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Basel II: A Review of Literature

By Saurabh Malik Student No. 0954187

University of East London

May 4th, 2010

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Contents

1. Abstract----------------------------------------------------3

2. Literature Review ---------------------------------------4

3. Conclusion -----------------------------------------------9

4. References------------------------------------------------10

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BASEL II

ABSTRACT

The implementation of the second of the Basel accord (Basel II) has been a crucial

debate around the world. In this paper, I will analyse the implications of Basel II in different

sectors of the international banking organization. The study will take into consideration some

of the important aspects like Retail and Small & Medium Enterprises, International

Competition Effects in European and U.S. Commercial Banks, the U.S. Credit Card Industry,

the Home Host implementation issues, the flow of money in Emerging Economies (EMEs),

the cyclicality effects in U.K. banks and finally the effectiveness of Basel II in the recent

financial crisis all of which will evaluate the effectiveness and the complexities of Basel II in

the current scenario. The methodology used in this paper is the critical review of different

literature and journals published during the last few years. Last section will show the

conclusion based on the findings.

INTRODUCTION

Basel II is the International Convergence of Capital Measurement and Capital

Standards: a Revised Framework which offers a new set of international standards for

establishing minimum capital requirements for banking organisations. The main purpose of

New Basel Capital Accord (or Basel II) which was approved by Basel Committee on Banking

Supervision (BCBS) in June 2004 is “to build a structure with greater flexibility and

sensitivity to risks and to evolve the practices of supervision and risk management.” 1.

Basel II is developed to form relationship between capital and risk. The explicit objective of

Basel II, thus, is to provide improved risk management practices in International banks. This

objective can be achieved through 3-pillars:-

Pillar 1: Risk based minimum capital requirement (credit risk, operation risk and

market risk)

Pillar 2: Risk based supervision (supervisory review process)

Pillar 3: Improved disclosures (market discipline)

1 See Elizabeth de Almeida Neves Di Beneditto, Accord (Basel II) – A multiple case study, Dec 2008

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The credit risk and minimum capital requirement are the crucial element of Basel II along

with market risk and operational risk. Another objective of Basel II is to create more future

oriented policies which can easily grow. This can be accomplished through risk management

rules followed in banks. Thus, the new Basel accord is a set of three pillars therefore it will

not be considered as implemented fully if any of the three pillars is missing.

It is sometimes also argue that Basel II is better than Basel I because of its more risk

focused nature in different approaches like standardised approach, foundation approach and

advanced approach. However these advanced approaches may not be suitable for many

international banking systems due to their differential goals. For example, in many countries

the objective of the banks are to improve their legal and accounting standards, the governance

of bank, the risk management practices and the role of supervisory agency. Banks are

managing themselves more widely on business lines without giving proper care to legal

entities.

In the past few years, Basel II has been highly objected for its complexities. In this

paper, I will review some of the important literature about the implication of Basel II.

LITERATURE REVIEW

An important study of Basel II and its international competition issues was made by

Gottfried Haber (2007) in which the author highlights some issues which are important to

consider on effects of competition of the new capital accord. The global competition effects

are important as European countries are following Basel II quicker where as US is still

having doubt about its implication. The comparison between European and US bank lending

are based on the type of rating system followed in each country. For example, the external

ratings are common is US whereas in Europe, only some big firm are using the ratings by

some official international agencies. Due to the lack of external rating structure the banks in

Europe have initiated a rating system internally since last 20 years because of the “risk

transformation” which is a main revenue source for banks. But this Internal Rating Based

(IRB) approach may not necessarily follow the standardized regulatory framework which is

developed by Basel II for their risk assessment system. The author strongly recommends

Basel II as an incentive for banks. This is because of the lower minimum capital requirement

in Standardised Approach which is similar to the minimum capital requirement of Basel I

accord. The “fifth quantitative impact study” (QIS 5), shows that the minimum capital

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requirement remained same for most of the banks. The impact of the new Basel II will thus be

very limited. The other cost which author consider is the one time cost of implementation for

commercial banks but this may not affect much to both the European and the US banks.

