Basel II: Implications for Financial Service Provider
In 2003, the Basel Committee on Banking Supervision began to devise new standards for banks and how they were required to produce income statements. These standards are called Basel II, and are crucial for the success of financial service providers in the modern world. Learn more about Basel II in this post!
The Role of Basel II in Financial Services
Basel II has come a long way since it was first enacted by the Basel Committee on Banking Supervision (BCBS) in 2006. It was designed as a means of determining how much capital banks need to keep on hand relative to their risk profile and size. The objectives behind Basel II were:
The framework was created in response to the Global Financial Crisis (GFC). The year 2007 saw a huge stock market crash and a collapse of the world's economy. Many companies, banks and governments were affected. This prompted BCBS to begin thinking about how they could approach regulation in a way that would help prevent another crisis from ever happening again.
So, on July 1, 2004, the Basel Committee on Banking Supervision published their first set of Standards and Regulations for all banks around the world. These standards were designed to increase financial stability and aimed to alleviate financial risk for all deposit holders worldwide (from individual investors to majorly institutions like governments).
The Problem Basel II Faced In the U.S.
One problem the United States faced when implementing Basel II was that it was not a perfect match for its regulatory framework, especially when it came to the capital requirements. The USA's regulatory approach to capital requirements had been developed by the Federal Reserve Bank and its method of assessing risk is quite different from international's methods of determining risk, which were rooted in a number of detailed qualitative assessments. So, how did the Fed decide how much money banks needed? It used qualitative measures to determine credit risk (i.e., how likely it is that a bank will run into financial trouble due to bad lending decisions). These measurements included things like the quality of documentation and the overall health of a bank.
How Basel II Began to Resolve These Issues
A huge problem faced by the United States when enacting Basel II was that it had very little time to take in any new information between 2004 and 2006, or draft new laws and regulations. As a result, there were several issues that had to be ironed out before all parties could agree on the framework. However, in July 2006, this was achieved and now it's used as high-level guidance across most countries. In fact, Basel II has been implemented through national laws and regulations in over 80 jurisdictions.
The Role of Capital in the New Regulatory Framework
The prime difference between Basel II and its predecessor is that it is primarily a risk-based approach. This means that the amount of capital required to be held by banks is directly related to the riskiness of their assets. Under Basel I, banks were required to maintain minimum capital ratios depending on their asset size and business model, while Basel II standardizes this practice but also includes both qualitative and quantitative standards. These standards are known as risk-weighted assets (RWAs). In other words, under Basel II, regulators determine how much capital each bank needs based on its level of risk.
Basel II also aims to harmonize the capital requirements among different countries. This means that banks from different countries can apply to join a specific international regulator's supervisory committee (called the Committee of European Banking Supervisors, or CEBS) to discuss and agree on how much capital each bank needs. Not only does this reduce transaction costs, but it also helps prevent banks from engaging in "borrowing practices that are designed to lower their regulatory capital requirements" (Basel Committee).
What Is Basel II? [CONTINUED] »
This will be our last post on Basel II. We will be doing an in-depth introduction on how CDSs work, how they are traded and structured.
How the Basel II Framework Relates to Risk Management
The main purpose of the financial framework is to help banks minimize their risk exposure, as well as to give credit for that risk in the form of capital subsidies. So, by rationally assessing and taking into account their own risk appetites, banks can determine appropriate standards and regulations when it comes to capital levels. Since the framework was first introduced, there has been a lot of talk about “internationally agreed principles” and how this or that country should follow them. There is a lot of confusion, not just in the industry but also among those who are not too well versed in the intricacies of the industry. In the following section we will try to shed some light on this subject.
Basel II as an International Standard
Following Basel I, Basel II’s overarching objective is to tighten up bank capital requirements and ‘harmonize’ them across national borders. This would help banks become more mortgage-like entities by ensuring they have adequate capital reserves to face periods of heightened stress. To achieve this objective, banks had to prove that their capital adequacy measures are reliable and effective through the application of risk based approaches. However, Basel II is not the only country specific capital adequacy measure. The main aim of those measures is to prevent a systemic collapse by making banks’ capital instruments safe against internal risks and this has been done through the use of national regulations.
Other countries have also come up with their own capital adequacy structure as they can’t impose this capital framework on others. This has led to a clash between the Basel Committee and many other regulators, who have been debating back and forth until some degree of consensus has been reached. However, regulation based on international standards rather than national regulations allows for better harmonization between parallel authorities around the world.
Bottom-up versus top-down approach
Top-down approach is when there are permanent and clear regulatory guidelines from the top of a hierarchy. This was how Basel I was implemented and it helped ease the ongoing debate at the international level. However, as we have seen in Basel II, this can cause problems as several countries wanted to localize certain aspects of Basel I, but couldn’t because they had no clear guidelines on how to do so. The root problem here is that different countries have different regulatory schemes and may not be able to harmonize their capital requirements using the same mathematical formulas.
Conclusion
The Basel Committee has been trying to come up with a middle ground in the ever widening gap between national variants of Basel II. The main aim of this strategy is to reconcile the needs of divergent regulatory regimes while trying to avoid the pitfall of becoming overly complex. In the end, however, it is up to each country’s regulators to decide how they want to implement Basel II within their national framework. Basel II has its flaws and it will almost certainly be revisited as time goes on. For example, one of its main weaknesses is that it does not hold banks accountable for a given amount of predictable revenue from activities outside their core business lines.