Evolution of Basel Norms and their contribution to the Subprime Crisis

The article highlights the emergence of the Basel Accord in 1998 and how it has evolved over the course of the last 23 years. Contrary to the popular belief capital regulations have been considered the biggest underlying factor of the subprime crisis owing to securitization, the shadow banking system and the flexibility given to banks in risk assessment. The recent Basel III norms though aim to mitigate the already caused damage, the results are still left to be witnessed.

Evolution of Basel Norms and their contribution to the Subprime Crisis

The article highlights the emergence of the Basel Accord in 1998 and how it has evolved over the course of the last 23 years. Contrary to the popular belief capital regulations have been considered the biggest underlying factor of the subprime crisis owing to securitization, the shadow banking system and the flexibility given to banks in risk assessment. The recent Basel III norms though aim to mitigate the already caused damage, the results are still left to be witnessed.

The Financial Crisis of 2008 shook the financial world and is still in tatters even after 3 years of its outbreak. From the New York investment bank Bear Stearns collapse in June 2007, Northern Rock liquidity support (Sep’ 07), Bank of America purchases of Countrywide Financial (Jan’ 08), Nationalization of Fannie Mae and Freddie Mac by the federal government (July 08), Lehman Brothers Bankruptcy (Sep’08), Takeover of Merrill Lynch by Bank of America, Rescue of AIG through $85 billion, to Washington Mutual being sized by FDIC (the largest U.S bank failure), the events leading to the crisis crumbled the financial world beyond repair.
The large-scale asset purchases (LSAP) in QE1, reinvesting the returns of QE1 in the purchase of Treasury securities and the operation twist adopted by U.S did little in boosting the confidence similar to the pre-crisis level. The crisis led not only the US financial markets feeling the heat but even exposed the strongest countries of Eurozone like Italy and Spain suffer the downgrade. The crisis exacerbated the situation to such an extent that even the three year €110 bn package by the Troika could not uplift the Greece economy. The continuous spat between German Chancellor Angela Merkel and French President Nicholas Sarkozy over the EFSF with Slovakia rejecting the plan to bolster the same got the European leaders again at loggerheads with no concrete resolution emerging from the discussions
Post the onset of the crisis there were widespread calls for better regulation and supervision of the international finance system. Economists often debated that the lack of having a stringent regulatory regime, resulted in reckless behaviour by the international banks and was the main cause of the crisis. However contrary to the popular belief it was the implementation of Basel Norms that led the developed world into the pit of a chronic debt crisis.
Origin of Basel I – A combination of regulatory and negotiating regulations
As Benjamin Cohen puts it, banks provide ‘the oil that lubricates the wheels of commerce’. To ensure that they can continue to perform this essential function – to ensure that the wheels of commerce keep spinning – banks must have the resources to withstand downturns in the economy. This is where capital regulation comes in.
United States witnessed the failure of about 747 out of the 3,234 savings and loan associations between 1980s and 1990s. In the wake of this savings and loan crisis (S&L), the vulnerability of the international banks to bankruptcy sent tremors to the stability of the financial system. As a result of this growing scepticism and lack of confidence the Basel Committee realised the immediate need for a multinational accord to strengthen the stability of the international banking system
The Basel Committee on Banking Supervision was created by the Group of Ten Countries (G-10) at the end of 1974, after the failure of Herstatt Bank and the New York-based Franklin National Bank in 1974 revealing that the crisis is no longer limited to a single currency.
The Basel Capital Accord (Basel I) was adopted in 1988, and had two main objectives; * Strengthen the soundness and the stability of the international banking system – minimum capital adequacy ratio by assessing the credit risk of the banks * Create a level playing field among international banks – Banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans
Fallout of Basel I and emergence of Basel II
Basel I set the platform for maintaining the adequate capital cushion required by the banks in the event of a default or grim situations. However the adequate capital (Tier I & Tier II) to be maintained was solely based on the credit risk (on-balance sheet, trading off-balance sheet, non trading balance sheet) assessment which was divided into 4 categories of Government Exposures with OECD countries - 0%, OECD banks and non – OECD governments – 20%, Mortgages – 50%, Other Exposures, retail and wholesale(SMEs) – 100%
Though the main aim of formulating the Basel Norms was to ensure the optimal capital cushion to be maintained required in the event of a crisis, the very introduction of Basel Accord, increased the gap between economical and risk-based capital and gave rise to regulatory capital arbitrage (RCB). The drawback that a loan to a safe industrial country and that to a volatile developing country attracted the same weight highlighted the inefficiencies of the Accord. The incentive to engage in regulatory capital arbitrage by lowering capital levels without actually reducing the risk was the paramount fallout of the Basel Norms.
Bad Debts, excessive leverage were primarily caused by the housing policy and the capital regulations. The shift adopted by the banks from traditional mortgage lending to securitization (RCB) along built up huge reserves of debt and encouraged banks towards more risk taking measures.
Revision of Basel I norms and the emergence of Basel II