However the benefits of the high quality of the risk management may equally affect both the

banks. There are also structural differences in terms of borrowers in both the countries, so it

is difficult to say which banks will be more sufferer i.e. European or US. Basel II may also

reduce interest rate distortions thereby improving market efficiency but it is only possible if

Basel II is globally accepted and implemented.

Nicholas Le Pan (2008) talks about three main realities which BSBS was facing in

implementing Basel II. First, there exist a huge difference between the complexities of big

international banks and the smaller banks, so the new framework is likely to be followed by

many countries through different approaches. The Basel committee never considered a “one

size fits all” approach of Basel I will keep developing on. Secondly, there also exist location

differences in the banks and supervisors within or outside G-10. For this reason, IMF and

World Bank are accessing the countries who want to implement Basel II. The third reality

considers growing diversity between the banks and their legal structures that are supervised

under law. The author explains this divergence through home-host implementation problems.

The host country has legal responsibilities which should be recognised. As a result of Basel

II, the relation between the host and the home countries is changing. The host countries are

required to depend upon home country because of the centralized analytics andrisk

management task. Similarly, home countries are to rely on the host countries in order to

measure the validation of locally applied Basel II analytics and data. The Accord

Implementation Group (AIG) is the first for the Basel committee and it has extended the

arrangement of home-host cooperation.

James Benford and Erlend Nier (2007) in their literature has analysed some evidences

on the cyclicality of Basel II capital requirements in UK banks. Under Basel II, the capital

requirements may vary with the change in economic conditions i.e. low in boom period and

high in recession. This may result in increase in the sensitivity of supply of credit. With this

the Bank of England emphasizes the cyclical variability of capital requirement for entire UK

banking sector but the Financial Services Authority (FSA) focus on the individual bank’s

capital adequacy. The literature suggests that the output of retail and corporate rating of UK

lenders is expected to vary with the change in market conditions. The use of internal ratings

for minimum capital requirements in Basel II improves risk sensitivity and provides

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improved risk management, also generates the risk by making the capital requirement more

cyclical with economic conditions. However, the unintended effects of Basel II can be

avoided by the industry and the market participants if banks do careful consideration in

capital planning by holding a voluntary buffer capital over the minimum requirement and if

the market participants make a careful scrutiny of bank’s rating system.

Simon Hayes & Victoria Saporta (2002) have studied the impact of Basel II on the

supply of capital in Emerging Market Economies (EMEs). They criticized the argument that

the new Basel accord will increase the lending cost to low credit quality borrowers in EMEs

thereby curtailing the supply of credit. Under Basel II, the credit quality of a loan portfolio

depends upon the international banks regulatory capital which implies that the capital charges

to lend to the borrowers will be expensive. However, the authors argue that banks themselves

want to keep a sensible amount of capital stock in order to prevent them from unexpected

losses. They call it as ‘economic capital’ which is associated with the credit quality of the

bank’s assets. The loan prices largely depend upon the cost of economic capital and thus will

be unaffected by the regulatory capital change. Unlike Basle I where capital charges are

based on the borrower’s domicile in OECD or non-OECD region, Basel II explicitly measure

capital charge to credit risk through external (Standardized Approach) or internal (Internal

Rating Based) approach. Secondly, Basel II could also reduce the distortions lending patterns

(like 8% charge for longer term and 1.6% charge for shorter term loans). Since international

banks have adopted IRB approach, the new accord will affect the lending to EMEs

internationally and domestically. The lending through international banks will clear the

OECD effect and maintain a clear relationship between credit quality and regulatory capital.

The regulatory charge of lending to EME will fall. As far as domestic lending is concerned,

the foreign bank participation in EMEs by establishing branches or purchasing subsidiaries

will raise a question which approach will be used. However, domestically owned banks will

follow standardised approach for which capital charge for lending to EME will not be

affected.

