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 (Sep08), 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
banks 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 IIFs 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 Americas
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 Peoples 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
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
Source: PWC report on Basel III


requirement, take on growing risks and
increase their leverage
Basel III and its subsequent impact (September,
2010)

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
o Harmonisation of regulatory capital
deductions
o Publication of detailed disclosures
Capital Conservation Buffer (CCB)
o Create buffers in good times
o Impose good bank governance
increasing regulators power
Countercyclical Buffer
o 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
o Volume-based ratio, not risk adjusted
o Credit Conversion factor of 10%
applies to unconditionally cancellable
commitments
o Cap on the build up of leverage
o Safeguard against model risk and
measurement errors
Systemic Add-on
o Reduce risks related to failure of
systemically relevant, cross-border
institutions (SIFIs)
o Decrease the probability of failure of
systemic risks
o Decrease the impact of failure of
systemic banks
Liquidity Coverage Ratio
o Adequate level of high-quality,
unencumbered assets to weather a
severe stress scenario
o Stock of highly liquid assets subject to
quantitative and qualitative eligibility
criteria
Net Stable Funding Ratios
o 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.
Source: PWC report on Basel III


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 its 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/StabilityPan
el.pdf
4. http://www.financialstabilityboard.org/public
ations/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. McKinseys Report on Basel III and European
Banking
10. PWCs report on Basel III, A risk management
perspective - 2011