Basel Accords - the Answer or the Problem?

05 Jul 2010

Much has been written about the global financial crisis (GFC), its causes, and its implications for the financial markets generally. A perception that financial institutions have operated without due regard to the risks associated with particular transactions has lead to a push by policy makers to improve the regulatory framework that operates to protect investors and the integrity of the financial markets themselves.

An important component of this regulatory framework is the minimum capital requirements imposed on financial institutions, as set out in what have become know as the Basel I and II Accords.[1] These accords are recommendations issued by the Basel Committee on Banking Supervision which are intended to create international standards that individual central banks or equivalent regulators can use when establishing a regulatory regime for financial institutions. Whilst not universally or uniformly applied, these accords are influential in the development of regulations by policy makers, including those developed by the Reserve Bank of New Zealand (Reserve Bank). The Basel II Accord, released in 2004, enhanced the then existing framework used to establish the appropriate minimum amount of capital that is required by a financial institution at any particular time. The amount of regulatory capital required by a bank is based, in general terms, on the underlying risks that the particular bank faces. One intention of imposing a minimum capital requirement is to create a buffer to protect investors from a decline in the value of the assets of a bank. Given the systemic importance of banks to the financial markets and the wider economy, this capital buffer is also intended to work to protect the banks themselves from the impact of adverse financial conditions.

An important addition to the Basel II framework was the inclusion of a variety of risk measures (those being market, operational and credit risk) which were intended to better reflect real risk associated with the underlying asset base of a bank and therefore allow for a more accurate allocation of capital. In theory then, the Basel II regime should have ensured that sufficient capital was set aside by financial institutions to create a protective buffer against the type of financial downturn experienced during the GFC. The success of Basel II in reducing the impact of the GFC has obviously been limited.

Since the onset of the GFC in 2007, there have been a number of economists, politicians and market participants that have questioned the utility of the Basel II Accord, with some even suggesting that, rather than providing a protective buffer in times of financial stress, in fact the capital adequacy regime contributed to, and exacerbated the extent of the GFC.

Basel II Criticisms

There are several common criticisms of the Basel II capital adequacy regime and its role in the GFC, including that:

1. the prescribed capital levels were inadequate to guard against a downturn of the magnitude of the GFC;
2. the Basel II Accord provides an incentive to remove riskier assets from the balance sheet of the relevant financial institution by way of securitisation, the residual risks of which are not always accurately assessed;
3. the Basel II Accord discourages the long term hold of assets given the regulatory capital impact and encourages the 'originate and distribute' model prevalent in the lead up to the GFC; and
4. capital requirements of the Basel Accords are cyclical and increase in a downturn when defaults and losses are more common. This impairs the capacity to lend and impacts liquidity across the financial market potentially exacerbating a financial downturn.

Criticisms of the role that Basel II played in the spread of GFC do have some merit. In particular, the pro-cyclical effect of the capital adequacy regime under Basel II is something that has been acknowledged and considered by the Basel Committee as part of ongoing adjustments to the Basel II Accord. Proposals from the Basel Committee to include forward looking provisioning based on expected loss rather than incurred loss and increased capital buffers are intended to partially address the cyclical nature of the existing capital adequacy regime.[2]

The prevalence of the 'origination and distribution' model where assets are originated and then sold to a wide array of investors (without due regard to underlying risk) and the increase in off balance sheet transactions are both illustrative of financial institutions exploiting the flaws contained in the existing regulatory regime. It is difficult to assess the extent to which Basel II in particular contributed to the rise of these behaviours and products, as the regulatory flaws to which their growth is often attributed were present prior to the introduction of Basel II. It is perhaps more appropriately seen as a response to the flaws in the Basel I Accord of 1988 and a break down in general market discipline independent of regulatory failure.

The true extent of Basel II's contribution to the GFC is very difficult to establish. One obvious reason for this is that the implementation of Basel II has not been uniform across all markets. The United States adoption of Basel II has been a slow process and was not intended to be complete until some time in 2010. In addition, in Europe, at the onset of the GFC the adoption and application of the new Basel II rules were limited, with many financial institutions deferring application of the Basel II framework until 2008, as permitted by the Capital Requirements Directive (this directive set out the implementation process with respect to Basel II in the European Union). Whether or not a fully implemented Basel II framework would have limited the extent of the GFC can not be definitively answered. However, it is certainly apparent that key flaws remain in the Basel II regime that were highlighted by the GFC. These flaws are intended to be addressed by the Basel Committee over the coming months.

The Response

The Basel Committee has produced two consultation papers entitled:

1. Strengthening the resilience of the banking sector; and
2. International framework for liquidity risk measurement, standards and monitoring.[3]

The intention of these consultation papers is to correct the apparent flaws in the existing Basel II Accord and include (amongst others) proposals to:

1. improve the quality of the capital base of financial institutions;
2. improve risk measurement around counterparty credit risk;
3. introduce a non-risk related leverage ratio;
4. include measures to address pro-cyclicality inherent in the capital adequacy regime, including the creation of capital buffers in, "good times" that can better absorb losses in times of financial difficulty; and
5. introduce measures to protect market liquidity in times of financial stress.

The response from market participants to the stated goal of these proposals (i.e. to better protect the financial markets as a whole in circumstances such as the GFC) has been generally positive. There has, however, been significant push back from central banks and larger financial institutions on a number of aspects of the proposals made.

The Reserve Bank, in its submissions to the Basel Committee on the consultation papers, has in general terms supported the intent of the proposals. In particular, the Reserve Bank supported the proposals to improve the quality of the capital base and agreed that the predominant form of tier 1 capital should be equity and retained earnings.

