And some people want more regulation? How Basel II allowed the banks to get it wrong - Posted by Jon Stanford The number of shocks to the banking system in advanced economies recently such as the nationalisation of Northern Rock Bank in England; the losses by a rogue trader from SocGen; the reconstruction of two smaller German banks after over-exposure to the subprime crisis; the increase in short term interest rates as banks are increasingly reluctant to lend to each other in money markets; the increase rates of interest on business and mortgage loans in excess of official central bank changes. The biggest one of all was the sale of Bear Sterns, a prominent New York investment bank and a leader in the sub-prime mortgage securitisation, to JP Morgans in a bargain basement sale officially supported by the Federal Reserve. All this take together is indicative of a banking system which has misjudged risks, has mispriced risk, has been unable to assess the creditworthiness of other banks. Is this just a case of banks having overextended themselves and made poor calls at critical points?. On the contrary I would argue that changes in international banking regulation brought about under the auspices of Basel II have allowed banks systematically to underestimate risk and loss allowances and to make inadequate provision of capital reserves to meet unexpected losses. Banks have been implicitly encouraged to place growth ambitions ahead of prudent management of their affairs. There are two changes under Basel II which deserve consideration. The first is to allow banks to employ credit ratings to measure individual banksâ credit risk. The second is to allow banks to use advanced statistical models to determine risk of default or failure in the event of external shocks. Concerns about credit ratings are not new; they were previously raised during the Enron scandal of 2002 and the Asian Financial Crisis of 1997. But under Basel II banks have been allowed to use credit ratings to determine the risk attaching to their loans and hence to calculate minimum capital requirements. An example of how this worked is: banks sell mortgages off their balance sheet to a securitisation vehicle which is rated AAA. In consequence, the bank needs to keep minimal capital reserves against this. If the bank lends the securitisation vehicle the funds to complete the purchase, the bank needs to make minimal, if any, provisions for capital reserves. When the securitisation loses its AAA rating the bank is then required to make substantial provisions for capital reserves up to eight per cent of the loan. If the loan to the securitisation vehicle is considered doubtful, then the bank must make explicit provisions for the expected loss. What started out as a clever piece of financial engineering has put the bank in difficult circumstances. The position is made worse if the sale of mortgages was not a âclean saleâ i.e. the bank provided implicit undertakings to purchase loans back. Also banks have been allowed to carry out their own risk assessment of other parts of their operation by using sophisticated statistical techniques which aim to calculate the risk of loss in the event of some external shock e.g. a rise in market interest rates, a shock to financial markets or a recession in the economy. As one might expect, banks used assumptions which cast their assessed risks in the best possible light. The general effect has been to allow banks to come up with models showing they face a lower risk which means they have to hold smaller amounts of capital. Banks like to hold less capital because it doesnât dilute control it increases leverage (able to use more borrowed funds) and hence profits when things are going well. However, when things are not going well, as they are in 2008, banks have to overcompensate by holding higher than the minimum capital reserves. Since they are unable to raise new capital on the open market (think how an issue of shares would be regarded when the price of existing bank shares have taken a severe tumble), banks have to cut back on new loans and try to increase their profit margins i.e. increase interest rates by more than official increases. The process is contagious. Banks become unwilling to transact with other bank because each suspects that the others have been up to the same tricks as they have so that balance sheets lose transparency. The interbank market come to a halt and liquidity dries up especially as banks now need to hoard cash. Is this analysis speculation? Well, the Presidentâs Working Group on Financial Markets on March 11, in a classic case of shutting the stable door after the horse has bolted, has made extensive recommendations for the reform of the credit rating industry, the use of statistical risk models and has called for certain of the Basel II to be sent back to the Bank for International Settlements for another look.
