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BASEL II: A NEW REGULATORY FRAMEWORK FOR GLOBAL

BANKING

Robert Guttmann (Hofstra University; Université Paris-Nord)

Introduction

In June 2004 the Basel Committee on Banking Supervision (BCBS), affiliated

with the Bank for International Settlements (BIS) and comprising central bankers

from the leading economies, proposed a framework for converging capital standards

of banks across the globe.(1) This so-called Basel II initiative obliges banks to calculate

minimum capital standards by assessing on a regular basis prevailing credit, market,

and operational risks. Those risk assessments will have to be shared with banking

supervisors in both home and host countries. And the banks will at the same time

also have to abide by rather stringent reporting requirements pertaining to their risk

calculations and capital provisions so that investors can get a good sense of what

banks have done to meet the requirements of the new regulation.

Even though its full implementation is still several years away, it is fair to say

that Basel II will in all likelihood emerge as the dominant new financial regulation of

the next decade and a major milestone in the evolution of banking. For one, we are

talking here about a regulatory initiative of unprecedented global scope which in the

end will probably have been adopted by one-hundred or so countries – among them

all the industrialized countries (ICs) as well as the principal emerging-market

economies (EMEs). It will induce banks to manage their risk-return trade-offs in

much more organized fashion and make that management central to their operation.

It will also transform the interaction between banks, their shareholders, and their

supervisors into a much more densely structured and transparent set of

relationships, which is supposed to enhance financial stability and improve the

efficiency of capital allocation. Its enactment is so complex that full implementation

of Basel II will take years, only to be superseded by further adjustments and

revisions stretching over decades.

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Such an ambitious and far-reaching initiative deserves a great deal of attention

on the part of bankers and government officials alike. And, indeed, conferences and

reports about Basel II have sprouted in both camps over the last couple of years in all

corners of the world. Carrying the potential of altering the modus operandi of

finance and its regulation, Basel II will also enter the radar screen of economists in

the near future. Addressing a gathering of heterodox economists working on money

and finance is a good occasion for my own learning process in that direction.

1. From Basel I (1988) to Basel II (2004)

Having witnessed the widespread undercapitalization of internationally

active banks and their credit overextension tendency in the unregulated

Eurocurrency market during the serious LDC Debt Crisis of 1982-87, the world’s

leading central bankers became convinced of the need for new, globally harmonized

regulations to address these dangers of transnational banking. The obvious vehicle

for such an effort was the Bank for International Settlements (BIS) comprising the

central bankers of the leading thirteen (“Group of Ten” or G-10) industrial nations.(2)

In 1975, after the first major crisis of the unregulated Eurocurrency market, the BIS

had set up the so-called Basel Committee on Banking Supervision (BCBS) to

coordinate regulatory and supervisory practices. The extension of its powers to

construct an internationally harmonized architecture of banking regulations occurred

in 1988 when the so-called Basel Accord charged the BCBS to impose a uniform, risk-

weighted minimum capital-asset ratio of 8% on internationally active banks across

their entire family of subsidiaries (Basel Committee on Banking Supervision, 1988).

The idea of giving different asset categories more or less weight depending on their

degree of credit risk was meant to encourage banks either to load up on low-risk

assets or put up more capital when investing in riskier, but higher-yielding assets. In

other words, the banks were forced to internalize and make explicit their calculation

of risk-return trade-offs while having to maintain a minimum level of capital.(3)

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While the Basel Accord was put into effect rather smoothly in about 100

countries over a four-year period, its implementation had negative side effects in

several major economies. Most importantly, it took effect during a period of

economic slowdown in the United States and, above all, Japan where dramatic

declines in share prices made it difficult for banks to raise capital. Undercapitalized

banks, of which there were quite a few in both countries at the time, thus opted for

slowing down asset growth or, in more serious cases, even cut back lending to

comply with the new capital requirement. This constraint contributed considerably

to the rather serious credit crunches unfolding in Japan after 1989 and in the United

States during 1990/91.(4) Similar developments may also have contributed to credit

crunches elsewhere in the early 1990s, notably Sweden. After full implementation in

1992 the new regulation seems to have had only marginal macroeconomic effects.

And if at all measurable, those were probably on the positive side as tangibly higher

capital-asset ratios (rising from a G-10 average of 9.3% in 1988 to 11.2% in 1996)

strengthened the banking sector.

Still, the 1988 Basel Accord showed its limitations early on. Applying

exclusively to commercial banks, the new rule considered only loans as risk-carrying

assets worthy of regulation. Hence it focused solely on credit risk (i.e. the risk of

losses arising from loan defaults) to the exclusion of all other risks found in financial

transactions. And its consideration of credit risk, calculated as the sum of risk-

weighted asset values, was rather crude. Three broad asset classes were specified

according to their respective risk weights: 0% weight for G-10 government debt, 20%

for G-10 bank debt, and 100% for all other debt, including corporate debt and non-G-

10 government debt. Additional rules applied to mortgages, local-government debt

in the G-10 countries, and contingent obligations such as derivatives or letters of

credit.

Looking at the 1988 Accord’s “one-size-fits-all” capital charge for corporate

loans, the banks soon began to practice a sort of regulatory arbitrage, which

undermined the new rule’s original intent of prompting more accurate consideration

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of risk-return trade-offs (Greenspan, 1998). On the one hand, all corporate loans

carried the same regulatory risk charge of 8% (i.e. a 100% weight) irrespective of their

actual riskiness. On the other hand, banks would estimate the respective default

probabilities of their loans. Based on these internal economic-risk assessments banks

would typically set aside between 1% and 30% in capital to cover the estimated loss

distribution of individual loans. The banks then realized that it made very little sense

for them to hold on to the relatively safe loans whose internal capital allocations

reflecting economic risk were below the regulatory capital charge of 8%. Those loans

could be gotten rid of before maturity by means of securitization. This key financial

innovation of the 1990s enabled banks to repackage pools of standardized loans into

asset-backed securities, which could then be resold to investors. At the same time it

made equally good sense for banks to keep holding onto riskier loans with a

relatively elevated internal capital charge, since the 8% regulatory capital charge

having to be set aside was lower than the internal risk charge justified by the loan’s

actual risk profile. Banks thus responded to Basel I by looking for greater risk and

then learned how to live with this bias by seeking risk protection through another

important financial innovation, the use of credit derivatives, which enabled them to

transfer economic risk to others. Both loan securitizations and credit derivatives

exploded in volume during the second half of the 1990s, indicating extensive use of

regulatory arbitrage between uniformly set regulatory risk charges and highly

variable internal (economic) risk charges by banks seeking to profit from the

difference between the two.(5)

Not only did Basel I end up inducing progressively worsening capital

allocation, but it also sent misleading signals about the soundness of banks. The

regulatory capital change hid the economic-risk profile of banks based on actual

default and insolvency probabilities. Banks carrying, say, a capital base of 12% may

have looked good compared to the 8% minimum target for bank capital, but would

in reality be severely undercapitalized if their proper internal economic capital

allocation against their loan portfolio would require a 15% capital charge, for

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instance. The imposition of a one-size-fits-all regulatory capital standard obscured

proper allocation of economic capital.

Amidst growing signs that Basel I provoked some unintended and

counterproductive consequences, the BIS began in 1998 to contemplate how to

improve the capital-adequacy standard. After a series of proposals, impact

assessment studies, consultations, and revisions stretching over several years, its

Basel Committee finally proposed in 2004 a new capital accord. Officially entitled the

“Revised International Capital Framework” but generally referred to as Basel II

(Basel Committee on Banking Supervision, 2004), this reform is a far-reaching

regulatory initiative bound to have a transformational impact on the conduct of

banks. It will let eligible banks set their own capital requirement as a function of their

specific asset profile in order to match regulatory capital much more closely with

economic capital. In essence, the banks will be able to calculate the sum total of their

minimally required capital base through regular and extensive risk assessments of

their investments and business practices. Basel II rests on three pillars – minimum

capital requirements, supervisory review, and market discipline. Its implementation

is set to start this year, but the committee is giving non-G10 governments flexibility

in choosing whatever timetable fits them best.

