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Conor Griffin explores both sides of the argument in relation to the impact of the capital adequacy regulator framework at this time of market turbulence, and summarises the possible amendments and additions that regulators are considering, and may adopt.

The Basel II capital adequacy regulations have been implemented by our banks and investment firms during what has been the most turbulent period in the financial markets for over 20 years. For most EU banks, effective compliance with the EU Capital Requirements Directive was required from 1 January 2008.

Many have claimed that the new rules will help address some of the causes of the recent financial market dislocations; others believe that the existing capital adequacy framework was a catalyst for the problems experienced in the structured credit markets, and far from addressing the problems, the new rules could in fact exacerbate them.

Causes of the credit and liquidity crunch

The Financial Stability Forum’s Working Group on Market and Institutional Resilience has attempted to identify the causes of and weaknesses revealed by the market turbulence. The critical weaknessesidentified include:

-Financial innovation led to the creation of very complex risk exposures not fully understood and assessed by both investors and the banks’ own risk management systems. -Poor underwriting standards and some fraudulent practices in the US subprime sector. -Poor risk assessment and risk management of market and funding liquidity, concentration and reputational risks. Insufficient regard for off-balance sheet risks and the interaction of tail risks under stress. -Poor investor due diligence practices, especially an excessive investor reliance on credit rating agency ratings. -Poor performance by the credit rating agencies in evaluating the risks of structured credit. -Various incentive distortions in relation to the regulatory capital treatment of securitisation, the opacity of information disclosures, and the structure of compensation schemes in the banking industry.

The market turmoil was then triggered and amplified by a resulting increase in risk aversion, falling market liquidity, and de-leveraging of risky exposures in an attempt by firms to build up liquidity positions. Did the existing Basel I regulatory capital framework help contain or exacerbate the credit and liquidity crunch, and does Basel II address any of these issues?

The old Basel I rules most definitely provided a regulatory capital incentive to the ‘originate and distribute’ model, which resulted in a reduced incentive for banks to monitor the credit quality of the loans they pumped into collateralised loan obligations and other structured vehicles. There is little doubt that the Basel I rules failed adequately to highlight contingent credit risk, which put strain on banks’ capital once the credit risk from conduits and structured investment vehicles (SIVs) started to come back on to bank balance sheets. Basel II attempts to ensure that the regulatory capital charge for a bank moving assets offbalance sheet is roughly in line with the charge had the bank retained those assets on the balance sheet.

The Basel Committee chairman, Nout Wellink, has stated that the subprime crisis may not have occurred – or may not have been so severe – had the new Basel II regime with its improved robustness of valuation practices and market transparency for complex and less liquid products been in place.

The Basel II regime does makes securitisation relatively less attractive to banks from a regulatory capital perspective, and it also seeks to better address contingent risk. Yet it is hard to believe it would have prevented the current problems in the structured credit markets.

Basel II relies heavily on a number of key elements which, to many eyes, appear weakened in light of the credit and liquidity crisis:

-Basel II further promotes the use of internal quantitative modeling techniques by banks in calculating their regulatory capital. Some commentators have expressed worries over the opacity of these more complex models, and the fact that the use of internal models by banks could potentially lead to conflicts of interest. -The new capital adequacy rules depend heavily on the use of credit agency ratings. Given the culpability being ascribed by many to the rating agencies in the structured credit market turmoil, should Basel II really give these agencies a quasi-regulatory role in relation to capital adequacy? -Despite improvements over Basel I, the new rules still focus very much on credit origination, as opposed to new credit derivative instruments and structured products. -The IMF has recently stated that the pro-cyclical nature of Basel II capital requirements, which require banks to hold additional capital against greater anticipated losses as the economic cycle turns downward, could exacerbate an economic recession by forcing banks to restrict their provision of credit in a downturn scenario. -The credit and liquidity crunch was partly the result of a widespread lack of information, which exacerbated the initial US subprime problems. Whilst enhanced disclosure is one of the three pillars of Basel II, it isrecognised as likely to be the weakest in terms of both prescription and enforcement. Basel II disclosure is required to assess an individual bank’s capital adequacy. But that is not enough: a strong bank capital base, while essential to avoid the collapse of any major financial institution, was not sufficient to prevent the systemic effects of the subprime crisis.

