It was then that a report of his views said:…conflicts caused by the Basel system of banking regulations, which determine how much capital banks must to keep their books in order, are the root cause of the crunch and were serving to worsen the City's plight.
The regulations meant that banks forced to take off-balance sheet assets from troubled structured investment vehicles on to their books had little choice but either to raise money from abroad or cut back dramatically on their spending, he said.
He warned that, if London's money markets remained frozen and the authorities retain the strict Basel regulations, the full scale of the eventual credit crunch and economic slump could be "disastrous".
Basel II Accord
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Basel II)
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.
The final version aims at:
- Ensuring that capital allocation is more risk sensitive;
- Separating operational risk from credit risk, and quantifying both;
- Attempting to align economic and regulatory capital more closely to reduce the scope forregulatory arbitrage.
While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic.
Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place.
[edit]The Accord in operation
Basel II uses a "three pillars" concept – (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline – to promote greater stability in the financial system.
The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.
[edit]The first pillar
The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk,operational risk and market risk. Other risks are not considered fully quantifiable at this stage.
The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach,Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach".
For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and advanced measurement approach or AMA.
For market risk the preferred approach is VaR (value at risk).
[edit]The second pillar
The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk,concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.It gives bank a power to review their risk management system.
[edit]The third pillar
The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.
[edit]September 2005 update
On September 30, 2005, the four US Federal banking agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) announced their revised plans for the U.S. implementation of the Basel II accord. This delays implementation of the accord for US banks by 12 months [1]. The Federal Reserve System is a private banking corporation and not part of the Federal government.
[edit]November 2005 update
On November 15, 2005, the committee released a revised version of the Accord, incorporating changes to the calculations for market risk and the treatment of double default effects. These changes had been flagged well in advance, as part of a paper released in July 2005. [2]
[edit]July 2006 update
On July 4, 2006, the committee released a comprehensive version of the Accord, incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. No new elements have been introduced in this compilation. This version is now the current version. [3]
[edit]November 2007 update
On November 1, 2007, the Office of the Comptroller of the Currency (U.S. Department of the Treasury) approved a final rule implementing the advanced approaches of the Basel II Capital Accord. This rule establishes regulatory and supervisory expectations for credit risk, through the Internal Ratings Based Approach (IRB), and operational risk, through the Advanced Measurement Approach (AMA), and articulates enhanced standards for the supervisory review of capital adequacy and public disclosures for the largest U.S. banks [4].
[edit]July 16, 2008 update
On July 16, 2008 The federal banking and thrift agencies ( The Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation; the Office of the Comptroller of the Currency, and; the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework (known as Basel II). The final guidance, relating to the supervisory review, is aimed at helping banking institutions meet certain qualification requirements in the advanced approaches rule, which took effect on April 1, 2008. http://www.occ.gov/ftp/release/2008-81a.pdf
[edit]Basel II and the regulators
One of the most difficult aspects of implementing an international agreement is the need to accommodate differing cultures, varying structural models, and the complexities of public policy and existing regulation. Banks’ senior management will determine corporate strategy, as well as the country in which to base a particular type of business, based in part on how Basel II is ultimately interpreted by various countries' legislatures and regulators.
To assist banks operating with multiple reporting requirements for different regulators according to geographic location, there are several software applications available. These include capital calculation engines and extend to automated reporting solutions which include the reports required under COREP/FINREP.
[edit]Implementation progress
Regulators in most jurisdictions around the world plan to implement the new Accord, but with widely varying timelines and use of the varying methodologies being restricted. The United States of America's various regulators have agreed on a final approach - see [5] for the Notice of Proposed Rulemaking. They have required the Internal Ratings-Based approach for the largest banks, and the standardized approach will not be available to anyone. In India, RBI has implemented the Basel II norms.
In response to a questionnaire released by the Financial Stability Institute (FSI)[6], 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015.
