Aktuelles Stichwort: "Basel II" Interview with Prof. Dr. Dr. h.c. Hans-Werner Sinn (in German) 18.10.2010 Media Library of the CESifo Group
Basel II, the second of the Basel Accords, refers to revised regulations on bank supervision and contains rules on protecting the equity positions of banks and financial service institutions. The main aim of Basel II is the protection of the international financial system through guarantees of an adequate equity base for banks and financial service providers.
The Basel II Accord was adopted by the European Union and Switzerland. It was made binding in corresponding EU directives (bank directive 2006/48/EC and the capital adequacy directive 2006/49/EC), for the EU member states as of 2007. It was put into effect in Germany with the “Solvency Regulation” of 14 December 2006.[1]
The Basel II Accord was issued by the Basel Committee on Bank Supervision, which meets at the Bank for International Settlements in Basel and was founded by the central banks of the G10 countries.[2] Currently (status: April 2010) its members are representatives of central banks and supervisory authorities from 27 countries.[3] The committee develops supervision standards and recommendations for bank supervision.
The driving motive was the fears of the G10 central bank presidents that the capital reserves of important banks might have fallen worldwide to inadequate levels. In 1988, in the first Basel Accord (Basel I), the Basel Committee recommended the introduction of comprehensive requirements for the capitalisation of financial institutions. The EU largely followed these recommendations.[4]
In the following years it became clear, however, that Basel I was in need of reform in light of developments on the financial markets and advances in banks’ risk management. Under Basel I the capital requirements for loans to a customer group (for example, enterprises or states) were independent of the creditworthiness of the borrower. Banks thus had an incentive to grant credit to higher risk customers since they could charge them a higher rate of interest and thus obtain a higher return on the required underlying capital. For this reason, with Basel II the capital requirements for bank credits were to be more strongly differentiated according to the credit risk.
In accordance with these goals, Basel II rests on three pillars:
Pillar I: New capital requirements
In the first pillar the rules for determining minimum equity requirements are formulated that contain a capital adequacy requirement for default risks. To achieve this, a weighting system is used that takes into account the degree of risk of the credit and not merely a minimum rate for the liable equity capital drawn from the balance-sheet total. For the determination of the degree of risk various risk-measurement procedures are available: simple, standardised approaches as well as banks’ own procedures. These options are supplemented by market risks evaluated in currency units, which are, for example, unforeseen changes in the exchange rate or rate of interest, and operational risks, for example, losses due to insufficient internal procedures or employees.
Pillar II: Examination procedures of bank regulators
The second pillar refers to the examination of the credit-assessment procedure and contains corresponding rules on the auditing process of bank supervision. It calls for the introduction of adequate risk management systems that are to be monitored by national supervisory agencies.[5] The financial institutions are required to implement the “Internal Capital Adequacy Assessment Process”, which ensures that they have sufficient internal capital to cover all major risks. In addition there must also be adequate management, operation and control processes. Compliance with these rules is also monitored and assessed by the respective national supervisory authorities.
Pillar III: Expansion of disclosure obligations
The expanded disclosure obligations stipulate that the banks make public not only the capital necessary for risk provisioning but also extensive information on the quality of their investment and credit portfolios and on their systems for risk measurement and management. This is based on the assumption that well-informed market participants will reward an effective risk management of credit institutes in their investment and credit decisions and that they will correspondingly sanction riskier behaviour.
In light of the financial crisis, a further revision of the Basel II Accord seems to be necessary since many banks, despite the Basel accords, have too-small an equity base. Have the accords failed?
The main criticism is that – in addition to the failure of the rating agencies – also the market and credit risks, which were determined by means of the banks’ own models, did not reflect the actual risks. The risk models are based on the wishes and proposals of the banks themselves, do not even cover some of their foreign activities, are based on statistical data going back only five years, hardly take systemic risks into account and leave too many loopholes. All in all, the Basel system led to a considerable reduction of capital requirements for the banks and thus to an increase in the crisis vulnerability of the banking system (see Sinn 2010. especially pp. 193–203).
