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Basel I and problems with its implementation
A major problem regarding the capacity of powerful players on global financial markets to carry out adequate supervision is the multiple use of financial leverage, particularly by financial institutions which deal in hedging (hedge funds). The trend towards creation of financial groups which combine commercial and investment banking operations with insurance and reinsurance has also made it practically impossible to carry out real time supervision of the conglomerates which make up the global financial superstructure. Parallel to this process of integration of the major financial players has gone the multiplication of risk related to the new forms of financial instrument, further complicating the issues of monitoring, regulation, and supervision. The Basel Bank Supervisory Committee’s capital adequacy standards no longer apply to major financial conglomerates. The high degree of interconnection between banking, investment banking, and insurance in these conglomerates allows a single dollar of equity to be multiplied many times. This advantage of the financial mega-groups allows them to create additional liquid resources outside national government control and to manage global development in line with their own priorities. The problem with the 1998 capital adequacy standards boils down to the question of averages. Because of its general nature, the capital adequacy standard of 8% set by the Basel Bank Supervision Committee fails to take into account specific activities cofinanced by a number of financial institutions. The fundamental objections made against the 1988 capital adequacy standards, particularly in the later 1990s, relate to the nature of risk and the need for more emphasis to be placed on the risk involved in the activity (investment) and less on the definition of the supervision rules themselves. The key to risk management and setting standards lies in direction of the risk management process within a framework of financial groups, or rather in the systems and procedures used to measure and manage risk. Practical admission that the 1998 Basel standards cannot be applied to the major financial groups began in early 1998. Accepting the Basel Committee’s guidelines on market riskbased capital management meant admitting the state regulators and supervisory bodies’ rights to authorize the application of internal banking procedures and models to the assessment of market risk exposure. At the heart of the new approach to setting capital standards (internal models) are more advanced risk management techniques and new risk
which is after all their basic reason for existing. The standard fails to take into account business cycle phase or degree of financial market development. due to the sophistication of financial markets. As a result. but de-stimulated it in non-OECD-member government securities. from margin buying to trade in derivatives to financing hedging operations. renders this operation essentially ineffective. Excessive risk exposure due to inter-bank loan financed transactions is dangerous because of Central Bank inability in practice to influence the generation of new liquid resources. the 1988 Basel standards did not stimulate banks to use new risk management techniques or the setting of capital standards grounded in modern credit portfolio management. portfolio structure became arbitrarily determined. Such a modest percentage stimulated inter-bank lending. Increasing the weighting would raise the cost of inter-bank lending. The new regulatory framework was based on the 2 . – The approach taken to determining the capital adequacy ratio was to general. regardless of the actual level of risk in developed. the high-risk asset weighting applied to short-term loans to banks from any country was 20 percent. given the major differences between the world’s regional financial and national markets. which influence financial innovations related to risk levels. The most important problems arising from application of the 1988 Basel capital adequacy standard were: – Under the 1988 Basel rules. The much reduced importance of required reserves for money supply management in developed countries. These weaknesses in the 1988 Basel Accords capital management standard were cited by financial players when proposing new structures of the capital standard and asset classification into risk categories. at least as regards preventing or moderating changes in the direction of the business cycle. often leading to the creation of fictitious liquid capacity and contributing to systemic risk. leading to better distribution of risk. developing. stimulating the securitization of short-term claims. or transition countries. based on banks’ risk levels. even though they in principle carry the same level of risk.insurance instruments. Funds from these sources were used to finance other activities. –Setting a zero weighting for investment in OECD-member government securities stimulated such investment. which have a decisive impact on the need for capital. particularly in newly industrialized OECDmembers. According to Institute for International Finance studies.
but have more groups and sub-groups of assets. For rating purposes. This provision. Under the new standards. and the maximum envisaged weighting is 150%. under the new rules. 4. The revised rules give two options. caused unequal treatment of government bonds on international markets. the revision refers to assessments carried out by approved institutions of the various countries’ long-term liabilities denominated in foreign currency. One of the most explicit critics of the rule was Alan Greenspan. The second case directly links the weighting to the rating of the bank the claims are on.following three principles: – Demands for a minimum capital adequacy level. Claims on the basis of loans secured against commercial property are. the former President of the US Federal Reserve. – Supervision of capital adequacy. the 100% risk weighting for non-members of the OECD will not be applied so long as the country agrees to a Special Standards for Data Dissemination requirement. The revised standards continue to refer to a minimum 8% capital adequacy ratio. the weighting for claims on banks would be as for the following category. The 1988 Basel Accords assigned different risk weightings to claims arising from government bonds purchases. while all bonds issued by non–members of OECD were assigned a weighting of 100%. regardless of whether the bonds of a given non-member of OECD were better covered than a given OECD-member’s bonds by the issuing country’s macroeconomic stability. The main features of the rule changes are as follows: 1. assigned a minimum weighting of 100%. clearly. depending on a country’s membership of various economic groupings. and –Market discipline. Under the first option. Many financial experts considered this rule a direct source of massive global liquidity and increased risk. The 1988 Basel rules assigned 100% weighting to all claims on companies. while high-risk companies get a 150% risk weighting. while loans secured against 3 . while the weighting on long-term claims on banks from countries outside the OECD was 100%. where claims based on bonds are involved. 3. regardless of their credit rating. The new rules assign a much lower weighting to claims on high quality companies (20%). 2. A 20% weighting was previously applied to all short-term claims on banks (and all long-term claims on banks within the OECD). The 1988 Basel Accords assigned a zero weighting to OECD-member bonds. confirmed by the IMF.