The overall simplistic approach followed in risk assessment of Basel I and the incorporation of only credit risk, led the Basel Committee make amendments to the existing norms and reduce the incentive for banks to engage in regulatory capital arbitrage through Basel II. The new accord rested on three ‘pillars’. In addition to specifying minimum capital requirements (pillar 1), the new accord provided guidelines on regulatory intervention to national supervisors (pillar 2) and created new information disclosure standards for banks (pillar 3). Though Basel II was perceived to ensure stability and soundness in the system with market risk also considered, it did exactly the opposite.
The misconception that the ‘advanced internal ratings’ based (A-IRB) approach and sophisticated models to estimate ‘value-at-risk’ (VaR) would reduce the incentive for regulatory capital arbitrage through a bank’s own risk assessment was never achieved. Hence the advanced internal ratings approach and the freedom to deploy VaR models acted as the main vehicles to the failure of Basel II
Advanced Internal Ratings (A-IRB) & VaR- The decision to allow international banks to use internal ratings for risk assessment was influenced by the Institute of International Finance (IIF), a powerful consultative group of major US and European banks based in Washington. The fact that Basel I had arbitrary risk weights assigned to it and that the banks would be better off in risk sensitivity when using internal rating approach got the consensus of almost all the developed nations but the Bank of England. By mid-2000, every member of the Basel Committee had come around to the IIF’s view,
By the time the small and the developed nations became aware of the proceedings, the internal rating approach had already been implemented which left them with little choice than to go ahead with it. The concerns were collectively voiced by America’s community Bankers (ACB), Second Association of Regional Banks, a group representing the Japanese regional banking industry, and Midwest Bank, an American regional bank catering to consumers in Missouri, Iowa, Nebraska, and South Dakota, Reserve Bank of India and the People’s bank of China. These banks highlighted the fact that the fundamental premise of ensuring adequate capital cushion and maintaining equality among international banks was being defeated. Since only the large (Too big to fail) banks had the requisite infrastructure and the technology to adopt the internal rating approach, it would prove to be a disadvantage for the banks in the emerging world. There was clear resentment that the pillar 1 would instead of maintaining stability would render the banks in the emerging banks vulnerable to takeovers because of lesser profit margins.
However as witnessed post the crisis the exact opposite of what was predicted happened. The emerging markets emerged almost unscathed despite using the standardized approach primarily due to the following reasons: * The internal ratings approach modulated the use of historical data to predict the future trend of asset performance. The assets behave differently in the expansion and in the crisis phase revealing no correlation and hence rendering the mechanism of keeping less capital cushion for certain assets ineffective * The banks found an easier way to widen the gap between the economic risk and the regulatory risk through the internal ratings and as a result the capital cushion decreased rapidly thus at the discretion of the individual banks engaging in higher degree of capital arbitrage. The capital cushion was reduced to the extent of 2% when the stipulated was 8%.
The VaR model (determining the probability of the fall in the value of portfolio) also met with criticism because of relying more on historical data and hence using statistical concepts which fail when the economy behaves in opposite directions. Economists suggested backtesting to evaluate the actual risks encountered and that predicted by the VaR models.
Shadow Banking System
This term refers to the system of ‘credit intermediation that involves entities and activities outside the regular banking system”. Ellen Brown explains the concept of Shadow Banking:
The shadow banking system operates largely through the repo market. “Repos” are sales and repurchases of highly liquid collateral, typically Treasury debt or mortgage-backed securities. The collateral is bought by a “special purpose vehicle” (SPV), which acts as the shadow bank. The investors put their money in the SPV and keep the securities, which substitute for FDIC insurance in a traditional bank. (If the SPV fails to pay up, the investors can foreclose on the securities.) This money is used by the banks for other lending, investing or speculating. But that puts the banks in the perilous position of funding long-term loans with short-term borrowings. When the investors get spooked for some reason and all pull their money out at once, the banks can no longer make loans and credit freezes. In September 2008, investors were spooked when the mortgage-backed securities backing their repo “deposits” proved not to be “triple A” as represented.
Much of the shadow banking system was actually a consequence of Regulatory Capital Arbitrage which encouraged securitization and off balance sheet entities, which peaked post Basel II norms.
Snapshot of the fallout of the Basel II norms
The crisis highlighted a series of shortcomings in the Basel II accords: * The capital requirement ratio of 4% was inadequate to withstand the huge losses * Source: PWC report on Basel III
Source: PWC report on Basel III
Responsibility for the assessment of counterparty risk (essential to the risk-weighting of banks’ assets and therefore in assessing the capital requirement) assigned to the ratings agencies, which proved to be vulnerable to potential conflicts of interest. * The capital requirement is ‘pro-cyclical:’ if the global economy expands and asset prices rise, the country and counterparty risks associated with a borrower tend to decrease and thus the capital requirement is lower; however, in the event of a recession, the reverse is also true, thus raising the capital requirement for banks and further restraining lending. * Basel II incentivises the process of ‘securitisation,’ As a result, this process enabled many banks to reduce their capital requirement, take on growing risks and increase their leverage
Basel III and its subsequent impact (September, 2010)
Source: PWC report on Basel III
Source: PWC report on Basel III

