing into different market for there not be any destabilisation.

Conclusion/Adjustments

In theory, we have seen that the Basel Accord has been slowly addressing many of the issues that
have come to light over the last three decades. However, as we have seen, there are a few
fundamental issues which in theory are still there however, which follow through from Basel I and
Basel II which are that there is still a reliance on credit ratings, there’s an allowance to use internal
risk models and the requirement for capital within the banks is still based on imprecise risk-weights
(Bank For International Settlements , 2017). Even with these being in theory an issue, Basel III’s
implementation has only really come into effect at the beginning of 2023 and therefore has not been
tested to the greatest extent, however after almost three decades it might be important to ask the
question of whether the form of the institution is keeping it from achieving their objectives. If we
find that Basel III fails like the previous two accords, then it might be time to suggest a little bit of
change to the regulations and reform the banking system.

One radical way we can tackle the issue is by looking at the political system in place and hoping that
the right system is in place to implement it. This would be dealing with the major problems that have
been set by all the Basel Accords which risk-based regulation and regulatory capture, by
implementing the right incentives and essentially abolishing the regulations that have been put in
place. In other words, free banking or financial laissez faire (Dowd, et al., 2011). This would mean
that whatever regulators and political influence is orchestrating the banking system would remove
themselves from the financial system. Systems like these have worked in the past, in which the banks
were tightly governed and the hazards that arose and the risks that were taken were under control as
those who had taken the risk had to bore the consequences. Incentives like these could help bring
back effective risk management and lead to banks recapitalising themselves. Although this sounds
nice in theory, it is based of the need of the political system to be running an accommodating
monetary policy.

It is evident that Basel III has only just begun its journey of mending the issues of the previous two
accords and will need time before we can truly see the impact of the regulatory system. The future of
the Basel Accords should look to balance and create a harmonious global banking system.
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Annex

FIGURE 1

Source: https://corporatefinanceinstitute.com/resources/risk-management/basel-accords/

Bibliography
Bank For International Settlements , 2017. High Level Summary of Basel III Reforms , Bael: Bank For
International Settlements .
Cantor, R. & Packer, F., 1994. The Credit Rating Industry. Quaterly Review, September, pp. 1-26.
CFI Team , 2017. Basel III: The global regulatory framework for banks. [Online]
Available at: https://corporatefinanceinstitute.com/resources/risk-management/basel-iii/
[Accessed 20 April 2023].
CFI Team, 2022. Basel Accords. [Online]
Available at: https://corporatefinanceinstitute.com/resources/risk-management/basel-accords/
[Accessed 20 April 2023].
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de Bandt, O. & Chahad, M., 2016. A DGSE Model to Assess the Post-Crisis Regulation of Universal
Banks. Banque de France Working Paper , Issue 602, pp. 3-34.
Dowd, K., Hutchinson, M., Ashby, S. & Hinchliffe, J. M., 2011. Capital Inadequacies, The Dismal Failure
of the Basel Regime of Bank Capital Regulatin. Policy Analysis, Issue 681, pp. 1-40.