Basel II - Basel II and The Global Financial Crisis

Basel II and The Global Financial Crisis

The role of Basel II, both before and after the global financial crisis, has been discussed widely. While some argue that the crisis demonstrated weaknesses in the framework, others have criticized it for actually increasing the effect of the crisis. In response to the financial crisis, the Basel Committee on Banking Supervision published revised global standards, popularly known as Basel III. The Committee claimed that the new standards would lead to a better quality of capital, increased coverage of risk for capital market activities and better liquidity standards among other benefits.

Nout Wellink, former Chairman of the BCBS, wrote an article in September 2009 outlining some of the strategic responses which the Committee should take as response to the crisis. He proposed a stronger regulatory framework which comprises five key components: (a) better quality of regulatory capital, (b) better liquidity management and supervision, (c) better risk management and supervision including enhanced Pillar 2 guidelines, (d) enhanced Pillar 3 disclosures related to securitization, off-balance sheet exposures and trading activities which would promote transparency, and (e) cross-border supervisory cooperation. Given one of the major factors which drove the crisis was the evaporation of liquidity in the financial markets, the BCBS also published principles for better liquidity management and supervision in September 2008.

A recent OECD study suggest that bank regulation based on the Basel accords encourage unconventional business practices and contributed to or even reinforced adverse systemic shocks that materialised during the financial crisis. According to the study, capital regulation based on risk-weighted assets encourages innovation designed to circumvent regulatory requirements and shifts banks' focus away from their core economic functions. Tighter capital requirements based on risk-weighted assets, introduced in the Basel III, may further contribute to these skewed incentives. New liquidity regulation, notwithstanding its good intentions, is another likely candidate to increase bank incentives to exploit regulation.

Think-tanks such as the World Pensions Council (WPC) have also argued that European legislators have pushed dogmatically and naively for the adoption of the Basel II recommendations, adopted in 2005, transposed in European Union law through the Capital Requirements Directive (CRD), effective since 2008. In essence, they forced private banks, central banks, and bank regulators to rely more on assessments of credit risk by private rating agencies. Thus, part of the regulatory authority was abdicated in favor of private rating agencies.