This tolerance level is the default probability of the bank. based on loan portfolio analysis. The tolerance level is the probability that the loss exceeds this maximum value. A typical problem with assessing credit risk on either the VAR (Value-at-Risk) or CAR (Capital-at-Risk) model is excessive reliance on historical data and the belief that the price of financial instruments will not vary significantly. If a trader exceeds the authorized VAR. 5. but solvency is not impaired. These two variables for risk management in commercial banking and financial institutions have been defined by Joel Bessis as follows: The Value At Risk. This future period becomes progressively shorter (a month. Also proposed is the use of external ratings for calculations of the minimum capital required for financial instruments issued on the basis of securitization of underlying securities.or higher rating to 150% for assets with a BB+ or BB. However. with the removal of the maximum 50% weighting earlier applied to derivatives operations on OTC markets. after diversification of risks. VAR can be associated with day-to-day banking operations. . Then VAR becomes CAR. CAR is the risk-based capital at a global level. CAR is indeed different from VAR for two reasons: 1. to react to steep changes in the market value of the instruments in their portfolios.rating. For the most part. 4 . Essentially the model involves assessment of the likelihood of losses due to changed market conditions over some future period.. the model relies on assessment of the coefficient of correlation between the instruments making up the portfolio and the return to risk ratio. as the bases of portfolio theory. a week.. One solution applied to the problem of risk management adequacy is the use of Value-at-Risk models to assess the placement required to reduce capital value (reducing the solvency of the banks) at a given risk level. or VAR. whereas VAR can be used at any other intermediate level of management. Both CAR and VAR measure potential losses.result in reduction of the capital by the full amount of the securitized part of the asset. 6. Hence. and when the risk is limited to the chances that some manager goes beyond some risk limit for a short time. CAR is the capital required to absorb potential losses at a given tolerance level. Securities securitized on assets with a rating below BB. the tolerance level is not the same when the solvency of the bank is at stake. The Basel Banking Supervision Committee instructed the main financial institutions to apply internal risk assessment models. The risk weighting is from 20% for securitization of assets with an AA.residential property get a 50% weighting. is the maximum loss at a given tolerance level.. The VAR methodology can also be used to define risk-based capital. or Capital At Risk. so that financial institutions face the problem of ensuring liquidity at very short notice. corrective actions are required. The conversion factors for off-balance sheet items remain basically unchanged. even a day). and CAR is more relevant when dealing with aggregated risk-based capital and with solvency issues.
Analyzing capital adequacy standards in their study of banking crises in developing countries. “a flight to quality”. or rather expectations change rapidly. nor have their banks (with several important exceptions) maintained actual capital ratios much above those found in countries with more stable operating environments. i. The entire structure of investment by financial institutions at the national.e. ensuring sufficient reserves to maintain the value of the currency in which government bonds are denominated. and in countries with currency boards the only. financial investors’ desire to increase return by favouring instruments from high-growth regions creates a conflict of interests and potentially the counter-effect of a sudden fall in market prices in a given region. the IMF should stand behind the value of risk-free securities. which is inconsistent with overall economic growth and so potentially creates a so-called “bubbleeconomy”. Since. and even more the international. This flight to the securities of unaffected countries affects the price of short-term securities. the likelihood increases that financial crises transfer from region to region. influences the reduction of additional sources of liquidity. alongside a very limited role as lender-of-last-resort. respectively). In 5 . which. rapid selling-off of securities denominated in the destabilized currency.2. Rapidly revised expectations cause a chain reaction. given full openness of capital accounts. On the other hand. leading to a sharp fall in the market price of the instruments that make up the portfolio. putting upward pressure on the value of the major currencies. institutions for creating additional liquidity. Morris Goldstein and Philip Turner conclude that: It is perhaps surprising that the authorities in most emerging economies have thus far chosen not to set national capital standards that are much above the Basel international standard. distributing risk over a number of regions and using low or zero-risk loan instruments (inter-bank loans or government bonds. CAR is based on a tolerance level higher than that of VAR since the solvency of the bank is at stake. level is called into question. Analysis of the environments in which developing countries’ banks operate and their IMF arrangements. liberalization of foreign trade. market confidence will shift sharply if the IMF refuses to support a country whose securities (particularly bonds) are oversubscribed. and strict budgetary constraints. Such countries’ Central Banks are obliged to keep fixed or near fixed exchange rates. often based on inter-bank loans. however. means that commercial banks represent the basic. As long as the financial instruments from high-growth regions in the portfolio are structured as portfolio theory recommends. particularly risk-free ones. in the final analysis.
as such standards would further reduce the sources of short-term and mid-term capital.spite of higher risk. national regulatory institutions therefore will not decide to set the standards for minimum required capital significantly higher. 6 .