Basel 2 under scrutiny as banks battle financial turmoil

While a growing number of analysts and regulators are criticizing the usefulness of the Basel 2 approach in today’s crisis, Asian banks that are halfway to achieving Basel 2 compliance could be forgiven for feeling discouraged.

Charles Adams, former assistant director of the International Monetary Fund (IMF) and a visiting professor at the Lee Kuan Yew School of Public Policy in Singapore, said banks will have to rise to the challenges posed by the potential developments in Basel 2.

“There will probably be big changes required when the crisis ends and new recommendations are formulated, “which unfortunately will not be Basel 2.1, but Basel 3. And it’s not going to be a minor 3,” Adams said, at a public industry tele-consultation organized by The Asian Banker.

Banks that chose the standardized approach under Pillar 1 face a relatively less challenging task than those that chose the more advanced approaches, as their main work will simply consider more operational risk and not a change in capital adequacy ratio.

However, banks that have received the green light from the regulator to follow with the more advanced approach will face difficulty “not just because of fitting into that framework, but also the liquidity requirements, which will be coming out,” he explained.

Many banks from Australia, Hong Kong, Japan, Korea and Singapore, among others, have adopted the most advanced approaches of Basel 2.

Adams noted that such banks have to handle the shift from a cross-sectional approach to a time series approach that allows for the possibility of varying capital standards on provisioning in a counter-cyclical way.

He also believes that Basel 2 has to answer macro-level issues.

“The current calculation of bank capital was based on bank’s individual assessment of risks and it wasn’t capturing the differences between systemic and private risks,” Adams observed.

He pointed out that Basel II was a compromise that resolved tensions between “very detailed, prescriptive regulation” and “principle-based regulation,” with reliance on internal risk models and self-regulation.

However, “the crisis raises fundamental questions about Basel 2. The premise of Pillar 1 was basically banks’ internal models and rating agencies in terms of determining capital to set aside for risk. Given what’s happened, we are going to look at potentially shifting the underlying philosophy of Basel 2,” said Adams.

Dr. Brad Setser, fellow of the Council on Foreign Relations and former director at the US Treasury, shared the same sentiment. Internal risk models, which supposedly call for “self-regulation” and provide the basis for regulating the financial sector,” have lost their credibility and raised questions about Basel 2.

But with the temptation to either step back from the current Basel 2 framework or move to an over-prescriptive approach, Adams questioned: “How far are you going to go? What is the solution in the middle? Are you going with ratings from the ratings agencies? Are you going to allow those firms to use the internal models? Let’s suppose the answer is no. Then, what do you do? Are you going back to the simple five risk categories of Basel 1? They were probably as much part of the problem as the solutions.”

The two speakers also discussed the roles of the Financial Stability Forum (FSF) and the Bank for International Settlements (BIS) during the crisis.

“They [Basel Committee] haven’t traditionally played a crisis management role,” Adams said. “The FSF has played a prominent role, but that is not in terms of crisis management, but in terms of responding to the G7 request for suggestions for supervision and regulation.”

However, “in terms of being a central intermediary between the world of central banks and the world private banks, the BIS has a bigger role it wants to play right now,” he said.        – The Asian Banker