http://us.ft.com/ftgateway/superpage.ft?news_id=fto022720081434030374 Turmoil reveals the inadequacy of Basel II By Harald Benink and George Kaufman Wednesday Feb 27 2008 14:25 The turmoil in world financial markets, triggered by defaults on subprime mortgages in the US, raises questions about macroeconomic policy, financial stability and the design of financial regulation, including the new Basel II capital adequacy framework for banks. The implementation of Basel II coincides with massive losses reported by some of the world's largest banks, requiring large-scale recapitalisations. The risk models that anchor Basel II are basically the same as the ones many of these banks have been using in recent years. Sheila Bair, chairman of the Federal Deposit Insurance Corporation in the US, recently noted that these models had important weaknesses which, in the light of today's market turmoil, were a flashing yellow light to drive carefully. Basel II aims to address weaknesses in the Basel I capital adequacy framework for banks by incorporating more detailed calibration of credit risk and by requiring the pricing of other forms of risk. Under the Basel II framework, regulators allow large banks with sophisticated risk management systems to use risk assessment based on their own models in determining the minimum amount of capital they are required to hold by the regulators as a buffer against unexpected losses. However, recent events challenge the usefulness of important elements in the Basel II accord. The need to recapitalise banks reveals that the internal risk models of many banks performed poorly and greatly under-estimated risk exposure, forcing banks to reassess and reprice credit risk. To some extent, this reflects the difficulties of accounting for low-probability but large events. A more fundamental problem is that Basel II creates perverse incentives to underestimate credit risk. Because banks are allowed to use their own models for assessing risk and determining the amount of regulatory capital, they may be tempted to be overoptimistic about their risk exposure in order to minimise required regulatory capital and to maximise return on equity. Bank capital-asset ratios are near historically low levels, typically at about 7 per cent of total assets (on a non risk-weighted basis). During the past five years, several so-called "quantitative impact studies" (QISs) have been conducted under the auspices of the Basel Committee on Banking Supervision to explore the consequences of shifting from Basel I to Basel II for large banks. These studies show that bank capital requirements will fall further for many banks when the Basel II rules are fully implemented. In the US, the QIS results indicate potential reductions in required capital of more than 50 per cent for some of the largest banks. The turmoil on financial markets, which has caused large banks to take substantial losses and search for significant new capital, indicates that Basel II should not be implemented, if at all, without first making a number of important changes. We advocate the following improvements in order to correct some of its deficiencies. First, we urge the Basel committee to conduct another quantitative impact study using observations from the recent turmoil before allowing banks to use their internal models for calculating regulatory capital. Second, we advocate the additional adoption of a meaningful non risk-weighted leverage ratio requirement, as currently applicable in the US, to supplement Basel II risk-weighted capital requirements. Consistent with the FDIC chairman, we believe that it is important to have a minimal capital cushion in the banking system, even when risk-based Basel II capital rules indicate lower risk. Strong capital allows banks to recognise losses and put problems behind them in times like the ones we are now experiencing. And strong capital gives banks the flexibility to serve as shock absorbers to our economy during difficult times. Third, we recommend that the Basel II approach using banks' own risk models should be complemented by a credible and effective form of market discipline. While Basel II contains information disclosure requirements, at the same time it fails to create incentives for professional investors to use this information in an optimal way. As long as professional investors holding bank liabilities have the perception that large banks are too big to fail - or that all deposits will be fully protected against loss, as in the Northern Rock case - they will have the idea that their money is not really at stake. This will mitigate their incentives to use the disclosed information. A mandatory requirement for large banks to issue credibly uninsured subordinated debt as part of the regulatory capital requirement could enhance market discipline, thereby mitigating banks' incentives to reduce capital.
Yes, the regulatory structure left the US system vulnerable. But no one seems to talk about OPEC driving oil prices up over the past 8 years. The peak at 145 made the world economy scream to a halt. The oil weapon was used and was able to work due to the inherent weaknesses within the system. There needs to be work to overcome the OPEC monopoly, or the problem will only return when they set a floor at 100 per barrel. I don't know why politicians are so quiet about the major cause of our current financial crisis.
Ummm banks were leveraged in some cases 40-1. I don't care who gave you the authority to hang yourself, the fact that banks did it, was DUMB AS HELL and how anyone can blame stupid STUPID calls like that on anything but GREED, is beyond me. Did regulation tell these dumb investment banks to split up AAA mortgage back securities and package them with SUBPRIME then sell them as AAA?!?!? WHAT JERKOFFS, and please regulation. To do something like that was just BLATANTLY DECIETFUL. I can go on and on, and sorry GREED played the role not regulation and yes these morons, until proven trustful need to be regulated. Then we will unregulate them sometime down the line and have another problem like this rise 100 years down the line, if we make it of this mess. I love the people that say Clinton unregulated the housing market too. OHHHH, so he told these guys to lend $500,000 based on collateral THAT WAS NEVER VERIFIED, or INCOME. JESUS CHRIST, WHO RUNS A BUSINESS LIKE THAT, AND SURVIVES. Just like Americans who don't want to except responsiblity for their spending habits, or buying a house they KNEW they coulnd't afford, but didn't want to hear it. Sounds like Americans might need to be regulated too! BECAUSE THEY HAVE NO RESPONSIBILTY IN ALL THIS EITHER, evidentally. PATHETIC.
Because no politician has the guts to come out and say, "GUESS WHAT AMERICAN, WE'VE BEEN FAT GREEDY PIGS THESE PAST X AMOUNT OF YEARS AND NO WE PAY THE PIPER!" It can never be America's fault no no no. We're to special, every house should have a plasma TV and 2 cars in the driveway, and should have 6 rooms for a family of 4, even though we forgot what it was to work hard and SAVE and earn all these things. We thought we deserved it and got our way with cheap credi. BUT ITS NOT OUR FAULT! Edit: And forgot to add the new outfit every week for school because we all know, being the best dressed and the coolest in HIGH SCHOOL, is what really counts in America, EDUCATION, BLAH overrated! I don't think Americans know what it means, to be told NO, you can't have that!
The bet played by the international bankers was that their leveraged suicide would be explained away as salesmanship in lending, that the crisis would be played off as uncontrollable market activity and dishonest borrowers, that the sole resolution was to give the bankers the mortgage value PLUS let them keep the homes to sell as well, and that the timeline to write that fat check was immediate to avert disaster. They won.