On a broader note, Basel II will only apply to banks (and EU investment firms). It does not extend to nonbank financial institutions such as hedge funds and the large US brokerdealers.

Regulatory response?

The financial market turmoil is likely to trigger regulatory responses. In a recent speech to the European Parliament’s Committee on Economic and Monetary Affairs, Commissioner Charlie McCreevy outlined the EU policy response which will include:

-Enhancing transparency for investors, markets and regulators, in particular on exposures to structured products and off-balance sheet vehicles. -Improving valuation standards, in particular for illiquid assets. -Examining potential conflicts of interest in the credit rating agencies business model, and the transparency of rating methodologies for structured credit products. -A targeted revision of certain aspects of the Capital Requirements Directive will be undertaken during 2008 and will include: new rules to limit the risk stemming from large exposures; harmonisation of the definition of ‘hybrid capital’; capital requirements for default risk in the trading book; a definition of the significance of risk transfer; and technical changes to the securitisation framework.

Basel II did not explicitly address the regulation of liquidity risk management, but the Basel Committee on Banking Supervision has begun work to improve supervisory practice and strengthen banks’ liquidity risk management.

It plans to further develop its sound practice principles to reflect recent experience. In particular this will focus on:

-Improving identification and measurement of the full range of liquidity risks, including contingent / off-balance sheet liquidity risks. -A greater emphasis on market-wide stress testing, and linkage of stress tests to contingency funding plans. -Improving communication and cooperation between supervisors in strengthening liquidity risk management practices. -Management of intra-day liquidity risks arising from payment and settlement obligations both domestically and across borders. -Management of foreign currency liquidity risk. -The role of disclosure and the market discipline.

Pillar 2 of Basel II (which focuses on the management of risks other than credit, market and operational) would seem to be the most appropriate home for the incorporation of these revised liquidity practices into the regulatory framework.

The International Monetary Fund (IMF) has argued that better guidance for supervisors on the transfer of credit risk from balance sheets is needed within the Pillar 2 supervisory review provisions of Basel II. The IMFhas also proposed a review of the risk weights for contingent credit lines within the Pillar 1 capital requirements.

Ireland’s exposure

The openness of Ireland’s economy means that our financial system is very highly exposed to global economic and financial market events and domestic regulation alone is not sufficient or optimal. Therefore, the Financial Regulator participates in, and will be guided by, the international level responses to the crisis discussed above.

In terms of this crisis, the Irish banks’ liquidity positions had been strengthened by the introduction in 2007 of the Financial Regulator’s new liquidity risk management framework. This system requires all banks to observe conservative quantitative liquidity limits (banks must carry sufficient liquid assets to cover 100% of potential outflows over a 0-8 day period and 90% of potential outflows over a 9-30 day period). However, the qualitative requirements around the liquidity management process and structure, and the focus on the need for rigorous stress-testing are equally important elements of this framework.

It is encouraging that Patrick Neary, Chief Executive of the Financial Regulator, in a recent speech, emphasised how important it is for the regulatory response to the crisis to “be an informed and consultative process that is focused on clear outcomes rather than a knee-jerk reaction of more regulation”.

However, with the credit and liquidity crisis having temporarily diverted the attention of regulators from responses to the banks’ Pillar 2 capital adequacy assessments, there is an expectation that regulators may now take a more conservative approach to the issue of potential Basel II capital releases, at least in the short term.

There have also been calls for more cooperation (and indeed integration) amongst and between national supervisors and this will be necessary in some form in order to prevent jurisdictional regulatory arbitrage.

Conclusion

Basel II is a definite improvement over Basel I. Its implementation will improve the standards of risk management practices across most of the banks subject to its provisions. It adopts a more sophisticated approach to risk management and to how credit derivatives and securitised assets are treated. But it is not a panacea, and whether it could have prevented or lessened the impact of the recent crisis is very debatable. Mostimportant for banks is that they ensure that the key elements of their Basel II risk management governance structures, policies, processes and systems are robust, integrated, and able to incorporate both the economics lessons and regulatory implications of the credit and liquidity crunch.

Conor Griffin is Director, Risk Advisory Services with Ernst & Young in Dublin. Email: conor.griffin@ie.ey.com