A joint study made by William Lang, Loretta Mester and Todd Vermilyea (2006)

about the competitive effects of the regulation of Basel II capital on U.S. credit card industry

reveals that the bank issuers that follow Basel II capital regulations (Basel II banks) will have

no competitive effects during normal economics conditions. However, during economic

downfall in credit card portfolios there are more chances of Basel II banks to face a

competitive disadvantage as compare to the banks that operate under Basel I capital

requirements (Basel I banks) and to nonbank rivals. Basel II could create competitive

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advantage only if the minimum capital regulatory is “binding” i.e. if the regulatory constraint

has a significant impact on credit card portfolio. The authors use the regression models to

evaluate that higher capital requirements under Basel II are possibly to be binding due to a

possible increase in bank’s estimated risk parameters like possibility of default (PD), loss

given default (LGD) and exposure at default (EAD) during the downfall periods. This will

result in more use of relatively cheaper Tier-2 capital. On the other hand, Basel I banks may

not face this binding constraint but they do need to face high level of market and supervisory

requirements in case of poor performance of their portfolio. Basel II regulatory capital cost

may not have a direct or indirect impact on the regional banks (with assets of more than $1

billion) and community banks (with assets of less than $1 billion) because of less competition

of these banks in credit card market. As far as non bank credit card issuers are concerned, that

normally issue credit card loans through Credit Card Speciality Banks (CCSB), the Basel II

capital constraint can be avoided by transfer of asset to the nonbank parent. Thus they could

benefit if the bank competitors face a rise in the amount of capital requirements.

In this literature Tor Jacobson, Jesper Linde & Kasper Roszbach (2005) explains the

Basel II with its implication on Retail and Small & Medium Enterprises(R&SME) credit.

They argue that R&SME has got important place under Basel II because of the smaller

exposure to systematic risk. They use the non-parametric Monte Carlo re-sampling method

which follows the approach of Carey (1998) on two banks’ entire portfolio to prove their

theory. They use the data from the loan portfolio of two Swedish Banks (bank A and bank B)

to evaluate the Basel II implications. Their main purpose was to study if the difference in the

treatment of “other retail” credit and SME loans in Basel II is supported by the real loss

distribution in their data. They, first, create the retail distribution of credit loss, SME, and

credit portfolios of corporate and then evaluate the economic capital required which is

maintained by these distributions. Their study criticizes the assumption of Basel II regulation

that SME and retail loans portfolio depicts smaller losses than corporate loan portfolio which

owes a smaller dependence on systematic risk factors. They found no such empirical

evidence through their sampling model. Moreover, risk weight function of Basel II emerges

to be only moderately successful corresponding to the actual rates of loss computed in their

data. The same results were seen for retail credit.

Now, I will discuss the ability of Basel II to react to the recent global financial crisis.

One such study was made by Jeffery Atik (2009). He argues that the new capital accord focus

only on the risk faced by individual banking institution which are based on the risk estimation

of historical data. It fails to examine the capital adequacy outside the banking system during

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unlikely or unidentified events for which there in no historical data. The main concern is that

the extent of losses which arise due to the unexpected events should also be considered along

with the frequency of events. Basel II optimizes a set level of capital adequacy requirement

which is only a ninety nine percent survival system. However, the remaining one percent may

result in more serious losses as in the case of recent global financial crisis. This literature

emphasizes a reconstruction of international banking framework i.e. Basel III which should

also include those possibilities that are not suggested by the historical experiences or may be

found outside the chosen period. The assumption of correlation of asset performance is not

true in Basel II framework under extreme financial crisis. In case of U.S. mortgage loans, the

prediction of defaults on mortgages was based on the prosperous times which underestimated

the risk. This is because during the housing boom, defaults were less due to positive

economic conditions and the rise in housing prices helped the borrowers to come out of any

difficulty by selling the assets. It resulted in an underestimation of the potential for loss and

eventually this led to a major U.S. subprime crisis. The same was true with the loss given

defaults which remained underestimated. These incidents explain the need of far more capital

required by banks than the minimum standards under Basel II. However, the study also

reveals that some banks were successfully managed to get additional capital from the national

or international organisations in their role lender of last resort. The BCBS does not have a

proper answer about the actual amount of additional capital require to fight against for such

low probability high impact events.