Basel II proposes a radically different approach to risk assessment than its

predecessor’s crude “one-size-fits-all” weighting of credit risk. This change reflects

impressively rapid progress in the risk-modeling and –estimation capacity of banks

during the last decade, coupled with a greater managerial will to use that capacity in

the face of appreciably greater loss possibilities in today’s deregulated, fast-moving,

super-complex, and highly leveraged business of banking. The idea here is to prompt

banks to strive for continuously improved risk management while at the same time

making sure that they would at least undertake a minimum in terms of taking

account of their portfolio’s degree of riskiness. That objective involved giving banks

a choice in risk assessment methods, depending in part on the sophistication of their

respective activities and internal controls. Banks opting for the most advanced risk

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measurement techniques would gain the benefit of being allowed lower minimum

capital requirements, providing so a direct incentive to push progress in this area.

2. The Calculation of Credit Risk (Pillar One)

With regard to credit risk, which relates to losses from the possibility of

borrowers defaulting on their loans, Basel II wants banks to match their regulatory

risk calculations more closely to economic risk and so stop the incentive for

regulatory arbitrage practiced widely with regard to Basel I’s crude risk weights. The

new approach offered banks a choice of several risk-management approaches

pertaining to credit risk, all designed to allow for a much greater degree of

differentiation of likely default probabilities.

Smaller and medium-sized banks with less complex forms of lending and

simpler internal controls have the option of using a “standardized” approach. Much

like Basel I, this approach does not require banks to provide their own risk inputs.

Instead it uses external measures, including for the first time ratings of rating

agencies and export credit agencies, to assess credit quality of borrowers for

regulatory capital purposes. In contrast to Basel I it ties risk weights no longer to the

legal status of borrowers, but instead to their estimated default probability for a more

accurate assessment of actual credit risks. This revision contains almost twice the

number of risk weights for loans than used to be the case. Charges for various loan

categories have been lowered, such as retail lending (6% compared to 8% previously)

and residential mortgages (2.8% instead of 4%), with the aim of inducing banks to

commit more loans in these newly privileged areas of bank credit. The new standard

also recognizes a much broader range of risk-reducing features of loan contracts,

such as collateral or guarantees, which are rewarded with a correspondingly lower

capital charge on thus-secured loans.

Banks with more sophisticated profiles of risk exposure and better risk-

management capacity have two additional options, based to varying degrees on their

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own in-house assessments of credit risk and thus referred to as internal ratings-based

(IRB) approaches.(6) The first, called a “foundation approach,” uses several risk-

measure inputs which have already become widely practiced when rating credit risk

in retail, corporate, sovereign, and intra-bank lending (see note 6). The banks only

have to provide the default-probability input here. The other approach, reserved

mostly for the biggest and most sophisticated banks, is the so-called “advanced

approach” (A-IRB) which allows those institutions to use their own estimates of all

relevant risk inputs – probability of default (PD), the expected amount of loss in case

of default (LGD), the amount the borrower owes at the time of default (EAD), and

length of risk exposure (M). The BIS clearly wants to encourage progress in risk-

measurement technology and give banks incentives to adopt the latest state-of-the art

techniques as soon as possible.

This new system of credit-risk computation raises a few practical questions.

One concerns the consistency of risk weights for the standardized method. For

instance, after the defaults of Russia (1998) and Argentina (2001) on their respective

international bonds, it is not so clear why claims on sovereigns rated BBB+ to BBB-

should be weighted only 50% while debt to banks or to corporations with those same

ratings are both weighted 100%. Should those claims not all carry the same weight if

they have the same (or largely similar) risk characteristics? Moreover, low-rated

banks will now have rather high weights (150%) despite their lender-of-last-resort

protection, which will make it more difficult for them to obtain reasonable financing

in the inter-bank market or through bond issues. They will hence be rendered even

more fragile, making their possible failure and bail-out more likely.

the difference in weights between a borrower who is not rated (100%) and one who is

rated poorly (150%) seems in contradiction to Basel II’s purported goal of

encouraging the practice of ratings.

With regard to the IRB approaches, especially the advanced approach, we

should note that these are still in their infancy. Banks do not yet have a long track

record collecting and processing data for their credit risk models, which

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unfortunately tend to require a lot of information. In the same vein it is not clear how

accurate their forecasts of future loan defaults tend to be. Until now these in-house

calculations of credit risk by banks have often been used for purposes other than

credit risk weighting, notably to determine loan conditions, such as risk premium or

collateral, or to assess troubled loans. The Basel Committee has also noted the need

to standardize the methodologies used by different banks in their risk calculations so

as to ensure comparability between them, but it is not easy to assure a modicum of

homogeneity among the many individualized approaches chosen.

Under Basel II there will be a much greater reliance on rating agencies, such as

Moody’s, Standard & Poor’s, or Fitch Ratings. While such agencies and their

procedures are well established in the United States, they are less so in Europe and

frequently non-existent in EMEs. Many countries will therefore have to undergo a

catching-up process and create their own rating agencies, preferably more than one

to maintain a modicum of competition. It will in this regard be important to promote

also alternative entities for rating, specifically central banks and export credit

insurers. Even then, there is a real question as to how effective the rating agencies are

in making accurate assessments of relative degrees of creditworthiness and default

probabilities. Let us just remember that in the weeks preceding the collapse of Enron

in the fall of 2001 neither Moody’s nor Standard & Poor’s budged from their top

ratings for the firm or gave any indication of trouble brewing. Both repeated this

dismal performance when giving subprime-based mortgage-backed securities top

ratings right up to the point where most of those instruments were about to go up in

smoke (during the summer of 2007). It may be time to impose tougher performance

standards and conflict-of-interest guidelines for rating agencies to assure objective

and accurate risk assessment.

In the transition from Basel I to Basel II banks are likely to make significant

adjustments in their loan portfolios, responding to differentials in risk weights

between the old system and the one replacing it. Bankers are likely to expand loan

categories carrying relatively lower capital charges than before, while cutting back

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on those loan categories with now-bigger risk weights. (7) Once that adjustment

period has run its course, there will still be a significant macro-economic impact on

national economies from banks’ new lending priorities, with some sectors and/or

loan categories better off than before due to increased access to external funds while

other segments of debtors find themselves with less or more expensive access to

bank loans.

3. The Inclusion of Market Risk (Pillar One)

With regulators becoming more focused on advancing the risk management

practices of banks, they also used the opportunity of revising the original capital-

adequacy accord and consider other types of banking risk as needing capital backing.

One such risk category has been market risk, a form of price risk from adverse

fluctuations in the market value of a securities portfolio, which may potentially arise

in the wake of various negative scenarios weighing on financial markets. Inclusion of

that risk category was prompted not least by structural changes causing banks to

carry much larger amounts of securities on their balance sheets. Key here is the

worldwide convergence towards a financial structure centered on multi-functional

universal banks combining traditional commercial banking (i.e. taking deposits,

making loans) with market-making investment banking (i.e. acting as brokers,

dealers, and underwriters of securities). That convergence, which has undone

decades of separation between those two different types of banking in such crucial

economies as the United States, Japan, and Britain, has been fuelled as much by

financial innovation, most importantly securitization and derivatives, as by

regulatory changes.