The European Union has already implemented the Accord via the EU Capital Requirements Directives and many European banks already report their capital adequacy ratios according to the new system. All the credit institutions will adopt it by 2008.
[edit]See also
[edit]References
[edit]External links
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By general accord, much of the current financial crisis arises from "regulatory failure", something to which numerous references have been made, not least by the shadow chancellor over the weekend, when he complained that "Gordon Brown's regulatory mechanism has comprehensively failed".
Osborne has though been reticent about identifying the specific failure and it took his boss David Cameronyesterday to hint at the specifics. There is a need, he said, "to break the self-fulfilling cycle that is reducing banks' ability to lend." The problem is this, he added:
When the value of financial assets falls, a new international accounting regulation called "marking to market" automatically downgrades the value of banks. They are less able to raise the money to carry on their business. That in turn causes further falls in the value of financial assets. And this is making the financial crisis worse than in previous downturns.
Cameron himself, however, blurs over the precise cause of this problem and it took
The Guardian to add more detail. The paper tells us:
A European Union directive passed in 2001 and adopted as a new accounting standard in the UK in 2006 dictates that banks have to value their assets on a daily basis. To do this they must base their calculations on the market value of each asset if it were liquidated that day. The problem with this is that as share values tumble in response to the credit crisis, millions of pounds are wiped off bank balance sheets causing a spiral of decline in asset values.
Actually,
The Guardian has got it wrong.
The "European Union Directive" in question is Directive 2006/49/EC of 14 June 2006 "on the capital adequacy of investment firms and credit institutions". Its short title is the Capital Adequacy Directive. This must be read in conjunction with Directive 2006/48/EC, the pair of Directives together implmenting the agreement.
That it is an EU directive, though, does not tell the whole story for it is this directive which implements crucial parts of the now notorious Basel II agreement. It is that agreement that which is the heart of the current problems which the banks are experiencing.
That Basel II is the problem – the "smoking gun", so to speak - has been widely promulgated for some time by acknowledged experts, most notablylast December by Prof. Peter Spencer, of the Ernst & Young Item Club, regarded as "one of Britain's leading economists". It was then that a report of his views said:
…conflicts caused by the Basel system of banking regulations, which determine how much capital banks must to keep their books in order, are the root cause of the crunch and were serving to worsen the City's plight.
The regulations meant that banks forced to take off-balance sheet assets from troubled structured investment vehicles on to their books had little choice but either to raise money from abroad or cut back dramatically on their spending, he said.
He warned that, if London's money markets remained frozen and the authorities retain the strict Basel regulations, the full scale of the eventual credit crunch and economic slump could be "disastrous".
Dismissing the assumption that banks are not lending to each other on the money markets because they lack confidence in each others' potential solvency, he argued that they were, in practice, prevented from lending the cash at all because it could leave their balance sheets falling foul of the Basel regulations.
"If these funding routes are not reopened it will have massive consequences for the economy as a whole," he said. "It will make 1929 look like a walk in the park."
He dismissed as "window dressing" the move announced by central banks around the world this week to pump extra money into the money markets and increase the type of collateral they will accept in return, in an effort to get them running again.
"This won't get to the core of the problem: the fundamental lack of collateral. As these problems drag on, the consequences for the macro-economy of not relaxing [the Basel regulations] are unthinkable."
Not only do the regulations, which stipulate that banks must have a minimum of 8pc capital among their liabilities, deter banks from lending to each other, they will also limit the amount they can lend to households and businesses. This could escalate the anticipated economic downturn next year significantly, he said.
This theme was picked up by Ambrose Evans-Pritchard a few days later, who cited Spencer saying that, "the global authorities have just weeks to get this right, or trigger disaster."
The Spencer analysis was then essentially repeated at the end of January by another acknowledged expert, Prof. Tim Congdon.
