Basel II Changes: Better Late Than Never

The Bank for International Settlements — the central banks’ bank — has announced some important changes to its Basel II Accord (Basel II sets out global standards for commercial bank capital requirements). They’re clearly aimed at preventing a repeat of the current financial disaster:

The Basel Committee on Banking Supervision today issued a package of consultative documents to strengthen the Basel II capital framework. These enhancements are part of a broader effort the Committee has undertaken to strengthen the regulation and supervision of internationally active banks in light of weaknesses revealed by the financial markets crisis. Nout Wellink, Chairman of the Basel Committee and President of the Netherlands Bank, said that "the proposed enhancements will help ensure that the risks inherent in banks’ portfolios related to trading activities, securitisations and exposures to off-balance sheet vehicles are better reflected in minimum capital requirements, risk management practices and accompanying disclosures to the public."

The proposed changes to capital requirements cover:

• trading book exposures, including complex and illiquid credit products;
• certain complex securitisations in the banking book (eg so-called CDOs of ABS); and
• exposures to off-balance sheet vehicles (ie asset-backed commercial paper conduits).

The Committee is also proposing standards to promote more rigorous supervision and risk management of risk concentrations, off-balance sheet exposures, securitisations and related reputation risks. Through the supervisory review process, the Committee is promoting improvements to valuations of financial instruments, the management of funding liquidity risks and firm-wide stress testing practices.

In addition, the Committee is proposing enhanced disclosure requirements for securitisations and sponsorship of off-balance sheet vehicles, which should provide market participants with a better understanding of an institution’s overall risk profile.

As we noted in the title to this piece, better late than never. However, not all of the institutions and entities that contributed to the global credit bubble are governed by Basel II (i.e., by their country’s central banks), so there’s still plenty of heavy lifting to be done by regulators worldwide; and for those revisions to be a net positive, they must be well designed and reasonably well coordinated, conditions that call to mind another pithy adage — easier said than done.

There are also several proverbial elephants in the room that are not addressed by the Basel II changes. BIS provides regulatory frameworks for central banks to apply to their client banks in the private sector — it does not regulate the policy actions of central banks themselves. Insofar as central bank policies helped set the table for the credit bubble and crisis, this is an important gap. And because the most important central banks have no explicit regulators, they face the daunting task of carrying out critical self-appraisals of their institutional status quos. This is a continuation of the ‘governance cycle’, a concept we’ve developed and followed over the past several years. It holds that higher standards of conduct, whether directed towards accountants, auditors, executives in Silicon Valley or on Wall Street, or elsewhere, are not only a double edged sword to those who call for them (e.g., the Spitzer Effect), but are also applied to most or all institutions eventually. The last time the Fed faced such a crisis was toward the end of the 1970s.

URLs:

http://www.bis.org/press/p090116.htm