Three crucial changes in the regulation of financial structures were especially

instrumental here. The first was the European Union’s Second Banking Coordination

Directive of 1989 whose “single market passport” allowed EU-based financial

institutions to operate throughout the union subject to the regulations of their home

country. This was followed by the global WTO Agreement on Financial Services in

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1997 which committed the vast majority of countries to “national treatment” of

foreign financial institutions. Finally, a decade-long debate in the U.S. Congress led

to passage of the Gramm-Bliley-Leach (Financial Services Modernization) Act in 1999

which allowed U.S. institutions finally to combine commercial-banking and

investment-banking functions.

With banks thus increasingly vested in the securities markets, they have gone

beyond market-making investment banking and engaged in either setting up or

managing institutional investors with large holdings of securities, notably mutual

funds, pension funds, and insurance companies. Today’s universal bank thus has

several venues to accumulate large holdings of securities among its income-earning

assets. Hence it faces not only credit risk (i.e. loan defaults), but also market risk

which reflects the possibility of losses arising from declines in the prices of securities

(e.g. stocks, bonds, derivatives) held in its portfolio.

The BIS tried to address the challenge of this structural change soon, but had

initially a hard time doing so. An early attempt in 1991 to negotiate, in conjunction

with the International Organization of Securities Commissions (IOSCO) representing

securities regulators, a globally harmonized market risk capital requirement for

universal banks and non-bank securities firms faltered because of U.S. resistance to

replacing its own long-standing Uniform Net Capital Rule (UNCR) in favor of

weaker rules favored by the EU. Progress accelerated in 1993 when the EU

introduced its Capital Adequacy Directive (CAD) to harmonize regulations

pertaining to bank capital across different national financial structures within the

newly created single market for financial services. That directive introduced the

notion of regulating functions instead of institutions in order to apply uniform

capital requirements to the securities operations of universal banks and to non-bank

securities firms alike. (8) Any EU-based universal bank would have to identify that

portion of its balance sheet comprising its securities operations as a “trading book”

(including holdings of equity shares, bonds, over-the-counter derivatives, repurchase

agreements, and certain types of loan-securitization instruments) and apply to it the

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CAD’s capital requirement while setting aside capital for its commercial-banking

operations in accordance with Basel I. The BCBS responded to the EU’s inclusion of

market risk by coming up with its own measure for this risk type just a few months

later, in April 1993, when it proposed capital requirements for open (on- and off-

balance-sheet) positions in bonds, equities, or foreign exchange to protect against

losses from adverse market-price movements, including interest rates, exchange

rates, and equity values (Basel Committee on Banking Supervision, 1993).

The proposed amendment met widespread criticism. The opposition was not,

as one would have thought, that the new regulation was going too far. On the

contrary, the general tenor of the comments submitted by financial institutions

expressed concern that the new BCBS proposal was not going far enough. Bankers

wanted better risk-management tools than the one the BCBS was suggesting to use.

Let us not forget that we were then, in the early 1990s, just witnessing the birth of

financial-risk management. Ever since the stock-market crash of October 1987 the

financial community across the globe had become aware of the presence of

considerable market risk. This sentiment was only reinforced in the early 1990s when

derivatives trades had created huge losses in a short span of time (Solomon Brothers,

Orange County in 1992; later Metallgesellschaft, Sumitomo Bank, Baring Bank). An

influential report of specialists (Group of Thirty, 1993) had shed light on the

inherently risky nature of derivatives and called for a systematic effort to manage

these risks in more organized fashion. In response several new risk-management

tools, notably Value-at-Risk (VaR), gained widespread and rapid acceptance. Based

on a probability distribution of a given portfolio’s market value at the end of one

trading period, this risk measure seeks to identify the worst-case scenario in terms of

likely maximum loss within a certain probability, say 90% or 99%. In its 1993

proposal the BCBS suggested a rather crude measure, a 10-day 95% VaR metric,

which recognized hedging effects only partially while ignoring both diversification

effects as well as portfolio non-linearities. Many commentators found this regulatory

standard for measuring VaR a bare minimum. Leading banks had at that point

already developed their own proprietary VaR measures which were more advanced

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and accurate, especially in terms of modeling diversification effects and even taking

account of non-linear exposures.(9)

Conscious of the rapid progress being made in this new field and not wanting

to stifle innovation in risk management techniques, the Basel Committee responded

to this criticism by going back to the drawing board. In April 1995 it came up with a

new and much improved proposal which it has also incorporated into Pillar One of

its Basel II Agreement. For one, the regulatory VaR measure, now called the

“standardized” measure and in essence still supporting a 10-day 95% VaR metric,

was modified to take account of diversification effects within (but not between)

broadly defined asset categories and prescribed additional capital charges for non-

linear exposures. Most importantly, the 1995 revision allowed banks to use their own

proprietary VaR measure for computing capital requirements provided this

alternative had been approved by regulators beforehand. Such approval would be

forthcoming if the bank could prove that it had an independent risk management

function, followed acceptable risk management practices, and used a sound measure

capable of supporting a 10-day 99% VaR metric and recognizing non-linear exposure

of options. The revision by the BCBS was approved in 1996 and put into effect by

1998.(10)

This last provision marked a crucial departure from standard regulatory

practice inasmuch as it gave banks the freedom to develop and use their own risk-

measurement techniques. Seeking to take advantage of rapid progress in this area of

banking, the regulators want to encourage further innovations and their rapid

diffusion by providing incentives for adoption of improved risk-management

methods in the form of lower capital requirements. In this way Basel II foresees the

world’s leading universal banks (e.g. HSBC, BNP Paribas, Deutsche Bank, Citibank)

using increasingly precise VaR measures, supplemented by marked-to-market

pricing, as well as stress testing of unlikely crisis scenarios which, if materializing,

would have potentially devastating consequences for the asset base of those banks.

Such progress needs to be encouraged, especially when considering the inherently

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uncertain nature of the future and the impossibility of predicting it with any degree

of accuracy. Measurable risk evaluations can at best only be proxies of intangible

uncertainty, imperfect approximations of what we are likely to experience. The better

these risk measurement models, they more relevant they are as guidelines for the

intangibly uncertain future.

Today’s VaR measures, while far better than just a short while ago, still are of

only limited usefulness. Even if the methodology of VaR and stress-test techniques

improves, the risk controllers at banks will still face serious problems of applicability.

Apart from varying greatly in their quality of measurement and finding it difficult to

consolidate data collected from different recording and processing systems, these

officers often lack reliable and complete data. They also have a hard time estimating

parameters, calibrating measurements, coming up with relevant stress scenarios, and

conducting meaningful back testing. Depending on the methodology chosen and

historical scenarios adopted as standards, different VaR models will yield greatly

different capital requirements for one and the same portfolio.

The VaR metrics and other market-risk models also contain considerable

theoretical weaknesses. This method tends to underestimate potential losses, because

the logic of its statistical profiling of expected price movements assumes a certain

order (and hence predictability) in price fluctuations – constancy of price variability

giving rise to recurrent patterns, reasonably limited standard deviations indicating

self-contained price movements, et cetera. Yet the market prices of securities and

currencies behave in particularly volatile fashion far beyond the normal law of error,

and their patterns constantly form new constellations of movement in defiance of

constant variance. Most important is the self-feeding nature of rapidly deepening

price collapses where the market’s propensity for widely shared panic selling

introduces an element of irrational excess. This “overshoot” tendency in financial

markets produces a systemic risk in the form of a collapse in market liquidity which

is typically not captured at all by prevailing VaR risk metrics (and only incompletely

by stress tests). As we shall note further below, the credit crunch of August 2007,

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which destroyed the markets for various securitized instruments (notably mortgage-

backed securities, collateralized debt obligations, and asset-backed commercial

paper), is a good case study of crisis scenarios beyond the purview of risk-

management models.