CONCLUSION

Thus after careful review of the different literatures, I will conclude that Basel II is

costly for banks to raise additional capital in case of unfavourable market conditions and

when it requires quick action. The regulation of Basel II is difficult to implement on a bank

with cross-border operation. This may create adverse impact on domestic market operation.

The problem arises if the supervisor in the parent country approves the adoption of IRB

approach but the host country’s supervisory capacity may allow it to adopt standardised

approach thus leading to home-host implementation problem. The assumption of Basel II that

R&SME loans portfolios are less risky than corporate loans is also not valid as the no results

have been received by empirical evidence. The new accord only highlights the risk

estimations of the individual banks based on the historical data and it does not take into

account the possibility of unexpected event, thus underestimates the potential loss. It takes

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into consideration the minimum capital require for expected events but leave the scope of

capital low probability high impact events. The compliance of new Basel accord is expensive

and complex with inefficient supervision in some countries. However, on the positive side the

improved risk management along with improved market efficiency in U.S. and European

banks will lead to reduced interest rate distortions. In U.K. banks market also we can

conclude that with the IRB approach, it will improve the risk sensitivity and better risk

management. The affect of Basel II on the supply of capital in EME will also be negligible.

The new Basel accord will rather closely linked economical capital to the capital charges.

Similarly the new capital accord will have very nominal impact on the U.S. credit card

industry which depends upon the nature of regional and community banks. Moreover, the

distinction of OECD and non-OECD region is welcomed in Basel II by following the new

IRB approach. Still the question arises is there a need for a revised Basel III? How well the

banks can perform by adopting Basel II? These questions remained unanswered until Basel II

is implemented globally.

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References:

http://www.rbi.org.in

ELIZABETH DE ALMEIDA & NEYAES DI BENDITTO Accord (Basel II) – A multiple

case study, Dec 2008

GOTTFRIED HABER, Basel-II: International Competition Issues, Published online: 30 November 2007# International Atlantic Economic Society 2007, Available at: http://www.springerlink.com/content/p046448834m301h4/fulltext.pdf?page=1

NICHOLAS LE PAN, “Remarks on Basel II” The Authors. Journal compilation New York University Salomon Centre, Financial Markets, Institutions & Instruments, V. 17, No. 1, February Published by: Blackwell Publishing, Inc.2008

JAMES BENFORD & ERLEND NIER, Bank of England Financial Stability Paper No.3 December 2007, “Monitoring cyclicality of Basel II capital requirements” Available at: http://www.bankofengland.co.uk/publications/fsr/fs_paper03.pdf

SIMON HAYES & VICTORIA SAPORTA, International Finance Division, and DAVID LODGE, Financial Industry and Regulation Division, Bank of England, Financial Stability Review: December 2002 – “The impact of the new Basel Accord on the supply of capital to emerging market economies” Available at: http://www.bankofengland.co.uk/publications/fsr/2002/fsr13art4.pdf

WILLIAM W. LANG, LORETTA J. MESTER & TODD A. VERMILYEA, May 2006, “Competitive Effects of Basel II on U.S. Bank Credit Card Lending” Available at: www.fdic.gov/bank/analytical/cfr/2006/sept/VermilyeaT

TOR JACOBSON, JESPER LINDE & KASPER ROSZBACH, Credit Risk versus Capital Requirements under Basel II: Are SME Loans and Retail Credit Really Different? Journal of Financial Services Research, 2005 Available at: http://www.springerlink.com/content/f7741v12348t1qx1/fulltext.pdf?page=1

JEFFERY ATIK, “Basel II: A Post-Crisis Post-Mortem” 17 TRANS. L. & COMTEMP. PROB. __ (2009 forthcoming); Available at: http://www.asil.org/files/atik.pdf