In the context of the Northern Rock affair, Congdon asserted that, "the Basel rules have failed", then arguing that "the scientific precision of the Basel rules was shown to be hocus-pocus." Banks, he wrote:
…did not know the true state of each other's capital and, hence, their ability to repay loans. Inter-bank markets seized up. If one bank - such as Northern Rock - ran out of cash, it had only one place to go, its central bank. But the assumption that the central bank would, quickly and reliably, extend a lender-of-last-resort loan to a solvent, but illiquid bank - an assumption written into banking textbooks for decades - was invalidated by the Bank of England's reluctance to lend in crisis circumstances last August.
So it was yesterday that Cameron stood up in front of the Conservative Party conference and declared that "…our regulatory authorities, together with the European regulators, need to address this difficult issue."
He did not name the Basel II agreement and, crucially, neither did he identify the more immediate cause of the problem, the EU Capital Adequacy Directive. Had he done so, of course, there would have been uproar, and the EU would have been catapulted to the top of the political agenda, which is the last thing Cameron would have wanted.
And it is the Directive which is now the problem. The reason for this is that, although the original Basel II agreement was produced in June 2004 with the assent of the British authorities – which had pushed hard to their adoption – the sponsoring organisation, the Basel Committee on Banking Supervisiondoes not produce legislation.
Instead, it "formulates broad supervisory standards and guidelines" and recommends statements of best practice in banking supervision "in the expectation that member authorities and other nations' authorities will take steps to implement them through their own national systems, whether in statutory form or otherwise."
Had the UK been an independent country in 2004 and subsequently, the government would have implemented the Basel II agreement into UK legislation, either through an Act of Parliament or through Regulations (SIs) – or a combination of both.
The trouble was that, not only was the UK a member of the European Union, financial services regulation was (and is) a "competence" of the EU and the UK had thereby ceded authority to legislate in this area. Thus, instead of being adopted into British law directly, it was adopted via an EU Directive.
That, at the time, did not present the government with a problem as it has been an enthusiastic supporter of the agreement. But, now that the flaws in the agreement have been exposed, or shown to be "hocus-pocus" as Congdon maintains, the provisions cannot be changed unilaterally by the British government. They are now part of EU law so, in order to achieve change, all we can do, as Cameron euphemistically put it, is have "…our regulatory authorities, together with the European regulators," address "this difficult issue."
And that equivocation is also part of the problem. One might ask why, if Cameron is now so (rightly) certain as to where the problem lies, his shadow chancellor has not raised it before.
To be fair to him, he has. He raised it on 21 April 2008 in the House of Commons in response to a statement by Alistair Darling on "financial stability". But it was only one sentence where he told Darling that the moves he had announced "should include reforms to the Basel accords."
Then, in a Newsnight interview on 17 September, just a few days ago, he mentioned it again, a reference which met with the approval of Telegraphcolumnist Gerald Warner, who noted:
Osborne did not overreact to the crisis by rushing to propose a host of regulations to monitor the stable door now that the horse has bolted. Instead, he proposed revisiting the Basel II Accord, which is now four years old.
Thus, while Osborne has belatedly come to the view shared by Spencer and Congdon, and evidently passed this view to his boss, neither he nor Cameron have mentioned Directive 2006/49/EC, nor even the European Union. Yet it is the Directive which must be changed.
Yesterday, Cameron entitled his speech, "Together we will find a way through". What he did not specify, however, was how he was going to "find a way through" the EU labyrinth to remove a damaging piece of legislation that is at the heart of this crisis.
Thus, while Osborne is accusing Labour of being "in denial" over its role in the financial crisis, the Conservatives too are indulging in their own form of denial.
The elephant has re-acquired its cloak of invisibility.
The picture shows the headquarters of the Bank for International Settlements in Basel, which hosts the Basel Committee on Banking Supervision meetings.
By general accord, much of the current financial crisis arises from "regulatory failure", something to which numerous references have been made, not least by the shadow chancellor over the weekend, when he complained that "Gordon Brown's regulatory mechanism has comprehensively failed".
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