4. Preparing for Operational Risk (Pillar One)

In a crucial extension of its regulatory approach to risk management of banks,

the BCSB has also insisted on the inclusion of operational risk in the calculation of

capital requirements under the new Basel II rules. It defines this type of risk as “the

risk of loss resulting from inadequate or failed internal processes, people, and

systems or from external events.” (BCSB, 2004, p. 140). Implied here is a distinction

between “man-made risks,” be they mistakes, faulty models, fraud, terrorism, or

wars, and “god-made risks,” whether natural disasters (e.g. earthquakes, floods) or

mishaps in the technological infrastructure (e.g. electrical blackouts, telecom

disruptions).(11)

In recent years we have had ample opportunity to observe how devastatingly

swift and paralyzing sudden manifestations of acute operational risk can be across a

broad spectrum of possible manifestations. Whether we are looking at the market

manipulation of a single rogue trader bringing down Britain’s legendary Baring

Bank, the massive disruption of the US inter-bank market on 9/11/01 following the

destruction of the Bank of New York’s crucial transfer- and settlements system in the

World Trade Center, or the impact on local banks of such catastrophes as the

December 2004 tsunami or Hurricane Katrina, each time the loss potential was

staggering. But these examples also demonstrate the inherently unpredictable nature

of operational-risk events. While credit risk and market risk are both taken

voluntarily in the pursuit of bigger returns and follow recurrent patterns, operational

risk occurs beyond the control of a bank’s top management and in typically

unprecedented fashion. To put it differently, significant operational-risk events are

few and far between, hence very difficult to predict. When they do occur, however,

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they may have a devastating impact on a bank’s bottom line. It is for all these reasons

an especially difficult risk category to prepare for.

The BCBS is fully aware of these difficulties and recognizes that the art of

coping with operational risk is still in its infancy, only eight years after making its

debut with the launch of worldwide preparations against the Y2K Bug. All it wants

to achieve at this point is to have banks take account of it in their determination of

capital reserves and in their organization of risk controls. Once again, as in the case

of the other two risk-preparedness regimes described above, the committee has

proposed a choice of three possible approaches across a graduated spectrum of

increasing sophistication.

•The first method of operational-risk management, known as the Basic

Indicator Approach, requires a capital charge of 15% of a bank’s gross income,

averaged over the last three years of positive results.

•In the Standardized Approach the activities of banks are divided into eight

separate business lines – corporate finance, trading & sales, retail banking,

commercial banking, payment & settlement, agency services, asset management, and

retail brokerage. Reflecting different levels of operational risk, these lines are

assigned different capital-level percentages ranging from 12% to 18% of (three-year-

average) gross income per line.(12)

•Finally, under the Advanced Measurement Approaches (AMA) banks

calculate their own capital requirements on the basis of their internal operational risk

measurement and management systems. Subject to supervisory review, those

systems have to meet minimal quantitative (data-collection) and qualitative

(organizational and processing) standards. Since statistical models of the kinds used

to calculate credit risk or market risk are not applicable here, operational-risk

managers have to rely on a more complex calculation methodology using a

combination of internal loss event data, relevant external loss event data (for

industry-wide averaging or line-based benchmarking), business environment and

internal control factors, as well as scenario analysis. Whatever measurement method

they end up using, it should capture potentially severe “tail” loss events which are a

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typical feature of operating risk. For this reason Basel II set the very ambitious goal of

estimating aggregate operational risk loss over a one-year period at a soundness

standard consistent with a 99.9 percent confidence level. These loss estimations

include both expected losses as well as unexpected losses, with the possibility of

getting waivers for capital backing of estimated losses that are adequately measured

and accounted for. Banks can also push for other offsets besides capital, such as

reserves of product pricing.

The operating-risk requirement of Basel II will surely serve as catalyst for

significant and rapid progress in this relatively new area of risk management which

is increasingly seen by experts as key to both the competitiveness and soundness of

banks. In the last couple of years we have seen steadily intensifying efforts to discuss

the most promising AMA techniques and estimation models for operating risk to

define industry-wide benchmarks and promote reasonable standards.(13) Banks are

busy revamping their management structure in line with Basel II recommendations

to give this issue greater priority. More analysis of loss scenarios reinforces vigilance

in areas of in-house vulnerability, such as information technology or settlement

procedures, and recording of transactions. Regulators are pushing banks to

strengthen their internal controls and corporate governance, especially in terms of

auditors, transparency, and conflict-of-interest rules, both of which the BIS regards as

having a direct bearing on operating risk (BCSB, 1998, p. 2). Efforts in this regard

have even gone beyond the confines of individual banks to collective efforts. See in

this regard, for instance, the recent initiative of the leading Wall Street firms, the so-

called ‘Fourteen Families,’ under the auspices of the Federal Bank of New York to

develop an industry-wide protocol for the legal, technological, and paperwork-

handling infrastructure in the hitherto unregulated and chaotic market for credit

derivatives so that minor processing hiccups do not degenerate into market-wide

paralysis because no one knows who owes what (D. Wessel, 2006).

One of the most urgent outstanding issues of Basel II yet to be resolved

concerns the cross-border implementation of the AMA for operational risk by

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multinational banking groups. Operating risk, the chance of suffering operating

losses from such events as fraud, technology failures, or settlement errors, tends to

get reduced when spread across the entire group, since it is highly unlikely that two

or more of its subsidiaries will suffer operating losses at the same time. Hence the

banking group as a whole should be allowed to hold less capital than would be

implied by the sum of operational risks for all its subsidiaries combined. But this

benefit of group diversification conflicts with the obligation of national supervisors

to keep the subsidiaries of internationally active banks under their jurisdiction well

capitalized, irrespective of the position of the latter on a group level. The BCBS has

proposed a compromise (Basel Committee of Banking Supervision, 2004b), a so-

called “hybrid” solution, under which “significant” internationally active

subsidiaries of multinational banking groups would use their own stand-alone AMA

calculation for operating risk while all other internationally active subsidiaries would

be allocated their portion of the group-wide AMA capital requirement. What

constitutes a “significant” subsidiary was left up to negotiations between home-

country and host-country supervisors concerned.

Whether such coordination between different national supervisors can easily

achieve rational outcomes remains to be seen. Those agencies responsible for

domestic banking vary greatly from country to country in customs, practices, and

organizational capacities. They tend to be very turf-conscious and wedded to their

traditions. The BIS has afforded them for the most part a great deal of autonomy, as

exemplified in the case of Basel II by the large number of so-called “national

discretions” whereby banking supervisors adjust the general provisions agreed to

under the auspices of the BIS to their local conditions.

5. Supervisory Review (Pillar Two)

This last point, what the BIS refers to as home-host issues, goes to the heart of

the likely success or failure of Basel II – the quality of prudential supervision within

countries as well as across national jurisdictions. While building on a gradually

18

expanding set of guidelines, principles, and processes of prudential supervision

developed under the auspices of the BIS over the last decade, Basel II provides in its

so-called “Pillar Two” for the most comprehensive elaboration of banking

supervision so far. This ambitious initiative rests on the valid notion that profit-

seeking banks need to be watched more closely by regulators the larger their degree

of freedom in running their own affairs. So if you now let them determine capital

levels on the basis of their own risk assessments, you will have to supervise them a

lot more closely to make sure that they use their newly found freedom properly.

The bank regulators responsible for prudential supervision will have to

establish an ongoing dialogue and review process with all eligible banks under their

jurisdiction. That engagement focuses, first and above all, on evaluating and

approving the risk assessment methods of banks, especially those institutions that

are eligible to use A-IRB approaches for credit risk and/or AMA for operational risk.

Supervisors will also have to make sure that the banks’ risk measurements are

reasonably accurate and matched by adequate amounts of capital. If not, banks will

be asked to set aside more capital or reduce risk exposure or a combination of both.