Criticism is also directed at the system-inherent procyclicality. In a downturn the credit default rates, for example, increase and loans to enterprises or even now to states are classified as riskier. This leads, via a risk weighting of equity capital, to a reduction of this capital since the risk weighting has changed. Since equity capital is only available in limited amounts, this causes the banks to reduce their credit volume. Businesses are deprived of the capital they urgently need. And for companies that manage to get loans, the borrowed capital is more expensive because of the higher capital adequacy requirements. This can lead to a credit crunch.
A further deficit of Basel II lies in the exceptions that are granted. Special purpose vehicles and hedge funds, for example, are not subject to the Basel Accord – precisely those business types that engage in particularly risky financial transactions.
As a result of the financial crisis, a reform of Basel II has been initiated. At the beginning of December 2009, the Basel Committee on Bank Supervision met in order to formulate a fundamental concept (Basel III) with the intention, among others, of introducing an upper limit for indebtedness and reducing the procyclicality of capital adequacy requirements. When such a concept will be approved and whether the United States will participate is still open.
[1] In the meantime (status: April 2010) the Basel II Accord has been converted into national law also in Australia, Hong Kong, Japan, Canada, Korea, Singapore and South Africa. In the United States only the internationally active, large banks are subject to the rules. The other banks can follow the rules voluntarily. [2] The founding was preceded by the collapse of the German Herstatt Bank, the largest post-war bank failure to that time. [3] The member states are Argentina, Austria, Belgium, Brazil, China, Germany, France, Hong Kong, India, Indonesia, Italy, Japan, Canada, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Sweden, Switzerland, Singapore, Spain, South Africa, Turkey, the UK and the US. [4] The rules were also introduced in Germany through the “Principles Regarding the Equity Capital of the Institutes”, according to which the financial institutions were required to maintain 8 percent of liable equity capital for covering default risks as a ratio of their risk-weighted assets. [5] In Germany bank, this supervision is the task of BaFin together with the Deutsche Bundesbank.
Document of the Bank for International Settlements: “Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework“
Document of the Bank for International Settlements on risk weighting: “An Explanatory Note on the Basel II IRB Risk Weight Functions”
Sinn, Hans-Werner, Kasino-Kapitalismus: Wie es zur Finanzkrise kam und was jetzt zu tun ist, completely revised edition, Ullstein Taschenbuch, 2010, Berlin. (English edition: Casino Capitalism: How the Financial Crisis Came About and What Needs to be Done Now, Oxford University Press, 2010, Oxford.)
Resti Andrea and Andrea Sironi, "What Future for Basel II?", CESifo DICE Report 8(1), 2010, 3–7 (Abstract / Download).
"Regulierung und Aufsicht der Banken: Brauchen wir Basel III", Beiträge von Franz-Christoph Zeitler, Bernd Rudolph, Christian Kirchner, Christoph Kaserer, Markus Ferber, ifo Schnelldienst 63(3), 2010, 3–20. (Abstract / Download)
"Drohende Kreditklemme: Sollten die Basel-II-Regeln überholt oder zeitweise ausgesetzt werden?" Beiträge von Martin Hellwig, Martin Faust, Hans-Peter Burghof, Mario Ohoven, Christoph Schalast, ifo Schnelldienst 62(15), 2009, 3–18. (Abstract / Download)
"Basel II: Führen die neuen Anforderungen an die Kreditinstitute zu einer Benachteiligung des Mittelstands?", Beiträge von Werner Müller, Helmut Krämer-Eis und Gregor Taistra, Gerhard Hofmann, Thomas Heidorn, Stephan Paul, Michael Paul und Stefan Stein, ifo Schnelldienst 55(3), 2002, 3–19. (Abstract / Download)
Ifo Policy Issue: Bank Regulation
Ifo Policy Issue: Financial Market Crisis
Lists of entries the database DICE on Supervision: Basel II
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