Oct 01

Basel II: Background

by David Harper, CFA, FRM, CIPM

FRM |

baselPillarsIntro100h

Learning Outcomes (FRM 2007)

  • LO 67.1: Identify the primary justifications for the existence of banking regulation.
  • LO 67.2: Discuss the potential moral hazard issues associated with deposit insurance.
  • LO 67.3: Discuss the benefits and weaknesses of the original 1988 Basel Accord.
  • LO 67.4: Identify the primary goals of the Basel Committee in developing the Basel II Accord.

The Basel Accord is a set of international agreements that coordinate the regulation of global banks ("an international framework for internationally active banks"). The Accords (the original Basel Accord and the new Basel II) tell banks how much equity capital they must hold as buffer against unexpected losses (the first pillar). Also, they give national regulators ("supervisors") a rule book for enforcing these capital requirements (the 2nd pillar) and they insist that banks disclose these risks to the market (the 3rd pillar, market discipline). By way of metaphors,

  • First pillar: Technical rules
  • Second pillar: The rule-book for the referees (supervisors) to enforce and intervene, where needed
  • Third pillar: Transparency is the sunshine that disinfects. The theory that, if banks enhance their disclosures, the market will engage in the "new and more" information and provide discipline, where needed

 

Regulatory Justifications (FRM LO 67.1)

The justifications for banking regulation are to protect depositors, to ensure a reliable money system, to mitigate systemic risks and to encourage financial efficiency.

 

broken piggy moneybox

Moral Hazard (FRM LO 67.2)

Moral hazard takes many shapes in the banking system. In the context sub-prime crisis, some argue that Fed relief (cutting the discount rate) is a moral hazard that encourages financial institutions to take undue risks (Larry Summers disagrees and maybe only Stephen Cecchetti can sort this out).

But the learning outcome asks about the moral hazard created by Federal Deposit Insurance Corporate guarantees.In regard to FDIC, the hazards are

  • Since depositors have a safety net (they are insured up to $100,000), maybe they will not bother to monitor their banks?
  • Since the bank does not bear less costs than if deposits were uninsured, maybe banks will seek more risks?

 

Original Basel Accord (FRM LO 67.3)

The original Accord is almost twenty years old and long in the tooth. It did, however, succeed in setting minimum global standards for capital. Further, as Jorion observes, the 1996 amendment (1998 enacted) that added market risk was something academics call a very big deal: the internal models approach allows banks to employ value at risk (VaR). But the original Accord looks quaint by today's standards. Most notably, the 8% Cooke ratio (i.e., banks must hold capital against 8% of their assets) is almost incapable of discrimination when it comes to different risks. It wants banks to hold the same 8% against a corporate bond, regardless of whether the bond is investment-grade bond or speculative:

originalAccordProsCons

 

Basel II Goals (FRM LO 67.4)

The goals of Basel II are introduced in the document. Compared to the Original Accord, the new Accord is impressive in ambition, scope and the diligence (e.g., five follow-on quantitative impact studies [QIS]). The new Accord recognizes different (heterogeneous) risk types, their mitigants (e.g., collateral, derivatives) and their forms (e.g., securitization). It contemplates the evolution from basic (ratings-based) to advanced approaches that allow the bank to shift from regulator supplied parameters to their own internal parameters. The price of this is complexity and, perhaps, a rule set that may be too ponderous to keep pace with actual financial innovation.

The goals of Basel II include:

  • To adjust capital requirements to more closely reflect actual risk; i.e., “to arrive at significantly more risk-sensitive capital requirements.”
  • To make greater use of banks’ internal systems as inputs to capital calculations
  • To provide a range of options for determining capital requirements that are most appropriate for their operations and their market discretion
  • To recognize that home country supervisors have an important role
  • To broadly maintain the aggregate level of capital minimum capital requirements, while also encouraging advanced, risk-sensitive approaches

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