Supervisory agencies are not only charged to enforce minimum capital levels

corresponding to any bank’s individual risk profile, but can also ask banks to set

aside additional capital above the minimum. The extent of that extra safety cushion

depends obviously on the aggregate risk exposure of the bank.

Supervisors are most likely to demand more bank capital beyond the

regulated minimum when they are worried about an imminent deterioration in

macroeconomic performance of the domestic economy. They are expected to

consider the actual state of the business cycle in their supervisory review and, by

extension, how cyclical downturns may aggravate the risk profile of the banks under

their jurisdiction. Such anticipation is crucial lest we wish to be surprised by

unexpected failures of undercapitalized banks in response to recession-induced

losses whose extent and likelihood were underestimated during periods of rapid

growth and relatively calm financial conditions. At the same time demanding higher

19

capital cushions in the face of worsening macro-economic conditions risks having a

pro-cyclical effect of making such an economic slowdown worse, since the quest for

higher capital levels might force banks to tighten their credit conditions.

Beyond being authorized to demand additional capital cushions for any of the

three Pillar I (credit, market, and operational) risks discussed above, banking

regulators have the additional power to make provision for consideration of risks

that are outside the domain of Pillar One because of their lack of easy measurability

or homogeneity. These include above all interest rate risk, credit concentration risk,

and counterparty credit risk each of which the Basel II accord discusses in some

detail how to take account of. Other sources of loss potential tied to bank operations

and hence considered as relating to operating risk can also become subject to Pillar

Two capital requirements if the regulator believes that the risk profile of the bank in

question warrants such an extra cushion of protection against losses.

Following a tradition put into effect three decades ago by the BCSB in its first

regulatory initiative, the Basel Concordat of 1975, Pillar Two clarifies the division of

labor between different national supervisors vis-à-vis internationally active banks

operating across jurisdictional boundaries.(14) While the earlier agreement addressed

mostly home-host information-sharing issues, Basel II necessitates a far more

ambitious range of cross-border cooperation between national supervisors as laid out

by the committee in its so-called High-Level Principles of cross-border

implementation. These specify the modalities of enhanced supervision involving

greater coordination and cooperation of different national supervisors vis-à-vis

multinational banking groups operating in their respective jurisdictions (Basel

Committee of Banking Supervision, 2003). Each internationally active bank is

uniquely structured in its transnational reach and will require a distinct approach

agreed to by its different national supervisors in consultation with its top

management. The principles resisted giving in to a widespread preference among

larger banks for a “lead supervisor” who in the case of any given bank would make

the ultimate regulatory decisions, validate advanced risk-measurement models, and

20

assure both a consensual approach and consistency of treatment among the different

regulators. Bankers prefer such a centralized approach, because they fear being

subject to different interpretations of the new capital adequacy accord by various

national regulators, hence be vulnerable to onerous reporting requirements and even

unduly high regulatory capital charges.

Still, the principles clearly imply a hierarchy of prudential supervision, with a

multinational bank’s home-country supervisor accorded a central role. That

regulator is responsible for all issues pertaining to consolidated group-level risk

management while host-country supervisors focus more narrowly on a bank’s

subsidiaries under their jurisdiction. There will obviously be a lot of communication

between the different supervisors concerned, not least because they have to achieve

consensus with regard to each and every internationally active bank. In contrast to

the sole decision-making power given to a “lead supervisor,” the BCSB’s softer

approach does not give the home-country supervisor that much authority and so

necessitates a consensual approach to jointly shared regulatory responsibilities. In

order to facilitate such consensus-building among banking supervisors coming from

very different national traditions, the BCSB set up in 2001 a so-called Action

Implementation Group (AIG) to define rules of engagement between them over a

whole range of issues.(15)

A similar struggle for the best method of cross-border implementation has

played itself out even more dramatically on the level of the European Union in the

wake of its 1987 decision to create a single financial-services market. While that

single-market concept encouraged adoption of a single currency (€) and a EU-wide

central bank (ECB), it failed to achieve similar centralization with regard to

prudential supervision of banks. That function was left in the hands of the national

supervisors. When the EU implemented the Basel II initiative, proposing the so-

called Capital Requirements Directive (CRD) in July 2004 which applied the revised

capital framework to all (approximately 8000) banks and (over 6000) investment

firms operating in the EU, it failed even to go as far as the BCSB in approving at least

21

the idea of a consolidating (typically home-country) supervisor. Article 68 of the

CRD requires that the quantitative capital requirements be applied only at the legal

entity level (of individual business units and subsidiaries) rather than on the group

level. Article 69 empowers EU member states to waive this individual application,

but only allows them to do so under the strictest of conditions and solely with regard

to subsidiaries under their jurisdiction. Those waivers do not apply across borders to

allow for consolidated group level results. While Article 129 gives ultimate

responsibility for internal model validation to a consolidating supervisor, it fails to

extend this to the supervisory review of Pillar Two or the information disclosure

requirements of Pillar Three without which there is no consolidated supervision.

Europe’s bankers are upset about their politicians’ inability to provide a

centralized and streamlined supervisory framework. They know fully well that

consolidated supervision is crucially important to their modus operandi. Both risk

estimations and capital requirements have to be calculated on the level of the group

rather than just by merely adding them up from its individual units. Only the top

managers at the head of the group have a sense of the whole and can take account of

diversification benefits. Hence the EU’s banks fear with good reason that the absence

of a lead supervisor or even of consolidated supervision will saddle them with more

onerous reporting and compliance requirements which may differ from one country

to the next. Even worse, they may actually end up with higher aggregate levels of

required capital, since diversification benefits will not be captured adequately.

Recognizing fully that this failure to integrate EU-wide banking supervision

constitutes a major comparative disadvantage for European banks relative to, say,

the more comprehensively supervised U.S. counterparts, its policy-makers in the EC

decided in 2005 to provide for a five-year transition period toward consolidated

group-level supervision. Only then will we have set the conditions for European

integration and restructuring of its financial-services industry in the absence of

which we have seen far fewer cross-border mergers and acquisitions of financial

institutions than anticipated.(16)

22

Of course, the EU’s troubles pertaining to integrated banking supervision are

very much rooted in the high degree of institutional fragmentation across the union.

When looking at the 27 members of the union, we can see a stunning variety of

arrangements for the regulation of the financial services sector. One basic distinction

exists between countries favoring a single regulator for banking, securities, and

insurance combined (see Britain’s Financial Services Authority) versus those

preferring separate sectoral regulators for each of these three areas of finance (e.g.

Germany). Some countries combine a regulatory agency for two out of those three,

whether banking and insurance (e.g. France), banking and securities (e.g. Finland), or

securities combined with insurance (e.g. Czech Republic). Then there is also the

question whether banking supervision should be the domain of the central bank (as

in Spain, Italy, the Netherlands) or better put into the hands of independent

regulatory agencies (e.g. Austria).

These arrangements all reflect deeply rooted national traditions. They can also

be defended on grounds of institutional rationality. Relying on a single regulator

across all three broad areas of finance provides major economies of scale (e.g. pooling

of expertise, single approval, avoidance of dual efforts, enhanced status and power)

as well as economies of scope (in terms of having regulators who are knowledgeable

of the entire spectrum of financial services). Such super-regulators also correspond

more closely to today’s formation of universal banks, which as financial

conglomerates engage in all three sectors of finance. Having central banks serve as

such super-regulators makes sense inasmuch as prudential supervision is directly

linked to monetary policy (with banks the main source of money creation and

interest-rate determination) as well as financial stability, the two principal central-

banking functions. Yet it also makes sense to place supervision in the hands of a

separate regulator who focuses on enforcing prudentially responsible behavior and

so has a better sense of what the regulated and supervised actors are up to. In the

same vein, it might be sensible to rely, as many countries still do, on a decentralized

organization of supervision using specialist regulators for each segment of finance.

