Basel II and the current crisis (II)

inSight

28 May 2009

Basel II and the current crisis (II)

Global authorities continue to strengthen banks' capital adequacy, risk management and supervision to make the financial system more resilient.

The current financial crisis has shown that a strong capital base is critical to bank resilience, and ultimately to broader financial stability. In the last article, we looked at some of the improvements to the risk coverage of the Basel II framework which have already been proposed by the Basel Committee on Banking Supervision (BCBS) as part of its efforts to enhance global regulation of banks' capital adequacy and risk management.

In this article, we'll look at some of the work the BCBS is doing for the longer-term development of the capital framework. A natural starting point is the work of the BCBS Definition of Capital Subgroup (of which the HKMA is a member) to strengthen the quality, consistency and transparency of regulatory capital, particularly the highest forms of "Tier 1 capital". Tier 1 capital refers to those elements of a bank's capital base which are designed, and have the greatest capacity, to allow a bank to absorb losses while continuing its operations as a going concern. While share capital and reserves are at its core, Tier 1 capital may also include (within specified limits) innovative financial instruments, often called "hybrid" instruments, incorporating elements of both debt and equity. When the Basel II capital framework was developed in the earlier part of this decade, substantial changes were made to the way banks' exposures, and the degree of risk attached to those exposures (risk-weighted assets), are calculated. However, the other side of the equation, the calculation of the banks' capital base, remained largely as it had been since 1998, when the BCBS made an announcement outlining "Instruments eligible for inclusion in Tier 1 capital". In the intervening years, there has been substantial innovation and growth in the hybrid capital market leading to some divergence in the treatment of hybrid capital instruments in various jurisdictions' capital-adequacy regimes. This, coupled with the need to consider the impact of changes in the capital treatment of banks' loan-loss provisions under Basel II, prompted the BCBS to fundamentally review the definition of capital for regulatory purposes. Obviously, international convergence is important in achieving a level playing-field. The BCBS's work in this area began before the current crisis, but it has been given added impetus by the crisis and in particular by the increasing market focus on common-equity share capital as a measure of capital strength.

During the crisis, the market has demanded more and better-quality capital when assessing bank resilience. Some banks' capital cushions (in particular their "core" Tier 1 capital) were too low to support their risk exposures going into the crisis, resulting in strenuous recapitalisation efforts in various jurisdictions, often involving government funds. Continued reservations about the ability of banks' capital to absorb further losses, expected to arise in the deteriorating economic situation, have prompted specially tailored stress tests in the US and elsewhere to assess capital resilience. The lessons from this fundamental credit-cycle part of the crisis, associated with large write-downs in some banks' corporate and retail lending books, are clear. The BCBS aims to ensure a stronger base of high-quality core capital to increase banks' resilience to losses, coupled with strong buffers above the minimum prescribed levels of capital to enable banks to continue providing credit to the economy even in severe downturns. This suggests that we should expect to see increases in both the level and quality of capital to promote the stability of the banking sector over the longer term. However, there is a clear message from the BCBS, endorsed by the G20, that it will not raise minimum capital requirements during the crisis. The work underway now is to provide a clear road map of where the Committee is heading.

As I mentioned in last week's article, Basel II is designed to be risk-sensitive and this makes it "cyclical" in the sense that capital requirements tend to decrease in an upturn (when risk is perceived to decrease) and rise in a downturn (when risk is perceived to increase). To the extent that this amplifies the natural business cycle, by failing to restrain exuberance in the upswing and by constraining activity in the downswing (and thereby essentially worsening its effects), the framework may be regarded as procyclical. The BCBS has always been aware of Basel II's inherent cyclicality and the framework has various features built into it to dampen the effect. The BCBS also has a capital monitoring group whose mandate is to systematically assess the quantitative impact of Basel II on the level and cyclicality of capital. The BCBS is now proposing to go further and build countercyclical buffers into the capital framework and banks’ provisioning practices. The idea would be for buffers of reserves and capital to be built up during times of earnings growth so that they can be drawn down when things are not going so well. The process of building up the buffer should restrain at least some of the expansion in the upswing and the release of the buffer should allow continued credit intermediation during the downturn. The BCBS is currently working on concrete proposals that can be applied globally and translated into national contexts, taking account of the economic cycle in different jurisdictions.

In addition to its work on strengthening Basel II and mitigating its cyclicality, the BCBS has also concluded that the capital framework should be underpinned by a non-risk-based supplementary measure (perhaps building upon the traditional leverage ratio) to act as a floor to the capital requirement and help contain the build-up of excessive leverage in the banking system during the expansionary phase of the business cycle. The BCBS is working to develop a simple metric for this purpose, designed to interact with the Basel II risk-based measure in a prudent and sensible way, by the end of the year. The measure, in addition to being simple to calculate, must be transparent and must address issues relating to off-balance-sheet exposures (which are not generally included in more traditional leverage-ratio measures) and accounting differences between jurisdictions.

Another BCBS initiative in response to the financial crisis will be to review the role of external ratings under Basel II, particularly their use for securitisation products. Over-reliance on ratings, particularly for structured finance products, was observed by the Financial Stability Forum (FSF – now the Financial Stability Board) in its review of the causes and weaknesses underlying the turmoil. Official recognition of ratings in various regulatory frameworks may have played a role in encouraging such over-reliance and the FSF recommended a review of the use of ratings in regulatory and supervisory frameworks to ensure it does not encourage uncritical reliance on credit ratings as a substitute for independent evaluation. In response, the BCBS will review whether there are any adverse incentives within Basel II on the use of external credit ratings. The review is expected to cover, among other things, the criteria for qualifying ratings and the expectations for banks in utilising them.

Taken together, these initiatives form a comprehensive strategy by the BCBS to strengthen bank capital adequacy and make it less procyclical. Banks in Hong Kong have so far weathered the financial crisis well with their overall capital positions remaining sound, but there are lessons for all of us from the evolution of this crisis. We at the HKMA support the BCBS' initiatives to promote a more robust banking sector and to limit as far as practicable any potential for the regulatory regime for banks to amplify the effect of shocks in the financial sector on the real economy. We will work with the industry to implement the BCBS' recommendations, once finalised, as appropriate in the context of Hong Kong.

Karen Kemp
Executive Director (Banking Policy)
28 May 2009

Click here for previous articles in this column.

Document in Word format

Latest inSight
Last revision date : 28 May 2009