24 February 2020

LSE: How the Basel Accord’s dependence on external institutions aggravated the 2008 financial crisis

Deficiencies in the Basel II accord, which set recommendations on banking regulation, have been highlighted as one of the main causes of the global financial crisis that emerged in 2008. Manuel Becker and Simon Linder explain that a particularly problematic feature was the accord’s reliance on so called ‘regulatory import’, where regulators incorporate governance from an external forum into their own regulations, thus making their own performance dependent on external institutions.

The Committee sets minimal capital requirements that shall function as a safeguard against potentially contagious series of bank failures due to credit default. For each claim, a bank must deposit some fraction of secure core capital. The first international accord that defined risk parameters was Basel I. The Accord had fixed risk weights for each asset class. For example, claims on the private sector had a weight of 100%, while claims on OECD banks had a risk weight of 20%. But 20% of what? The information to answer that question is derived from the balance sheet.

The Committee was aware that the sub-issue of balance sheet regulation was of importance for its own regulatory performance. Instead of defining its own accounting rules, the Committee decided to make use of externally defined standards and to incorporate them into the Basel Accord. It did so for two reasons: First, accounting requires specialised knowledge, which the Committee did not possess at the time. Second, it wanted to avoid conflict with accounting authorities and legal inconsistencies in global financial regulation. The import of external accounting rules, however, made the Committee dependent on external accounting authorities regulating balance sheets in a complementary way.

The import of external governance went even further with Basel II. The new accord replaced the fixed risk weights with floating risk parameters. The Committee did not develop its own framework for these new floating risk weights. Constantly determining counterparty failure risk for each market participant was again a task outside the Committee’s competence. Therefore, the Committee delegated credit risk assessment to large banks with the necessary capacities to develop and use advanced statistical methods. Additionally, the Committee imported risk measurement frameworks from credit rating agencies for medium and small sized banks into Basel II, making the Basel Accord’s performance even more dependent on external risk assessments.

The first unintended consequences arose when the International Accounting Standards Board (the Board), the global authority in accounting, adopted an accounting standard that made “fair value accounting” the principal method for rating financial instruments on balance sheets. The Board adopted “fair value” to increase transparency of financial statements, but did not sufficiently consider the effects on the Basel Accord.

The import of external credit risk assessment undermined Basel II by transmitting failures of credit rating agencies into banking regulation. The pro-cyclical rating behaviour of credit rating agencies led to what we call multiplicative pro-cyclicality. Now, not only the capital to risk ratio is influenced by accounting practices, but also the value of the risk weight itself.

Since regulatory import creates a one-sided dependence and vulnerabilities towards external dynamics, it should be accompanied by the installation of inter-institutional coordination mechanisms to limit unintended consequences. Therefore, authors assess post-crisis reforms as important but not sufficient steps towards greater coordination in global finance. The Committee and the International Accounting Standards Board instigated institutional dialogue and committed to a closer relationship after the crisis. However, the one-sided dependence remains and incentives for accounting authorities to adhere to concerns of banking regulators remain largely unheard. With respect to credit rating agencies, public attempts to limit their autonomy were not effective. Despite the overwhelming post-crisis critique, credit rating agencies remain as an integral part of the regulatory structure.

Full article on LSE

© LSE