Apart from being smaller and presumably more flexible, better suited to close

23

monitoring, and capable of targeting more precisely the unique challenges posed by

each regulated actor, the specialists can also be justified by fundamental differences

in risks and regulatory needs between banking, securities, and insurance. Finally,

competition between different regulators can be an inducement toward improved

efficiency among them.(17)

While creation of a EU-wide super-regulator seems a good idea for a single

financial-services market (see M. Aglietta, L. Scialom, T. Sessin, 2001), a case can be

made in favor of maintaining a certain degree of national heterogeneity in regulatory

structures across the globe. For one, there is obviously no ideal model of regulating

financial institutions and markets at a time when both are in the midst of profound

structural transformation. Moreover, regulators everywhere will be so challenged by

implementation of Basel II over the next five years that they do not need the added

burden of reforming their existing institutional architecture before they know

precisely how best to do that. Instead they should at this point focus on training

many more supervisors in the intricacies of risk management and improving their

cooperation with each other. Increased ties among regulators from different

countries, a sine qua non for the success of Basel II, will allow for a collective

learning curve about the pros and cons of the different national arrangements.

Enhanced cooperation between national regulators envisaged by Basel II will surely

encourage a gradual convergence among them in developing norms and standards

for how to deal with multinational financial conglomerates operating across their

respective jurisdictions. Here the initial heterogeneity of experiences and structures

will add a lot to our understanding of how best to oversee risk management and

capitalization of those conglomerates. Still, amidst such decentralization it is

imperative to provide consolidated risk management on the group level as well as a

“lead supervisor” vis-à-vis each of the major internationally active banks as

centralizing counterweights. The BIS should assure a large degree of transparency

about national differences in regulatory structure and Basel II implementation.

6. Market Discipline (Pillar Three)

24

The new regulatory approach of supervised self-regulation promulgated in Basel

II relies, beyond the watchful eyes of government regulators, also on the disciplining

force of the marketplace. Such market discipline arises from investors punishing

banks whom they deem inadequately prepared to cope with the innate risks built

into their portfolio or arising from their operations. Those banks can expect to pay

higher interest rates for their funds and face lower share prices. Well-prepared

banks, by contrast, will benefit from investors rewarding them with cheaper funding

opportunities and/or higher share prices. Such discrimination between punishing

poorly run banks and rewarding well-run banks also occurs among other

stakeholders, notably rating agencies, market analysts, counterparties, potential

merger partners, and scarce top talent for whose job commitment the banks compete.

The ability to exert such pressures of market discipline rests predominantly on

everybody involved having lots of accurate and reliable information about the

businesses targeted, in this case the banks. More specifically, shareholders and

stakeholders can only make meaningful decisions as to which banks to engage in and

which banks to abandon if they know quite precisely how those institutions calculate

risks, prepare for them in terms of risk mitigation strategies or crisis management,

and set aside capital as a safety cushion. The idea therefore is to make sure that banks

provide all material information related to their risk management and capital

provisions to the widest possible public in an accessible manner so that whoever

wants to form a judgment about a particular bank can easily do so.

Towards that objective the Basel II agreement proposes extensive and rather

precise specifications of what banks must let the public know about themselves and

in what format as well. These disclosure requirements include information about

how banks intend to deal with such key strategic questions as risk mitigation or

plans for raising capital. Basel II defines general disclosure rules and, in addition,

demands both specific quantitative data as well as qualitative information with

regard to capital (structure and adequacy), all areas of risk (i.e. credit risk, market

25

risk, operational risk, interest rate risk, counterparty credit risk), and risk mitigation

(including securitization). Depending on what risk assessment strategy any eligible

bank has opted for, there are different disclosure rules for standardized approaches

and the more advanced (e.g. IRB or AMA) approaches. Given its scope and its depth,

Basel II’s Third Pillar is without a doubt the most ambitious information-disclosure

regime ever applied to financial institutions.(18)

If you believe in efficient markets, like most U.S. economists and policy-

makers do, then you are likely to be convinced of the efficacy of market discipline as

an appropriately constraining force of caution on the behavior of bankers. In that

orthodox paradigm everybody has perfect information and acts rationally on it. This,

however, is not a given in the case of banks whose very existence as intermediaries is

based on having an information edge over others. For instance, banks are better than

ultimate savers in assessing creditworthiness of borrowers, which is precisely why

they get to loan out a large portion of the nation’s savings for a profit. The banks’

asymmetric information access clashes with the transparency needed for market

discipline to work, a contradiction nowhere more clearly manifest in the case of

derivatives where banks serve as counterparties on an absolutely massive scale (in

the trillions of dollars) without carrying any of this exposure on their balance sheets.

Just as bankers are in the business of absorbing risks (e.g. funding long-term assets

with short-term liabilities), so they are also in the business of monopolizing

information as a source of profit. Their ability to turn information into a commodity

renders their activities intrinsically opaque, a characteristic reinforced by the

intangible nature of their services. We therefore do not know at this point how well

transparency-based market discipline can work given the opacity of financial

intermediation. The massive write-down charges by leading money-center banks

(Citibank, UBS, HSBC, Barclays, etc.) during the second half of 2007 have shown that

not even the top bankers themselves have a clear idea of losses arising from their

massive risk exposures that do not show up on their balance sheets.

7. Implementation and Application Issues

26

The implementation of Basel II, a gradualist step-by-step process planned over

the next four years, is bound to be a complex affair, an ambitious project of

establishing an institutional architecture of global governance in an area where the

globalization process has been the most advanced. While committing its member

countries to putting its multilateral agreements into effect, the BIS leaves national

authorities a measure of sovereignty and hence a certain degree of flexibility to adapt

those agreements to national specificities. It is this dialectical interplay between

supra-national needs of regulatory harmonization and national sovereignty that

renders this policy-coordination issue of financial regulation such a fascinating and

important experiment. Still, global governance does not happen in a vacuum. On the

contrary, its particular modalities certainly reflect (and in turn re-shape) the

prevailing hierarchy of political power relations. The dimension of Basel II with the

most long-lasting and far-reaching implications for global capitalism may well be its

impact in the emerging market economies (China, India, Russia, Brazil, Mexico, Iran,

etc.)

as those countries try to reconcile traditionally large-scale involvement of their state

apparatus in the domestic economy with vibrant participation in a free-market

capitalism of global reach. But Basel II will also play an important role in balancing

the co-existence of the two most powerful global actors, the United States and the

European Union.

The EU committed itself early on to full adoption of Basel II and an aggressive

agenda of its implementation. In the Capital Requirements Directive (CRD) of July

2004, which the European Parliament passed into law in September 2005, its policy-

setting European Commission (EC) proposed to apply Basel II to all of the EU’s

(approximately 8000) banks and (over 6000) investment firms. That directive also

managed to address some EU-specific priorities. Recognizing that it is less risky to

hold a large number of small loans than a small number of large loans, the CRD

permits a lower capital requirement for lending to small- and medium-sized

enterprises (SMEs). This will help the comparatively finance-constrained SMEs of the

27

European Union to obtain cheaper and easier external funding and so contribute

more effectively to the employment creation and growth dynamic of their national

economies, more akin to their American counterparts. A similarly reduced capital

requirement for banks has been put into place for their venture capital investments

carried out as part of a sufficiently diversified portfolio, boosting an aspect of equity

financing of small start-up companies crucial to technological progress which until

now has been quite marginalized in Europe when compared to the United States.

