A pillar of strength


22 November 2010


Amid the post-financial crisis policy-making storm, it is imperative to remember some of the important merits of Basel II. Especially within the scope of the framework’s second pillar, writes Gonzalo Gasós, adviser at the European Banking Federation.


The Basel II Accord was conceived as a global standard for capital adequacy. It is the result of a compendium of expertise from the banking sector's stakeholders, including bank employees, central banks' experts, academics and supervisors from across the world. More than seven years of research in various working groups and five quantitative impact studies were undertaken
to produce the final paper in 2005: International Convergence of Capital Measures and Capital Standards.

The Basel II framework provided the basic elements, or 'pillars', for an improved prudential structure: risk-sensitive statutory capital requirements (Pillar 1), supervisory review of the capital adequacy assessment, risk procedures and internal control (Pillar 2) and appropriate disclosure by each bank to allow for market discipline (Pillar 3). The three pillars were intended to complement each other and be applied consistently by all internationally active banks. At present, the implementation of Basel II is still fragmented (many jurisdictions such as the US and developing countries have not implemented it) and partial (only the first pillar has been applied in its entirety).

Basel II focused on improving the risk-weighting methods but left the definition of capital and its minimum requirement as it was under the Basel I regime.

When the financial crisis struck the global economy in 2007, Basel II was only an upcoming change in the EU, and only a future plan in other countries around the world. It is unwarranted to put the blame of the financial crisis on Basel II, given that the fiasco of the sub-prime instruments had been developing underground during the reign of the former Basel I regime. However, it is broadly accepted that a revision of Basel II is necessary, in particular to the quantity and quality of capital, in order to strengthen the resilience of the banking sector.

As a result, the Basel III regulatory package is focused on Pillar 1 measures, notably large increases in the numerator of the solvency ratio - the capital. In contrast, the most effective measures in crisis prevention are sound risk management practices and effective supervision, which were envisaged within the scope of Pillar 2.

The numerator

The capital ratio is essentially a quotient between the eligible capital available (the numerator) and the risk-weighted assets (the denominator). By way of example, the regular risk weight of an asset would be 100%, which implies that the bank needs to hold capital equivalent to at least 8% of the exposure amount under the current Basel II regime. A better quality credit could have a risk weight of 50%, which requires a capital support of at least 4% of the exposure. A loan to a highly creditworthy corporation with a risk weight of 20% would only require 1.6% capital. On the other side, riskier exposures can have risk weights above 100%. For instance, a securitisation rated BB+ would be weighted at 250%, thus requiring 20% capital; an unrated securitisation would bear a weight of 1,250%, hence having to be fully backed by capital.

On 12 September 2010 the Basel Committee on Banking Supervision (BCBS) took the remit of the G20 to redefine the structure of the eligible capital. The lift in the minimum core equity ratio from 2% to 4.5%, together with the more stringent definition of eligible capital, so that only core equity and reserves qualified, will undoubtedly increase the likelihood of each and every banking institution to withstand future economic upheaval. Moreover, the new enhanced risk-weights of market risk and re-securitisation exposures willrequire banks to back them with higher amounts of capital if they are to maintain the same level of exposure in those asset classes.

In general, the banking industry has acknowledged the need for enhancing the quantity and the quality of capital. However, the BCBS proposals seem to have gone above and beyond by adding two layers of capital buffers, without mentioning other measures under discussion, such as capital surcharges for systemically important financial institutions. Yet the G20 declaration of April 2009 mandated that buffers above the regulatory minima should be increased, once recovery is assured, and that buffers should also be allowed to decline to facilitate lending in deteriorating economic conditions. It also foresaw a requirement for banks to build buffers in good times from which they can withdraw when conditions deteriorate.

Given the final BCBS proposals, it looks as if the remit of the G20 may have been read in an overly conservative way, in three aspects: firstly, the magnitude of the buffers (2.5% each); secondly, the intrusive intervention in the dividend policy of going concern banks, by curtailing the dividend pay-outs; thirdly, the imposition of a country-wide countercyclical buffer to all banks with no regardto their contribution to the excessive credit growth during the upswing of the economic cycle.