Basel III will result in less available capital to cover higher RWA requirements and more stringent minimum coverage levels
The main considerations for Basel III apart from the enhanced quantitative measures are the following: * Revision of regulatory capital structure * Harmonisation of regulatory capital deductions * Publication of detailed disclosures * Capital Conservation Buffer (CCB) * Create buffers in good times * Impose good bank governance – increasing regulators’ power * Countercyclical Buffer * Prevent excessive credit growth * Macro Prudential Buffer – add- on to CCB to protect from excess credit levels * Country Dependent – exposure to private sector * New Leverage Ratio * Volume-based ratio, not risk adjusted * Credit Conversion factor of 10% applies to unconditionally cancellable commitments * Cap on the build up of leverage * Safeguard against model risk and measurement errors * Systemic Add-on * Reduce risks related to failure of systemically relevant, cross-border institutions (SIFIs) * Decrease the probability of failure of systemic risks * Decrease the impact of failure of systemic banks * Liquidity Coverage Ratio * Adequate level of high-quality, unencumbered assets to weather a severe stress scenario * Stock of highly liquid assets subject to quantitative and qualitative eligibility criteria * Net Stable Funding Ratios * Incentive for structural reforms to shift from short-term funding profiles to more stable long term funding profiles
Impact on the US and the European Banking Sector

Basel III will have significant impact on the European banking sector. By 2019 the industry will need about €1.1 trillion of additional Tier 1 capital, €1.3 trillion of short-term liquidity, and about €2.3 trillion of long-term funding, absent any mitigating actions.
The impact on the smaller US banking sector will be similar, though the drivers of impact vary. The Tier 1 capital shortfall is estimated at $870 billion (€600 billion), the gap in short-term liquidity at $800 billion (€570 billion), and the gap in long-term funding at $3.2 trillion (€2.2 trillion).
The capital need is equivalent to almost 60 percent of all European and US Tier 1 capital outstanding, and the liquidity gap equivalent to roughly 50 percent of all outstanding short-term liquidity.
Basel III would reduce return on equity (ROE) for the average bank by about 4 percentage points in Europe and about 3 percentage points in the United States.
The retail, corporate, and investment banking segments will be affected in different ways. Retail banks will be affected least, though institutions with very low capital ratios may find themselves under significant pressure. Corporate banks will be affected primarily in specialized lending and trade finance. Investment banks will find several core businesses profoundly affected, particularly trading and securitization businesses. Despite the long transition period that Basel III provides, compliance with new processes and reporting must be largely complete before the end of 2012
Outlook for the next 10 years
The Basel III norms have been introduced at a time when there is a dire need of a stringent regulation in the international banking stability. However it’s too early to predict the positive benefits. There are other risks that we need to be cautious of: * The implementation timeline for these regulations is relatively long, in order to avoid any negative impact on credit conditions and the still recovering economy * Since most of the regulations are supposed to be implemented in between 2013 and 2019, though banks would be having sufficient time to take care of the infrastructure issues, the implementation would force certain small banks out of credit access. * Basel Committee and IIF are of different opinion regarding the change in GDP corresponding to a percentage point in capital requirements * The solution of the shadow banking system (such as insurance firms, hedge and pension funds, and investment banks) is still in shambles as they fall outside the purview of the regulations of even the new norms * ‘Regulatory Arbitrage’, still remains a concrete risk for the international banking, as US and UK government focus on a sooner implementation. * Securitisation wrecked the stability of the financial system, with assets being shifted to the off balance sheet. Since the credit conversion factor (the risk-weighting) of these items has risen from the current 20% to 100%. This means that banks will have to increase their capital for asset-backed loans by a factor of five. * Since trade finance instruments represent more than 30% of world trade, the fivefold increase in the costs would either be passed on to the consumers or banks would resort to less expensive trade finance instruments or other forms of unsecured financing such as forfeiting.

References 1. http://www.algorithmics.com/EN/media/pdfs/Algo-WP0910-LR-Basel3-Exd.pdf 2. http://www.dnbgov.com/pdf/DNBBaselIII.PDF 3. http://www.iafe.org/html/upload/StabilityPanel.pdf 4. http://www.financialstabilityboard.org/publications/r_110412a.pdf 5. http://www.bis.org/publ/bcbs57.pdf 6. Report: NOT WHAT THEY HAD IN MIND:
A History of Policies that Produced
The Financial Crisis of 2008 by ARNOLD KLING 7. Why Basel II failed and Why any Basel III is doomed by Ranjit Lal 8. Report: NOT WHAT THEY HAD IN MIND:
A History of Policies that Produced
The Financial Crisis of 2008 by ARNOLD KLING 9. McKinsey’s Report on Basel III and European Banking 10. PWC’s report on Basel III, A risk management perspective - 2011