That latter superpower, never a great believer in subjecting its own national

interests to the logic of global harmonization of regulations and policies, has taken a

more cautious approach to Basel II. Its bank regulators, above all the Federal Reserve

(Fed), the Federal Deposit Insurance Corporation (FDIC), and the US Treasury’s

Comptroller of Currency which are grouped together in the so-called Federal

Financial Institutions Examination Council (FFIEC), agreed in October 2005 to a

revised capital-adequacy agreement which would require America’s so-called “core

banks,” its twenty or so leading, internationally active banking institutions, to use

the advanced risk assessment methods prescribed in Basel II exclusively. All the

other U.S. banks – nearly 8000 of them – will have the option of either following the

simpler risk formulae of Basel II’s “standardized approach” or, especially if they are

small community banks, stick with the Basel I rules.(19)

It is worth noting that U.S. banks face already two additional domestic capital

requirements which have kept their capital base fairly high by international

standards. One concerns the so-called leverage ratio, which divides total equity capital

by average assets and which should exceed 5% for a bank to be considered well-

capitalized. The other is a new mechanism of prompt corrective action (PCA) for

undercapitalized banks, introduced in the Federal Deposit Insurance Corporation

Improvement Act (FDICIA) of 1991 as part of a reform of that lender-of-last-resort

mechanism. That reform introduced five zones of capital adequacy ranging from

“well-capitalized” to “critically undercapitalized,” with any bank rated accordingly

(CAMEL-1 to CAMEL-5 ratings). When banks become “undercapitalized,” with a

leverage ratio below 4%, their regulators would impose specific remedial actions.

28

Those combined mandatory provisions, such as increased monitoring, suspension of

dividends and management fees, asset growth restrictions, prior supervisory

approval for certain expansion steps, and recapitalization, with discretionary steps

such as restrictions on certain activities, limits on deposit rates, replacement of top

management, or divestitures. The lower the capitalization of the bank concerned, the

more severe the remedial actions required by regulators. When banks have dropped

into the worst zone with a leverage ratio below 2%, regulators can begin closure

procedures. The ratings given to U.S. banks by regulators do not just take account of

capitalization levels, but also degrees of risk incurred.(20) U.S. regulators have

decided that the PCA framework complements Basel II well and should be

preserved. The idea here is to force problem banks make timely adjustments as they

become riskier and/or more undercapitalized. Huge write-down charges from

subprime-related losses among many leading U.S. banks in late 2007 remind us that

banks will overextend and in the process underestimate their risks to permit such

excess. They need to be obliged to correct their mistakes the moment their troubles

begin to reach a critical mass.

The FFIEC has been worried about Basel II ever since a Quantitative Impact

Study (QIS-4) in 2004 showed the 26 reporting institutions applying Basel II

provisions ending up with substantial declines of 15.5% in aggregate minimum risk-

based capital requirements compared to Basel I, with half reporting declines in

excess of 26%. Questions about the revised framework’s ability to provide for

sufficient levels of capitalization were further reinforced by the large variation of

results even among banks with relatively similar asset compositions. While some

degree of variability is inevitable in light of the inherent subjectivity of risk estimates,

the extent of dispersion found in the latest impact study was far too large to ignore.

In light of these troubling results, the FFIEC decided to delay the initial

implementation schedule planned for Basel II by one year. Its final implementation

rule of November 2007 includes transitional safeguards which limit the permissible

declines in a bank’s capital to 5 percent per year over three years.(21)

29

7. Financial Instability and Systemic Risk

In August 2007, after years of relative calm in the world’s booming financial

markets, a relatively limited problem, located among U.S. subprime mortgages,

exploded into a global credit crunch. Doubts about the viability of these homeowners

with checkered credit histories amidst a rapidly worsening U.S. housing crisis

created a loss of confidence in mortgage-backed securities containing subprime loans

which deepened into a total collapse of liquidity for all securitization instruments,

notably collateralized debt obligations and asset-backed commercial paper, and - by

further contagion of spreading panic – into paralysis in the interbank market, the

nerve center of the world economy. Only massive, coordinated, and sustained

liquidity injections by a dozen or so central banks, led by the European Central Bank,

managed to prevent this full-blown credit crunch from getting totally out of control

to the point of triggering a global depression. While the worst of this crisis episode

may have passed, its damage will take some time to digest.

This horrifying experience of massively disrupted credit flows is stark

reminder that banks are subject to recurrent financial crises whose underlying forces

are potentially far more powerful than any restraints from Basel II’s three pillars of

“supervised self-regulation.” Such crises are a recurrent phenomenon in capitalist

free-market economies, part of that system’s cyclical modus operandi.(22) They start

typically during boom periods feeding on collective euphoria. At that point profit-

seeking investors become too enthusiastic about the future, which prompts them to

offer excessive amounts of credit at unrealistically easy conditions. It is precisely this

contagious “conspiracy of greed” embedded in boom-induced market euphoria

which drives the financial system collectively to a point of unsustainable

overextension. At the cyclical peak there occurs inevitably an unexpected disruption

which reveals starkly to everyone how overextended funding positions have become.

The mood suddenly shifts to pessimism, perhaps even panic, triggering a rush to

liquidity and a self-feeding wave of cutbacks which rapidly degenerate into open

financial crisis. Credit conditions deteriorate just when overextended debtors fall

30

short of cash. Assets get liquidated to boost dwindling cash positions, forcing asset

sales into declining markets, which can rapidly become self-feeding. In the face of

such recurrent sequences of greed-driven euphoria and fear-inspired panic banks

cannot escape these socially elaborated mood swings. Typically they collectively

downplay or disregard risks during boom periods, only to take then too pessimistic a

view when in the grip of retrenchment. Unless both banks and supervisors consider

the macroeconomic context of business and credit cycles when assessing the

effectiveness of risk management models, they will be inclined to underestimate

risks until they will come to regret it.

Acute financial crises may spread to a point where even the most

sophisticated risk-management models become obsolete. The statistical concepts

used to measure risk – probability distributions representing outcomes, arithmetic

means summarizing the most likely outcome in the form of the expected value, the

(standard) deviation of actual outcomes from the expected (mean) value, the

covariance measuring how different asset returns are interrelated – simply cease to

apply in such episodes of turbulence. Any well-behaved patterns of predictability,

which such statistical laws of modern portfolio theory imply, are simply

overwhelmed by the entirely unpredictable course of violent ruptures and

adjustments characterizing such crisis. As we have witnessed once again just a short

while ago, the course of full-blown financial crises defies the parameters of standard

risk-measurement models. The collapse of liquidity so typically found during acute

financial crisis, when everybody needs to sell in order to generate cash yet nobody

wants to buy, can deflate asset prices very quickly and push overextended borrowers

to the brink of default. The non-linearity implied here gets typically aggravated

because of the leverage factor magnifying negative rate of returns on capital for any

given loss as well as margin calls (i.e. requests on borrowers for immediate cash to

cover eroded collateral values) triggering cumulative asset sales and avalanche-like

price declines. Ever since the stock-market crash of 1987 we have come to appreciate

the mutually reinforcing inter-play of securities (stocks, bonds) and derivatives

31

(stock-index futures, bond futures) pulling each other’s prices down with amazing

ferocity.