The magnitude of the buffer, the way it needs to be accrued and the contribution of banks' behaviour to procyclicality are issues that would typically be assessed in the supervisory review and evaluation process. Otherwise, the new regulation could start puttingforward the wrong incentives, such as:

  • the incentive to move assets to more capital-efficient lending sectors (normally unregulated or barely regulated)
  • the incentive to seek higher reward for the heightened level of capital, compelling banks to take on riskier assets
  • the incentive for investors to reduce their investments in the banking sector due to the uncertain dividend expectation
  • the incentive for banks to lend more during the upside of the cycle.

The Basel II Accord provided an adequate framework for the assessment of the aspects mentioned above: it is called Pillar 2.Regulators should allow and encourage supervisors to make good use of it.

Risk sensitivity

The Basel II Accord was aimed at standardising a growing industry practice that came along with the development of more advanced
risk methodologies during the 1990s. Financial firms became more able to rank and measure the risk involved in every transaction across different asset classes.

The fact that the risk weights of certain asset classes needed to be recalibrated does not invalidate the risk sensitivity principle of
the Basel II framework. In fact, once the recalibration is in place, the overall risk assessment should
be more robust.

A return to the blunter, risk-insensitive Basel I regime would be a step backwards and would represent a failure in terms of offering the right incentives to risk management. There are grounds for thinking Basel III could mark a subtle way to return to Basel I by burying the risk-sensitivity merit of Basel II with supplementary provisions that would lift and tend to equalise the risk weights of all exposures. What, then, is the incentive to run sophisticated risk measurement processes if the ranked and proportionate results are finally flattened by the imposition of a leverage ratio and the obligation to comply with stringent funding structures?

Hopefully, the observation periods set by the Basel Committee of 2013-16 for the leverage ratio, 2011-14 for the liquidity ratio and 2012-17 for the net stable funding ratio will end up in Pillar 2 guidance rather than in Pillar 1 rules. If the merits of Basel II risk-sensitivity are to be preserved, transactions should be assigned levels of capital commensurate to the risk involved as determined by Pillar 1 and be subject to the overall assessment of capital adequacy under Pillar 2.

Improved supervision

One lesson learnt during the financial crisis was that banks that had a stronger risk culture in place were more able to cope with one of the root problems of the crisis: the role that risk management plays in the institution. But what has this got to do with Basel II?

Perhaps the major contribution of Basel II to the safety of the banking sector is its framework of risk management and its principles of supervisory review, all within the scope of the second pillar. Indeed, Pillar 2 is intended to encourage banks to develop and use better risk management techniques in monitoring and managing their risks.

Had Pillar 2 been working in the run-up to the crisis, the story would have been quite different. Indeed, the key elements to counter the root problems that led to the crisis had already been thought through in Pillar 2:

  • a sound risk-management process, including a comprehensive assessment of risks; this covers not only credit risk, but also
    other sources of risk, notably concentration risk and liquidity risk
  • board and senior management supervision, acknowledging that bank management is responsible for understanding the nature and level of risk being taken by the bank and how this risk relates to adequate capital levels; the board is also responsible for ensuring that the formality and sophistication of the risk management processes are appropriate in light of the risk profile and the business plan
  • a supervisory review process with emphasis on the quality of the bank's risk management and control.

The solution to the crisis, therefore, had already been invented. Pillar 2 only needed to be fully put into operation.

The wide range of regulatory proposals underway needs a good deal of understanding and flexibility in its implementation. The supervisory review and evaluation process envisaged in the Pillar 2 scope is set to gain momentum and should be used to a large extent in the adoption of the prudential framework. Supervisory resources and methods should be generously reinforced to achieve the new regulation goals.

In Europe, the constitution of the new European Banking Authority should pave the way for a more Pillar 2-oriented implementation of the Basel III package.

Basel III should encourage the use of Pillar 2 in combination with a less rigid approach to Pillar 1 measures. It is not overly tight regulation that will prevent the next crisis, but rather sound risk management and reliable supervisory review.