The first of two articles on Basel II in the context of the current crisis and providing updates on proposals by the Basel Committee to improve the framework.
It has been a couple of years since Basel II was last discussed in this column. "Basel II" is of course shorthand for the revised international capital-adequacy standard for banks developed by the Basel Committee on Banking Supervision, which was implemented in Hong Kong on 1 January 2007. We were among the first jurisdictions to adopt this standard. However, not long after its implementation, we witnessed a "once-in-a-century" financial crisis which has swept around the globe. Some of the most illustrious names in the financial industry have been overwhelmed and government intervention, on a previously unimaginable scale, has resulted. All of this has, not surprisingly, prompted criticism and questions about the credibility of Basel II, including why it did not help avert the crisis and, indeed, whether it contributed to the crisis.
In defence of Basel II, it is fair to say that the seeds of the current crisis, characterised largely by rapid financial innovation and significant growth in market-based credit intermediation involving complex, structured products, had been sown well before Basel II became effective. So this crisis had its origins firmly in the Basel I environment. In deference even to Basel I, it might also be observed that many of the weaknesses revealed by the crisis stemmed not from the structure of the regulatory framework but were indicative of the failure by individual financial institutions to observe basic credit-underwriting, governance and risk-management standards. While it is not realistic to expect Basel II to address all of the issues arising from the crisis (it is, after all, first and foremost a capital-adequacy standard, and not, for instance, a liquidity standard), Basel II, with its stronger risk differentiation and sharp focus on risk management, is generally viewed as contributing to the greater robustness of banking systems where it is implemented effectively. In fact, the timely implementation of Basel II was pinpointed by the Financial Stability Forum (now the Financial Stability Board), in its April 2008 report on "Enhancing Market and Institutional Resilience", as a starting point for improving banks' capital adequacy in response to the crisis.
Basel II certainly represents a major improvement over Basel I for several reasons:
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First, Basel II adopts a more risk-sensitive approach to credit risk than its predecessor. It does not, for example, treat all loans to all corporate customers as bearing the same degree of risk for the lending bank, but seeks to allow the bank to differentiate between the credit-worthiness of its customers. It allows banks to calculate their capital requirements using more sophisticated models if they meet the requisite criteria and, in so doing, encourages them to systematically collect and analyse loan data to assess the probability, and likely severity, of losses occurring. The Basel II framework also imposes an explicit capital charge for operational risk, and prescribes more risk-sensitive capital treatment for securitisation exposures (although such treatment will require further enhancement in the light of some of the lessons learned from the crisis).
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Second, Basel II requires banks to assess the full range of other risks they run and determine how much capital to hold against them. These include interest-rate risk in the banking book, liquidity risk1, credit-concentration risk and reputation risk. In doing so, it also encourages banks to develop and use more sophisticated risk-management techniques, by offering the prospect of potentially lower capital requirements.
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Third, Basel II requires banks to make greater public disclosure about their business and the associated risks, including the risks related to their securitisation activities. This enables market discipline to play a greater role in reinforcing appropriate behaviour by banks. The crisis has served to highlight the importance of clear, timely, accurate and relevant disclosure by financial institutions in underpinning market confidence.
Although Hong Kong has had Basel II for over two years now, it is still too early to assess the full extent of the benefit of early implementation in the context of the crisis. This is especially so when the local banking system has been much less affected by the crisis than its peers in some overseas jurisdictions. But it seems clear that Basel II has provided an impetus for our banks to improve their capital and risk-management capabilities, with some aspiring to adopt the more advanced credit and market-risk approaches.
Of course, I'm not saying that Basel II is perfect. It is probably fair to say that it was always going to be a "work in progress" to some degree, even without the financial turmoil. The lessons from the current crisis have clearly indicated areas where amendments can be made to the capital framework to extend its risk coverage and make it more robust. For example, most of the losses suffered by financial institutions during the crisis have resulted from their trading-book assets (a major proportion of which were complex, less liquid credit products) and other exposures to "re-securitisations" (collateralised debt obligations of asset-backed securities), where the existing capital requirements might, with the benefit of hindsight, be regarded as too light for the risk involved. In response to the identified weaknesses, the Basel Committee has already drawn up, and undertaken a consultation on, a set of proposed enhancements to the Basel II framework for implementation in 2009 and 2010. These include -
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higher capital requirements in respect of risks in the trading book, and risks associated with securitisation and re-securitisation products and liquidity facilities in conduits;
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supplementary guidance to address the flaws in risk-management practices revealed by the crisis. The guidance focuses in particular on risk-management principles relating to firm-wide risk oversight, risk concentration, off-balance-sheet exposures, securitisation and associated reputation risk. Measures to improve valuations of financial instruments, liquidity-risk management and firm-wide stress-testing practices are also covered; and
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enhanced disclosure requirements in respect of securitisation and re-securitisation exposures as well as sponsorship of off-balance-sheet conduits.
We support the initiative of the Basel Committee to strengthen the Basel II framework and plan to implement the proposals, in line with the Committee’s timetable as far as practicable, while, as always, taking into account local circumstances and further market developments.
The Committee is currently developing further, longer-term enhancements to the capital framework, in such critical areas as the quality of capital, the potential pro-cyclicality of the framework's capital requirements and the role of external credit ratings within the framework. I will say more about these future developments in the next article.
Karen Kemp
Executive Director (Banking Policy)
21 May 2009
1 From the standpoint of holding capital rather than as a standard for setting liquidity-risk tolerances and liquidity buffers.
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