Worst of all, if left unchecked, financial crises can intensify to the point of

posing systemic risk as they unleash a combination of paralyzing disruptions in the

credit system, huge losses shared by borrowers and investors alike, and sharp

declines in economic activity. Ever since the disastrous experience of the Great

Depression of the 1930s we are quite aware how devastating this worst of all risks

truly can be. Systemic risk, threatening the credit system and the economy it

supports in toto, arises when a financial crisis realizes its potential of contagion and

starts spreading like wildfire. The crisis deepens amidst a self-feeding loop of losses,

panic selling, further losses, more panic, and so forth. It could spread geographically,

as happened so extensively in the Asian crisis of 1997 which moved to Russia in 1998

and Brazil in 1999 before consuming itself in a last fire burning down the currency

board of Argentina in 2001). It may also spread from one financial market to another

- from derivatives to securities, from currencies to bank loans, from agency securities

to government bonds, et cetera. Today’s financial markets and institutions are

interwoven in a myriad of complex interconnections some of which only become

evident unexpectedly and violently in times of great stress. Such multi-level

contagion also carries the potential of transforming financial risks. As many banks in

East Asia found out painfully in 1997/98, when the local currency’s peg broke amidst

panicky capital flights, it turned to have been a really bad idea to have funded

liabilities in dollars while carrying most assets in the (now sharply devalued) local

currency. Market risk thus turned right away into credit risk, further compounded

by acute liquidity risks and interest rate risk. We have seen the same qualitative

amalgamation of mutually infectious risks in the current crisis of subprime

mortgages and securitization instruments.

None of these earthquake-like risk transformations and non-linear contagion

processes can be adequately captured a priori by even the most sophisticated risk-

estimation models. Those models focus ironically on predicting problems while

32

being rendered moot precisely when the worst-case scenarios become true. They

work in good times, but cease to be meaningful precisely in those bad times against

which they were supposed to protect us. Hence we need additional measures beyond

the Basel II approach of supervised self-regulation. We need a regulatory regime of

prompt corrective action for undercapitalized banks threatened by losses, as the U.S.

experience with such an PCR regime over last 15 years has proven. We also need

effective lender-of-last-resort mechanisms with which to manage financial crises by

containing their spread. Three major global debt crises, the LDC debt crisis 1982-87,

the Asian crisis 1997/98, and the subprime crisis of 2007/08, have taught us about

the need for effective global crisis management beyond the domestic lender-of-last-

resort mechanisms. The early-warning system being constructed by the International

Monetary Fund (IMF) and the mobilization of additional resources for its crisis

interventions are steps in the right direction, as are new clauses written into

international bond contracts providing for orderly restructuring in case of de-facto

defaults. Ultimately an effective lender-of-last-resort mechanism requires the ability

of (possibly unlimited) liquidity injections by central banks, perhaps even the IMF.

Notes

1) That proposal was published first in June 2004 and then again in a revised version

in November 2004 (Basel Committee on Banking Supervision, 2004).

2) The so-called “Group of Ten” (G-10) members of the BIS, represented by their

central bankers, actually have grown to thirteen since the group’s inception in 1960 -

Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands,

Spain, Sweden, Switzerland, UK and US.

3) The Basel Accord of 1988 also clarified the definition of bank capital. By

introducing different categories of bank capital, the BIS allowed banks to build up

capital from less conventional sources (e.g. loan-loss reserves, subordinated debt)

whenever primary capital sources were hard to get.

33

4) For empirical studies of this capital constraint effect in the wake of the 1988

Capital Accord on bank lending and economic growth in the United States see D.

Hancock and J. A. Wilcox (1997, 1998) as well as J. Peek and E. Rosengreen (1995).

For similar empirical findings of that connection in the case of Japan see A. D.

Brunner and S. B. Kamin (1998), S. B. Kim and R. Moreno (1994), as well as J. Peek

and E. Rosengreen (1997).

5) See the excellent report by P. Jackson et al. (1999) on the impact of Basel I,

including a detailed account of regulatory arbitrage practiced by banks.

6) According to Basel Committee on Banking Supervision (2001), the two IRB

approaches focused on the same four credit-risk variables, namely probability of

default, loss given default, exposure at default, and maturity of exposure, but to

different degrees of modeling and measurement.

7) For a preliminary analysis of such shifts in bank lending portfolios in response to

risk-weight differentials, especially comparing here EU-based banks and U.S. banks,

see N. Caillard, P. Laurent, and V. Seltz (2001).

8) The single-passport concept of the 1989 directive enabled universal banks from

Germany and France to implement themselves as such in places like Britain, where

commercial- and investment-banking functions are still separate. Those universal

banks would then have to compete with Britain’s securities firms and investment

banks which were subject to altogether different capital requirements. The EU’s 1993

directive overcame this problem by means of the crucially important institutional

innovation of shifting the focus of banking regulations from institutions (e.g. one set

of regulations for commercial banks, another for securities firms) to functions (i.e.

bank lending posing credit risk, securities holdings containing market risk).

34

9) For more detail on the rapid progress concerning VaR modeling see K. Dowd

(1998), P. Jorion (2000), G. A. Holton (2003) as well as the useful web sites

riskglossary.com or GloriaMundi.com.

10) See Basel Committee on Banking Supervision (1996). Since the original CAD of

the European Commission in 1993 had not provided for the use of internal risk-

measurement models, EU banks were put at a competitive disadvantage compared

to non-EU banks. To remedy this situation, the European Commission issued its own

revision, known as CAD II.

11) See R. Jayamaha (2005), p. 2.

12) According to Basel Committee on Banking Supervision (1998, p. 3), operational

risk is more likely in large-volume, low-margin business lines, such as transaction

processing and payments-system related activities, which may also have such risk-

prone characteristics as high turnover, fast-paced structural change, or complex

support systems.

13) Evidence of such efforts, in the case of the United States for instance, can be

collected by visiting the web sites of the American Bankers Association

(www.aba.com), the Institute of International Finance (www.iif.com), or the regional

Federal Reserve Banks (e.g. such as FRB Boston’s www.bos.frb.gov).

14) This so-called Basel Concordat (Basel Committee on Banking Supervision, 1975),

passed after two bank failures in 1974 (Herstatt, Franklin National) had revealed

serious cross-jurisdictional problems posed by the supranational Eurocurrency

market, offered a framework for increased cooperation among national authorities in

the supervision of liquidity, solvency, and foreign-exchange positions of banks that

operate in more than one country. That agreement among the world’s leading central

bankers paid particular attention to defining the coordination, information sharing,

and task allocations between home- and host-country authorities.

35

15) See B. Bernanke (2004) for a U.S. perspective on the host-home issues between

national supervisors raised by Basel II.

16) For more on this five-year plan of moving banking supervision to a more EU-

wide level of cooperation among national regulatory authorities see its Committee of

European Banking Supervisors (2005). Those CEBS guidelines have been widely

criticized by the lobbying groups of the financial-services industry in Europe (e.g.

European Banking Federation, European Federation of Finance House Associations)

as “too little, too late.” For a typical criticism by bankers, in this case the head of the

Dutch ING Group, see C. Maas (2005).

17) See D. Plihon (2001) for a good summary of the widely divergent practices and

structures of prudential supervision across the European Union.

18) This information-disclosure regime of Basel II will have to be integrated with the

emerging body of accounting rules for financial institutions being developed by the

International Accounting Standards Board (IASB) as well as the joint IMF-World

Bank analyses of member countries’ financial systems known as Financial Sector

Assessment Program.

19) Initially, the FFIEC had planned a different route to Basel II, namely letting its

8000 or so non-core banks follow a revised Basel I framework commonly referred to

as Basel 1A which still would have applied credit-risk weights over broadly defined

asset categories, but with greater sub-divisions reflecting differentiations in default

probabilities. But then the regulators dropped this idea, fearing Basel 1A would

discriminate too strongly between core and non-core banks while also moving U.S.

practice too far away from international rule.

20) For a good summary of the FDIC’s application of the new PCA rules see L.

Shibut, T. Critchfield and S. Bohn (2003).

36

21) See Federal Deposit Insurance Corporation (2006) for more details about the

results of QIS-4 and the worries expressed by the U.S. regulators. The final Basel II

implementation rule by the FFIEC is discussed by R. Kroszner (2007).

22) For more discussion on the inevitable dynamic of financial crisis see R. Guttmann

(1994, 1996), H. Minsky (1982), and M. Wolfson (1986).

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