However, the Reserve Bank also raised real concern with the practical application of some of those proposals in the New Zealand market context and more generally.[4] One concern raised by the Reserve Bank was the imposition of a non-risk related leverage ratio (in simplest terms being the ratio of bank capital to exposures). One of the fundamental characteristics of the Basel regulatory regime is around risk analysis and assessing the capital adequacy requirements of banks based on a sound analysis of that risk. A leverage ratio without reference to risk is a departure from this principle. The Reserve Bank's view is that a leverage ratio may, depending on its method of calculation, impact many relatively simple, transparent banks, with low risk portfolios that are well capitalised, while providing little or no comfort about higher risk, poorly-capitalised banks.[5]

In the New Zealand context, variations of the leveraged ratio were often applied in the finance company sector. On the face of these leverage covenants, a number of finance companies appeared to be adequately capitalised. However, given the risk structure of their loan books (in particular the concentration of loans in the property sector) it became apparent that in fact these companies were under capitalised when looking at their relative risk profiles, with large numbers then failing once the downturn hit. It must also be said that liquidity, in addition to leverage, played a major role in these failures.

Another issue raised by the Reserve Bank and other market participants, including the Australian Bankers' Association, is the narrow eligibility criteria for liquid assets which must be held by banks at all times.[6] The GFC has clearly demonstrated that the financial markets do not always remain liquid in times of stress. This lack of liquidity was one of the contributing factors to the sub-prime mortgage crisis that began in the United States spilling over into the wider real economies. The second of the consultation papers has proposed two liquidity standards that should be met by banks to ensure stable liquid funding sources in the short and longer term. The consultation papers have defined a limited category of assets that can be considered liquid assets for the purpose of complying with these liquidity ratios. Government issued bonds, which would constitute a liquid asset, are in relatively limited supply in a market such as New Zealand and in fact would not be sufficient in number for banks operating in New Zealand to meet the liquidity requirements of the consultation paper. It has been argued by both the Reserve Bank and the Australian Bankers' Association that the criteria for liquid assets be broadened to include certain corporate bonds and (in New Zealand at least) covered bonds. The Reserve Bank has recently come out in support of the development of a covered bond market in New Zealand stating that there is no regulatory impediment to their issue. It is anticipated that up to NZ$16 billion may be raised by banks from the issue of covered bonds.

It does seem somewhat counter intuitive, particularly in the New Zealand context, that a single class or very narrow category of assets be required to be held by banks for the purpose of meeting liquidity requirements. In times of general financial stress, you would expect that if all financial institutions were looking to trade the same category of asset, that those assets may in fact become quite illiquid. Some greater level of diversification than that proposed by the Basel Committee within set parameters would seem sensible. In a market such as Europe where the depth and volume of particular assets is far greater than in New Zealand, the criteria of assets suggested by the Basel Committee are likely to be less problematic. However, in both Australia and New Zealand it would appear from the submission of the Reserve Bank and the Australian Bankers' Association that the current proposals are not workable.[7]

The approach of the Reserve Bank to the Basel Committee proposals (including Basel II) appears to be to adopt those elements that can be applied to the New Zealand market and adjust or ignore those elements which in the New Zealand context are inappropriate. Certainly, with significantly different market characteristics in New Zealand, when compared to the European Union or the United States, it seems appropriate that a flexible approach to the Basel Committee proposals contained in the consultation documents be taken.

Summary

Whilst the GFC has highlighted areas where the capital adequacy framework established by the Basel Accords is flawed, it is perhaps not correct to say that the existing capital adequacy regime (and in particular the Basel II Accord) was a significant cause of the GFC. The stated aims of the consultation papers produced by the Basel Committee have been accepted in large part by market participants. However, the detail of the proposals in the consultation papers have caused a significant amount of concern around the practicalities and suitability for application across all financial markets. Certainly in the case of New Zealand, the Reserve Bank's approach of applying a somewhat tailored version of the Basel Committee recommendations to the New Zealand market appears appropriate. There are a number of other factors not addressed in this article that influence the development of products and practices across the financial markets. However, an improvement in the current capital adequacy, risk and liquidity regimes should only improve the ability of the financial markets to withstand (or at least reduce) the impact of the next financial crisis. Unfortunately, the approach of some financial institutions to risk, which was a contributing factor to the GFC, cannot entirely be addressed by regulation. Market discipline itself and an improvement to the operational structures within financial institutions will also contribute to the level of risk and the overall stability of financial institutions and markets.

[1] For further information on the Basel Accords and Basel Committee on Banking Supervision go to http://www.bis.org/bcbs/index.htm.

[2] See the Basel Committee consultation paper entitled "Strengthening the resilience of the banking sector" available at http://www.bis.org/list/bcbs/index.htm.

[3] Full text of the consultation papers are available at http://www.bis.org/list/bcbs/index.htm.

[4] Reserve Bank of New Zealand submissions available at http://www.rbnz.govt.nz/finstab/banking/3958953.pdf

[5] See the Reserve Bank of New Zealand submissions available at http://www.rbnz.govt.nz/finstab/banking/3958953.pdf

[6] All submissions to the Basel Committee on the consultation papers including those of the Australian Bankers Association are available at http://www.bis.org/publ/bcbs165/cacomments.htm.

[7] The Reserve Bank has developed its own liquidity protections for the New Zealand market. See http://www.rbnz.govt.nz/finstab/banking/regulation/0094291.html for more detail.