10 April 2008

BIS: Wellink on recent market developments and the role of Basel II

The Basel I framework, as recent events are demonstrating, has increasingly failed to deliver its objectives, Nout Wellink, Chairman of the Basel Committee on Banking Supervision said on the Basel II Implementation Summit in Singapore. Basel II is an important next step to enhance bank resiliency. Moreover, it provides supervisors with a better framework within which to make enhancements in the future, as financial markets evolve.

Mr Wellink outlined in his speech how the Basel II capital framework is better able to achieve these objectives in the face of rapid financial innovation. He discussed some lessons from the recent turmoil and their potential implications for Basel II going forward, and summarized the work of the Committee to supplement strong capital with improvements to global liquidity risk management and supervision.

The current financial market turmoil underscores the importa­nce of strongly capitalised banking systems, Wellink said in a related FT article. It also highlights the shortcomings of the Basel I capital regime, which has been in place since 1988 and has contributed in the past few years to the concentration of risk in the banking sector.

Please find the FT article below. His speech is attached at the bottom of the page

FT article: Basel II is sophisticated and sorely needed

There is a strong consensus that the implementation of Basel II will put capital regulation on a sounder footing. Among other things, Basel II will enhance capital regulation, super­vision, risk management and market transparency. All exposures, whether on or off the balance sheet, will be subject to regulatory capital charges. There will be greater differentiation in the capital requirements for high and low-risk exposures. Basel II will create more neutral incentives between retaining exposures on the balance sheet and distributing them to investors through securitisations. It will introduce more robust capital requirements for banks’ rapidly growing trading and derivatives activities. Supervisors will be given the tools to help strengthen banks’ risk management and governance. Better disclosure of banks’ risk profiles, including structured credit and securitisation activities, will be required.

These enhancements are achieved by reinforcing the basic building blocks of sound credit risk management practices, subject to rigorous internal controls and supervisory standards. The framework is therefore more adaptable to rapid innovation in financial markets and products. Moreover, the three pillars of Basel II (minimum capital, risk management and supervisory scrutiny, and market transparency) provide multiple perspectives on banks’ risk profiles and capital cushions.

Recently this page has featured the arguments of a number of Basel II critics, primarily from the academic community. First, it has been argued that Basel II adopts the models that failed to perform in the recent turmoil. As a result, it is argued, the framework does not place constraints on bank risk-taking. This claim is based on a mis­understanding of what constitutes a model. Basel II does not allow banks to use the credit pricing models that failed to perform. Nor does it permit the modelling of correlations, which broke down under stress. Instead, the framework requires banks to develop robust data series on defaults, losses and recoveries that include an econ­omic downturn. These data inputs are filtered through a prudential capital framework specified by supervisors. This will induce an important upgrade in banks’ risk management systems that, had these enhancements been achieved before the crisis, would have helped put banks on to a sounder footing.

Second, it has been argued that Basel II is too procyclical, amplifying financial crises. However, it is not possible to have greater risk differentiation – a main objective of strengthening capital regulation – without some fluctuation in minimum capital requirements as credit quality deteriorates. The Basel committee has worked hard to introduce many safeguards across the three pillars of the framework to achieve a reasonable balance between risk sensitivity at banks and the stability of industry capital over the cycle. This includes the requirement that banks perform stress tests and demonstrate that they hold adequate cushions above the minimum during good economic conditions, in order to weather such stress.

The Basel II framework will change bank incentives and require them to develop more forward-looking approaches to assessing, managing and holding adequate capital for risks. Supervisors will have stronger tools to intervene early before capital minimums have been breached.

The Basel committee has put into place a rigorous data collection framework to track the impact of Basel II across member countries. Where the framework proves to be too cyclical, the committee will take the necessary steps to achieve a better balance. But, whatever is done, we need to retain the benefits of risk differentiation across banks and over time to highlight supervisory attention on those banks that take on excessive risk for a given unit of capital.

There are no quick-fix, simple measures or ratios that will achieve our objective of a robust capital regime. Basel II is being implemented only now in most countries, but the market turmoil has already provided some important lessons that will help guide the Basel committee in further strengthening the framework. Overall, it is the best practical approach we have that balances a range of objectives and trade-offs. I believe Basel II provides regulators with a better tool to ensure that capital cushions reflect banks’ changing risk profiles in an environment of rapid financial market ­innovation.

While strong capital is a necessary condition for a stable banking and financial system, it is not sufficient. Sound, company-wide risk management, including prudent underwriting, strong supervision and robust liquidity cushions, is also a critical element. The committee’s work agenda seeks to strengthen practice in these areas. It has been devoting particular attention to strengthening global standards for the management and supervision of liquidity risk, which it will issue for public comment in the coming months.

The writer is president of the Netherlands Bank and chairman of the Basel committee on banking supervision

By Nout Wellink

© Graham Bishop