Whither the Basel Accord?
Starting in June 1999, the Basel Committee on Banking Supervision released several proposals to reform the original 1988 Basel Accord. These efforts culminated in what bank supervisors refer to as Basel 2, which is based on three pillars. 1. Pillar 1 links capital requirements for large, internationally active banks more closely to actual risk of three types: market risk, credit risk, and operational risk. It does so by specifying many more categories of assets with different risk weights in its standardized approach. Alternatively, it allows sophisticated banks to pursue an internal ratingsbased approach that permits banks to use their own models of credit risk. 2. Pillar 2 focuses on strengthening the supervisory process, particularly in assessing the quality of risk management in banking institutions and evaluating whether these institutions have adequate procedures to determine how much capital they need. 3. Pillar 3 focuses on improving market discipline through increased disclosure of details about a bank’s credit exposures, its amount of reserves and capital, the officials who control the bank, and the effectiveness of its internal rating system. Although Basel 2 made strides toward limiting excessive risk taking by internationally active banking institutions, it greatly increased the complexity of the accord. The document describing the original Basel Accord was 26 pages, while the final draft of Basel 2 exceeded 500 pages. The original timetable called for the completion of the final round of consultation by the end of 2001, with the new rules taking effect by 2004. However, criticism from banks, trade associations, and national regulators led to several postponements. The final draft was not published until June 2004, and Basel 2 started to be implemented at the beginning of 2008 by European banks, but full implementation in the United States did not occur until 2009. Only the dozen or so largest U.S. banks are subject to Basel 2: All others will be allowed to use a simplified version of the standards it imposes. The financial crisis of 2007 to 2009, however, revealed many limitations of the new accord. First, Basel 2 did not require banks to have sufficient capital to weather the financial disruption during this period. Second, risk weights in the standardized approach are heavily reliant on credit ratings, which proved to be so unreliable in the run up to the financial crisis. Third, Basel 2 is very procyclical. That is, it demands that banks hold less capital when times are good, but more when times are bad, thereby exacerbating credit cycles. Because the probability of default and expected losses for different classes of assets rises during bad times, Basel 2 may require more capital at exactly the time when capital is most short. This has been a particularly serious concern in the aftermath of the 2007–2009 financial crisis. As a result of this crisis, banks’ capital balances eroded, leading to a cutback on lending that was a big drag on the economy. Basel 2 has made this cutback in lending even worse, doing even more harm to the economy. Fourth, Basel 2 did not focus sufficiently on the dangers of a possible drying up of liquidity, which brought financial institutions down during the financial crisis. As a result of these limitations, the Basel Committee has begun work on a new accord, Basel 3. Its goal is to beef up capital standards, make them less procyclical, make new rules on the use of credit ratings, and require financial institutions to have more stable funding so they are better able to withstand liquidity shocks. Measures to achieve these objectives are highly controversial because there are concerns that tightening up capital standards might cause banks to restrict their lending, which would make it harder for economies throughout the world to recover from the recent deep recession. When Basel 3 will be implemented is anybody’s guess.