Financial Crisis and the Implementation of Basel II

Financial Crisis and the Implementation of Basel II: Potential Economic Impact for Trinidad and Tobago Lester Henry and Michelle Majid 1

Roadmap of the Paper • • Introduction Overview of Basel I & II Financial Crisis and Basel II: Are they linked? The Tn. T Financial System Some issues of concern to T&T The way Forward for T&T Summary and Conclusion 2

Introduction • Financial Crisis partly seen as regulatory failure. • Basel I and Basel II were supposed to prevent • • • such Many Caribbean Countries were expected to adopt Basel II over the next few years (from 1 or 2 in 2007 to 4 -6 between 2010 – 2015) Examine Basel II’s role in the crisis Identify issues arising from possible adopting Basel II determine the extent to which Basel II may impact T&T and by extension the region Inform policymakers whether focus should be on 3

Overview of Basel I Pillar 1: Regulatory capital Minimum capital requirements Risk-weighted Assets (Denominator) Credit Risk (1988) ≥ 8% Risk-weighted assets Definition of Capital (Numerator) Market Risk (1996) Standardized Approach Models Approach 4

Shortcomings of Basel I • Capital required did not mirror a bank’s • • • true risk profile Too simple for advanced banks Inflexible against new developments Covers only credit and market risks Only quantitative in nature Limited recognition of collateral 5

Basel II in a Nutshell Basel II Pillar 1 Pillar 2 Pillar 3 Three Pillars Minimum capital requirements Supervisory review process Risk weighted assets Standardized Approach Internal Ratings-based Approach Definition of capital Operational risk Credit risk Basic Indicator Approach Standardized Approach Market discipline Market risks Advanced Measurement Approaches Standardized Approach Core Capital Supplementary Capital Models Approach 6

Objectives of Basel II • Greater emphasis on banks’ own • • • assessment of risk Comprehensive framework for credit, market and operational risk Encourages rigorous bank supervision Ensures market transparency, disclosure • More risk sensitive; better align regulatory capital with actual risk exposure 7

Basel II and the Financial Crisis • I. the average level of capital required by the • • • new discipline is inadequate and this is one of the reasons of the recent collapse of many banks; II. the new Capital Accord, interacting with fairvalue accounting, has caused remarkable losses in the portfolios of intermediaries; III. capital requirements based on the Basel II regulations are cyclical and therefore tend to reinforce business cycle fluctuations; IV. in the Basel II framework, the assessment of 8 credit risk is delegated to non-banking

Basel II and the Financial Crisis…. continued • V. the key assumption that banks’ internal • models for measuring risk exposures are superior than any other has proved wrong; VI. the new Framework provides incentives to intermediaries to deconsolidate from their balance-sheets some very risky exposures Source: Francesco Cannata Mario Quagliariello (2009) 9

In Defense of Basel II • Only recently implemented • In US only applies to top tier banks operating • internationally -- most of system is exempted Pillar II and Pillar II have been given very little attention, a careful application would involve; – Remuneration packages in investment banking and of management boards; – Transparency of a bank's risk profile; – Management's true understanding of both the bank's risk profile and its risk positions. • source Van Kemper, Cris (2009) 10

Can Basel X work? A Minskyian alternative View • Can help in some cases but ultimately limited in • • preventing crises Sources of instability are “built-in” to the system During expansions managers competence will be questioned if they don’t go after higher returns In normal times the “three-six-three” rule applies During Busts credit supply dries up regardless of any stimulus policy 11

Snapshot of Tn. T Financial System: Asset Growth banks and 19 NBFIs • Eight commercial 12

Snapshot of the Financial System: Capital Adequacy 13

Snapshot of the Financial System: Asset Quality 14

FSAP (2005): T&T’s deficiencies • Inadequate financial sector laws • High-levels of connected exposures • • across banking and insurance companies BCP Non Compliance with Market Risk, Large and related exposure limits 0% risk weighting all sovereign debt 15

Some Areas of Concern • • • Credit Risk Assessments Macroeconomic Issues Capital Requirements Distortion of allocation of credit Interbank Lending Regulators in emerging economies Home-host Issues Local Banks in T&T BCP Compliance 16

Credit Risk Assessments • Shallow credit rating market (reduced to • • flat rate) Rating linked to level and volatility of capital flows Prohibitive cost and incentive to become rated Who will rate the rating agency? Potential pro-cyclicality and circularity (Powell, 2002) 17

Macroeconomic Issues • Three factors indicate that tighter regulatory capital requirements are likely to cause a domestic credit crunch: * economies are shallow * banking sector concentrated * presence of government in the real economy 18

Regulators • Deficient regulators can be an important • • determinant of banking crisis (much more than adequate capital provisions) (Barth, Caprio and Levine (2001)) Increased skills of examiners Shift from generalists to specialists (BCBS, 2004) 19

Local Banks in T&T • Banks would need to improve • • infrastructure for measuring and monitoring risk – COSTS!!!! Foreign-banks within T&T can piggy-back on parent Where does that leave T&T local banks? 20

Limitations and Areas of Further Research • Limitations: Lack of data to do QIS Basel I shortfalls to address Credit rating assessments Regional workshop to resolve common issues 21

The Way Forward for T&T • Get the Vision combined with • • preconditions right Create detailed and specific gap assessments Produce detailed plans to address gaps with sufficient lead times Establish a process to oversee and deploy Basel II implementation 22 There is no substitute for extreme

Selected References • Francesco Cannata and Mario Quagliariello (2009) “The role of Basel II in the subprime financial crisis: guilty or not guilty? ”, CAREFIN Working paper 3/09. • Wray, Randall can Basel II enhance financial stability? A Pessimistic View”, Working paper 84, Jerome Levy Institute. 23

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