The Effects Of Basel III

The causes of the crisis are complex, multiple and wide spread gue to the interconnectedness of the financial system. However the effects were not felt the same way in all the countries and some were lefts unscathed such as Brazil, Russia or Asia in general.

There are many explanations on why the financial crisis occured : macro economic imbalances, lax monetary policies, regulatory and supervisory failures, too big to fail and dissorted incentives, excesses of securitisation, unregulated firm (shaddow banking), corporate governance failure, risk management failure (excessive leverage). We can divide these explanations into two groups : the first four are due to government’s, central banks behaviour, the last four blame mainly the markets, financial products etc… Furthermore, some of these reasons are cyclical whereas others are structural. One of the major cyclical cause was very lax policy of the federal reserve after the burst of the internet bubble. It lowered it’s intervention rate to 1% causing raging inflation. However, one should also glance at the interest rates worldwide which decreased since the 1990’s.

Before the crisis, the market was particulary liquid which made it difficult to spot liquidity risk. It is only when liquidity became scarce that banks became fully aware of the risk and realized they had insufficient fund to meet their obligations. Another issue was the quality of the capital. Most of the capital was of really poor quality (manifested in its low loss-absorbing feature) because of low inflation and low returns wich lead investors to look for even riskier financial instruments and increased leveraging in a a very excessive way. High leveraging amplified losses as banks desperatly tried to sell these rotten assets into dying markets. Due to lack of transparency, counterparty credit risk was misunderstood and risk concentration dramatically understimated. And to make matters worse, the flip-side to the global market coin was that when a counterparty defaulted, the interconnectedness of the system meant the shock was transmitted through the entire system whereas banks did not have the buffers to take the shock.

Most of these flaws can be related to Basel II framework. It used a three pillar concept : first one’s goal was to adress risk, the second one aimed to ensure good supervision and the third to watch over market discipline.

One major issue of basel II framework was that it misassessed systemic risk. Systemic risk is the risk of distress in the financial system caused by an imbalance or a failure of a significant part of the financial sector - one large institution or many smaller ones - that has the potential to have serious negative consequences for the real economy (this definition mainly follows IMF, BIS and FSB and Acharya’s . Systemic risk has two conceptual points of view : the cross-sectional dimension which could be seen as a more « geographic » or physical approach : if one bank has trouble, it may injure other banks. It is called the domino effect. We touch here to one of Basel II sensitive issue. In deed, the rationale behind Basel II was to minimize every bank’s likeliness to default their payements. This was seen as the main way to create a stable and overall secured banking sector . However it was only seen as an idealistic end. Observators (Kaserer 2010) argued that the core of financial regulation is to ensure a global financial stability, and that this statement should be reaffirmed. Basel II focused too much on bank’s financial well being and therefore failed to fulfil it’s task due to a lack of concern for systemic risk and interconnectedness.

The second dimension of systemic risk is time related and is deeply linked with the notion of procyclicality: how this risk evolves through time. The basel II capital formulae for credit risk was pro-cyclical (any economic quantity that is positively correlated with the overall state of the economy is said to be procyclical) which means that as a downturn occurs, the likelihood of borrower’s default increase. In this case, there is a higher and greater need for regulatory capital.

Another problem was that under Basel II, Banks had the incentive to get bigger, more numerous and way too interconnected because it was told that they would be bailed in times of distress, as it was the case with JP Morgan, Bank of America or Citygroup. In such a regulatory framework, the system provides money to these institutions that cause negative externalities to other traders . It is argued that supporting individual institutions is a short-sighted intervention which would most likely have shortsighted positive effects but not for the future. A predictable bailout means that “too big” (TBTF), “too many”(TMTF) or “too interconnected”(TITF) to fail banks can rely on this guarantee in times of great stress and therefore remove some essential market mechanismes and eventually weaken the system. As a consequence, governments have to make clear that they will provide support during times of extreme distress and their help should be seen as was to stabilize the whole financial system since in all likelihood it will provide it with a saffer environnement . On the other hand, it is still mandatory to support some of the activities of certain banks for some of them are necessary to the survival of the system.

I) systemic risk and Basel II drawbacks

1) what is a systemic risk

When we deal with a worldwide crisis, we deal we systemic risk. Systemic risk is the risk of collapse of an entire financial system or an entire market caused by the failure of one large institutions or many small ones. A risk is systemic when the action of one bank can have negatives externalities (consequences) on the entire system. Authors noticed that an individual financial body may try to take measures to try to prevent its own collapse but rarely take into consideration the systemic risk they impose on other banks . It is a risk that raised endegenously in the financial system .

There is no doubt on the fact that the current system is procyclal as a consequence of Basel II agreements. In order to reduce systemic risk, it is compulsory to eliminate procyclicality. The BCBS is aware of the dangers of procyclicality, it is shown by the fact that they clearly highlight that there is a trade off between procyclicality and capital requirement. (as we will see later). Their point is that important risk sensivity at a given moment always includes procyclicality in capital requirements over time.

But how does a bank become of systemic importance ? IMF, BIS and FSB studies ansewered that size is the major factor, but also interconnectedness… These are the two main ones but there are other contributing factors such as idiosyncratic

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