Basel II - Will Banks Change Their Minds?

Sub-prime difficulties faced by both sell-side and banking conglomerates are now questioning the existence of the core pillar of the Basel II Accord. It is ironic that within three years of the second report of the Basel Committee (written to strengthen global banking practices on sound principles of credit, operations and market risk monitoring), it is now coming under pressure itself from its large member banks. The sound principles and guidelines debated at length in boardrooms and banking corridors have proven inadequate in dealing with pricing and rating issues of new instruments in the credit markets.

According to the Basel II report 2006, total risk-weighted assets are determined by multiplying the capital requirements for market risk and operational risk by 12.5 (i.e. the reciprocal of the minimum capital ratio of 8%) and adding the resulting figure to the sum of risk weighted assets for credit risk¹.

According to the principles advocated by Basel, banks can identify risk based on their internal rating mechanism. The committee advised the use of two important mechanisms to measure the risk associated with advances and operations. The first is the Internal Rating Based (IRB) approach and the second is the Advanced Measurement Approach. These approaches are expected to help banks identify any operational failures or associated risk on capital. This would have helped banks to understand the probability of specific events and its impact on tier one and tier two capital structure.

It now appears that these tools have provided banks little with which to mitigate the probable event of risk – not because they are inadequate but because players overlooked the risk while focusing on other business priorities such as higher fees and returns. This eventually undermined the importance of risk mitigating strategies. Credit defaults are now attributed to faulty ratings by the rating agencies. Banks have created securitised instruments by mixing bad loans and advances with good quality assets. Furthermore, players have created derivative instruments in the credit markets linked to these asset classes. These higher fee-earning instruments with larger spreads are considered as off-balance sheet transactions. When it comes to credit derivatives and financial instruments based on mortgage-backed securities, it appears that industry players have overlooked the importance of deeper analysis of their exposure in worst-case scenarios. Deals were stuck at a rapid speed based on the available ratings, which did not take the contamination effect into account.

Lower interest rates, higher liquidity, availability of better ratings and the relentless pursuit for alpha have all played an important role. An inadequate framework for pricing and valuing the deals further reduced the clarity of the exposure in the event of default. These aspects are now debated at length. It is astonishing to see that most banks that have significant exposure to sub-prime markets have little knowledge about their overall risk exposure. Figures are changed at regular intervals to reflect their own discovery process. In addition, banks are now faced with a decline in housing markets and vanishing demand for these asset classes. Considering the expected loss amounting to US$94.3bn, it is likely that the Basel II accord itself will come under tremendous pressure. Within the industry, it is now feared that few of the large banks which are looking for a bail-out may even opt out of Basel II compliance – even though this move could potentially increase the cost of funds thereby affecting their own rating further. The table below indicates the rapid decline of asset quality and return among some of the leading global banking conglomerates.

Figure 1: Decline of Global Banks’ Asset Quality
Source: Federal Deposit Insurance Corp/The IRA Bank Monitor

Though the list is not alarming yet, the indication is that more banks are in the pipeline to declare a slide in their asset and return qualities. The Basel II Accords suggest the use of an internal model to employ current market data to compute current exposure. It also prescribed using historical data to estimate volatility and correlation when at least three years of historical data are used. And it is required to update this information quarterly or more frequently, if warranted by market conditions. However, since bad loans and good advances are mixed to get better external ratings on the basis of consistent cash inflow, deals have increasingly been struck on the faulty pricing and valuation of these asset classes. These are the primary reasons behind why even sophisticated risk managers across banks are currently struggling to calculate the exposure unbundling.

A contamination that was originally thought to be the recipe for better business acumen is now questioning the fundamentals of the world financial markets structure. For the first time in banking history, banks are unwilling to lend to each other in the interbank markets. Faced with this new reality, intervention by central banks is increasingly sought by industry players as well as policy makers to control the greater risks. Though there will be some more ripples before the verdict is out on Basel II compliance by the banks, rumours of many banks’ inability to meet the prescribed norms of tier 1 capital requirements as per the Accord hold some truth. I believe that member banks’ difficulties in meeting these norms are the single most important challenge faced by the Basel Committee today.