V A Practitioner’s View

Basel III from a practitioner’s perspective

Esa Tuomi and Eriks Plato

HISTORICAL CIRCUMSTANCES

Modern international financial cooperation can be said to have begun in 1930, with the establishment of the Bank for International Settlements (BIS). The BIS was initially set up to facilitate German World War I reparations, but effectively took over management of the Bretton Woods system of foreign exchange in 1945. In order to provide the Bretton Woods system with more tools for policy management, the International Monetary Fund (IMF) and the World Bank also were created at this time. This was the first time that a large number of nations (44 initially) had negotiated a fixed monetary and exchange rate regime.

The Bretton Woods system broke down in 1971 and this led to the threat of instability of large cross-border financial institutions speculating across many currencies and time zones. The focus then turned to regulating the institutions themselves rather than managing a fixed rigid system.

In 1974, the Basel Committee on Banking Supervision was created at the BIS. The culmination of cooperation in regulating banks came in 1988 with the adoption of the Basel I Accord. Originally 13 countries were party to the Accord, but more than 100 others eventually enacted the principles in their national regulatory framework.

The work of the Basel Committee is based on working groups focused on Standards Implementation, Policy Development, Accounting and Consultation. The Policy Development working group is the one that works out the actual regulatory proposals and its work is also divided into numerous subgroups. Each member country appoints its representatives to this work and generally they are central bankers, treasurers or other high-ranking policy-makers in their respective countries. It is important to realize that this is no anonymous, academic body, but rather an assembly of national policy-makers.

The main goal of Basel I was to introduce a standardized framework of banking supervision. It introduced five risk classes (weightings) and a universal 8 per cent capital requirement in a document consisting of 30 pages. It is important to note that the Basel Accords are only a cooperative framework and that the actual legislation is enacted at a national level. So, in fact, far more than 30 pages of regulations had to be complied with. The actual regulation that banks followed went into hundreds of pages (per country).

Given the success of Basel I, in terms of actually having negotiated a set of international regulatory standards, very soon work began on improvements to the framework. Simply put, Basel I was seen as being too simplistic. Actual risks within the individual asset classes might vary a lot. It was plain to anyone that a large manufacturer with a 100-year track record listed in the United Kingdom constituted a different credit risk than the start-up of a rural restaurant in Afghanistan. This had not been taken into account at all in the original Basel framework.

In the 1990s the committee, together with the banking industry, discussed a new, much more comprehensive and, supposedly, more realistic policy framework based on sound economic rationale. The proposal for a new framework came from the Committee in 1999 and it was finally worked out and adopted in 2004 with a number of subsequent revisions.

On 347 pages, the Basel II Accord outlines a regulatory framework based on three pillars:

• • Pillar 1 outlines the capital requirements based on credit, operational and market risk.
• • Pillar 2 outlines how the authorities should monitor the banks.
• • Pillar 3 outlines the reporting requirements by the banks.

Once again, this is only the outline. The actual regulations are national. In the 27 member countries of the European Union (EU), it is the EU Banking Directive that legislates the overall Basel II framework, yet the actual regulations are adopted at a national level. Therefore, there are thousands of pages of regulations that a bank must comply with. Unfortunately, many countries such as the United States, China and Russia have not fully adopted Basel II and even in those that did adopt the new standards, most banks have yet to meet all of the requirements.

The core of Basel II is Pillar 1, which prescribes the actual capital requirements for credit, market and operational risk. For each one of these areas the following approaches are possible:

• • Standardized approach: all parameters are external.
• • Foundation internal ratings-based approach: customer ratings are internal (i.e. use the banks’ historical data for probabilities of default).

• Advanced internal ratings-based approach: credit conversion factors, loss-given default and certain other parameters internalized.

Basel II is really quite theoretically sound, to the extent that it provides for credit risk differentiation-based company probabilities of default, empirically observed losses given default, and adjustments for products and maturities. In addition, it also provides for market and operational risk. Quite magnificent to be able to match regulations to real-life expected outcomes of financial transactions. Unfortunately, it did not work.

The events of 2008 provided ample evidence that the existing regulatory framework will not prevent the type of crisis that occurred. In fact, it can be argued as to whether bank regulation or deregulation (i.e. the repeal of the Glass-Steagal Act in the United States) had any impact at all. After all, Lehman Brothers did not fail because it engaged in retail banking nor did Washington Mutual fail because it engaged in investment banking. In fact, the entire United States (US) subprime crisis that precipitated the Great Recession did not arise due to inadequate regulation. The regulations on mortgage finance in the United States are quite comprehensive and seem quite reasonable. However, the regulations in place were obviously not adequately enforced.

It seems that another reason for the crisis was the lack of understanding of many bank decision-makers on the nature of the risks that they were undertaking. Once again, it is not so certain that you can entirely regulate away stupidity.

At the end of the day, banks alone had to write off US$3-4 trillion and the costs to the overall economy are difficult to ascertain. One anti-Wall Street non-governmental organization (NGO) calculated the cost to the US economy at roughly US$12 trillion in lost gross domestic product (GDP). Whatever the actual numbers, the impact was huge on banks, on governments and on societies.

There was a public outcry. ‘Obviously someone has to pay.’ Though nobody relevant has yet been prosecuted. ‘Obviously, bankers are greedy.’ Though banks have been bashed in the press, one must remember the old adage that ‘sticks and stones may break my bones, but words will never hurt me’. Obviously, laws must be enacted so that this does not happen again. Unfortunately, here the public got its wish.