Basel II under attack
Basel II has been intensively criticized since the last financial crisis.
In this article we aim to answer the following two questions:
A) What is Basel II?
B) What is the problem with Basel II after all?
C) Can we propose an alternative or correct the current weaknesses?
To answer these questions we first need to understand Basel II.
The Basel Accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision.
Basel II is the second of Basel Accords that requires financial institutions to maintain enough cash reserves to cover losses incurred by their investments and operations.
Such an international standard can help protect the international financial system from the types of problems that might arise from a major bank or a series of banks defaulting.
Basel II attempts to accomplish this by setting up risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to their exposure.
Intuitively, these rules mean that the greater the risk to which the bank is exposed, the greater the amount of capital the bank needs to hold on reserves.
Basel Accords ultimate goal is to promote stability to the financial system.
Basel II objectives:
-Capital allocation according to risk sensitivity
-Quantification of credit, operational and market risk separately
-Reduce regulatory arbitrage by aligning economic and regulatory capital
Basel II consists of three pillars:
(1) minimum capital requirements
(2) supervisory review
(3) market discipline
The first pillar
Deals with RISK.
It calculates the minimum regulatory capital required, based on three components of risk:
Credit Risk; Operational Risk and Market Risk. Other risks are not taken in account.
- Credit Risk can be calculated in three different ways “standardized approach”, “Foundation Internal Rating-Based Approach” and “Advanced Internal Rating-Based Approach”.
The standardised approach sets out specific risk weights for certain types of credit risk. The standard risk weight categories are used under Basel 1 and are 0% for short term government bonds, 20% for exposures to OECD Banks, 50% for residential mortgages and 100% weighting on unsecured commercial loans. A new 150% rating comes in for borrowers with poor credit ratings. The minimum capital requirement (the percentage of risk weighted assets to be held as capital) remains at 8%. For those Banks that decide to adopt the standardised ratings approach they will be forced to rely on the ratings generated by external agencies. Certain Banks are developing the IRB approach as a result. - Operational Risk, uses three different approaches: Basic Indicator Approach (BIA), standardized approach (TSA), and the Internal Measurement Approach (the advance approach is called advanced measurement approach or AMA).
Operational Risk has been defined by Basel II as “The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”.
Internationally active banks and banks with significant operational exposures are expected to use an approach appropriate for the risk profile and sophistication of the institution. - Market Risk the common practise and preferred approach is VaR (value at risk).
Basel II recommendations will move from standardised requirements to more refined and specific requirements that have been developed for each risk category and for each individual bank. Banks that develop their own bespoke risk measurement systems will be rewarded with potentially lower risk capital requirements.
The second Pillar
The “supervisory review” allows the supervisors to successfully review risk results and methodologies in place.
Supervisors will evaluate the activities and risk profiles of individual banks to determine whether those organisations should hold higher levels of capital than the minimum requirements in Pillar 1 would specify and to see whether there is any need for remedial actions.
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 banks a power to review their risk management system.
The third Pillar
“Market discipline” main goal is to empower regulatory bodies with the necessary tools to enforce the series of recommendations and requirements of Basel II.
This pillar is designed to motivate prudent management by enhancing the degree of transparency in banks’ public reporting to shareholders and customers.
It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation.
The Committee believes that, when marketplace participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not.
Weaknesses
Now that we understand Basel II, we can analyse what are the weaknesses of the methodology:
a) The Committee expects that, when supervisors engage banks in a dialogue about their internal processes for measuring and managing their risks, they will help to create implicit incentives for organisations to develop sound control structures and to improve those processes.
To this end, banks that develop their own bespoke risk measurement will be rewarded with lower risk capital requirements. However, in our view, this implies that by quantifying your risk with your own bespoke model somehow impacts the price of that risk; where a bespoke quantified risk will be cheaper than a risk that is calculated with standard method. The danger here is that the bigger players of the market, i.e. big Banks, will invest into developing their own bespoke risk methods (with assumptions that may or not be valid), yet resulting in lower risk requirements. It creates a bigger leverage in the larger players, those that are considered “too big to fail”.
It also would penalise the smaller players, as they would need to hold in reserve more capital to operate and therefore impacting their ability to compete in pricing the deals. Decreasing competition creates unstable markets and ultimately oligopoly.
b) Value-at-Risk is insufficient on quantifying market risk.
VaR is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level. The assumption of normality is questionable and this method does not take in consideration extreme events that may cause losses to occur in the extremities (tails) of the distribution.
Furthermore, if the realised losses (over a consecutive period of time) fall under the tails of the distribution, VaR fails to weight this data effectively, ignoring the effect of market inertia.
c) Heavy reliance on Credit Agencies ratings.
Credit Ratings are usually out of date and sometime grossly inaccurate. i.e. Lehman Brothers had A rating from Standard and Poors when it opened bankruptcy.
http://www2.standardandpoors.com/spf/pdf/fixedincome/Lehman_Brothers.pdf
The alternative is to use IRB methods (Internal Rating Base Approach), however these use static recovery rates or alternatively very simplistic set of correlations. At present correlation matrix and recovery rates do not consider the stochastic element that may impact the recovery rates in a specific sector, region or individual institution. Additionally IRB methods are not revised with the frequency needed in the present financial climate.
d) Public Disclosure is inadequate and insufficient.
Although the overall regulatory reporting structure leads to great deal of public disclosure, banks have a large degree of flexibility in meeting regulatory disclosure requirements and thus maintain considerable control over what information is disclosed.
e) Operational Risk is not quantified efficiently. The lack of historical and quality data regarding operational risk makes it virtually impossible to quantify accurately its real exposure and model or forecast future operational failures.
Further criticism:
- The latest revisions mainly addressed the regulatory arbitrage issue however there are still areas where regulatory capital requirements diverge from the economic.
- Basel II hasn’t addressed the problem in defining bank capital consistently; it diverges from accounting equity in important respects.
So how can we improve Basel II?
Can we propose a better set of recommendations, requirements, and methodologies?
Certainly, to tackle the weaknesses we have identified above, we propose:
Solutions
a) Capital requirements should be formulaic.
Model should be provided by the Basel Committee.
There should be no reward for developing your own bespoke model. The banks that develop their own bespoke model, will gain knowledge and control of their own risks and capital requirements, there should be no further gain from it.
b) Market Risk should encompass: VaR, DV01, CR01, TVaR, EV.
c) Use IRB method that compromises variable recovery rates and include a stochastic element in the correlation matrix and recovery rates calculation.
d) Provide a standard risk report to be used across all financial institutions and estipulate a periodic public disclosure.
Tighten regulatory demands and penalties for those that do not comply.
e) Operational Risk should be modelled and quantified.
Processes should be mapped and assigned a risk weight that reflects their probability of failure.
IT equipment should be identified and assigned a risk weight that reflects their probability of failure.
External Events should be mapped and assigned a risk weight that reflects their probability of failure.
Then for each element of operation risk we should apply the following:
Operational Risk = Probability of failure * Cost
Further improvements:
- Regulatory capital requirements should be consistent and aligned with the economic.
- Arrive to a consensus of Bank Capital: defining bank capital consistently. The same definitions should apply for accounting proposes.
- Residual Risk, should be broken out into the individual componets: systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk, legal risk and/or any other risk. These should be measured and modelled accordingly.
by Andrea Graves
09.May.2010
