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Shortcomings of Basel-II
Importance of diversification in Pillar 1
Credit risk capital rises linearly regardless
of exposure size
Unclear and inconsistent definition
of capital
Non- application of regulatory
adjustments across jurisdictions
2. Single
Global Risk
Factor
Non recognition of
interdependence across exposure &
geographies
Shortcomings
3. Securiti
zation
5. Subjective
Risk Inputs
Warehousing of securitization
exposures on and off-balance sheet
4. Pro-cyclicality
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Weak transparency
Inadequate disclosure provided by banks about their regulatory capital bases
Insufficient details on the components of capital
Difficulties in assessing capital quality and performing comparisons with other banks
Reconciliation of regulatory capital components with the published financial accounts frequently absent
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Stress testing
Non comprehensiveness in stress testing of counter party
credit risk
inappropriate models
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Underwrites Risk
Bank B
20% Risk Weighted
Lends $1000
Re-insurance
Company
Outside the scope of Banking
system, thus non application of
BIS capital rules
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Promise
Transformations
Bank A
Bank A
Bond Face Value
1,000
80
Bank A
Bank B
Regulatory Adjustment
50% Off B/sheet Wt.
1.5% Surcharge Coef. & 8% Required K
16
Bank B
Underwrites to Reinsurqnce $50 perm,
2.6
80
16
2.6
Re-insurer
Basel risk weighting led to perverse outcome i.e. greater the Tier-1 adequacy of the bank greater the cumulative losses
Low capital Vs. the un-weighted balance sheet is symptomatic of a banking risk culture a culture of privatizing gains and
socializing losses
2.5
Switzerland
2.0
2.5
Germany
UK
1.5
Belgium
Ireland
Australia
Canada
1.0
Spain
Italy
0.5
France
Norway
Japan
0.0
Switzerland
Germany
2.0
Belgium
1.5
UK
Canada
Australia
1.0
France
Ireland
Spain
Norway
0.5
Japan
Italy
0.0
10
11
Tier 1 ratio
Better Tier 1 capital ratio, greater the loss
12
10
11
12
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Shortcomings of Basel-II
Components of Basel-III
Enhanced transparency,
consistency & quality
of capital base
Inadequate treatment of
Liquidity Risk
Enhanced liquidity
standards including
LCR & NSRF
Excessive BS growth
despite relatively small
levels of capital
Causes pro-cyclical
amplification of shocks
in financial sector
Adoption of measures to
counteract pro-cyclicality
The Proposed
BASEL-III Accord
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Risk management
post the crisis
Significant
market-to-market losses
2
2
3
3
Capital Management
Underestimation of risk in
complex financial products
Self-reinforcing
irrational exuberance
Investment Companies
5
4
Deregulation of the
Transparency and
macro-economic indicators
Information Disclosure
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10
Copious inflow of foreign funds from countries with current account surpluses
The turn of this century witnessed China, oil exporting nations and Japan investing huge amounts of surplus
national savings in treasury bonds and related securities issued by the USA, UK and parts of EU.
Availability of surplus funds plummets interest rates and spurs aggressive lending
Fed interest rates were around 5.5% p.a. prior to year 2002. Inflow of foreign funds plummeted rates to 1.6%
between 2002 to 2005.
Combination of low interest rates and aggressive lending & investment practices leads to
innovation of new financial products
Innovation of structured credit products, modeled (and rated) as low risk - high yield instruments.
All the above factors, backed by huge house-hold and corporate demand, spurred lending, significantly
increased leveraged positions of Banks and changed maturity transformations
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11
Substantial growth in the financial sector lead by the structured credit model
The lending model using structured credit instruments caused banks to view that all risks involved in the
transactions were transferred to the buyers of such instruments, which was later on proved to be false.
Growth in the financial sector coupled with huge profits caused a vicious loop of
self reinforcing irrational exuberance
Model Risk prevalent in complex structured credit products were significantly undermined and ignored.
Deregulation of the financial services industry, in the USA, fuelled systemic risks
Emergence of shadow banking, Lack of capital requirements for non banking investment companies etc.
During 2006, Fed increased interest rates. Rates were substantially increased in year 2007 also
Average rates increased from 1.6% p.a. between 2002 to 2005 to 4.9% p.a. between 2006 to 2007.
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Increase in interest rates, initial incidence of sub-prime defaults and over-supply of real estate properties cause
real estate prices to fall & initiates a wave of negative market sentiment
10
Banks with heavy dependence on short-term funding faced liquidity dry-up. Deposit runs by retail and corporate
customers further added to the liquidity concerns (i.e. Bear-Stearns, Northern Rock).
11
Banks incur massive credit losses from real estate financing. Investment Companies incur huge marked-tomarket losses on real estate investments
12
Failure of huge Banks and Investment Companies (initially considered as "too big to fail"). It leads to significant
loss of confidence and downward spiraling of macro-economic indicators
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