Question

QUESTION 1 Does the Basel II Accord deserve its share of the blame in the run up to the financial crisis of 2007 Those who say "no" however point to shortcomings of Basel 1 Accord as the possible reason. At a time when countries had just begun the implementation of the Basel II Accord, the remnants of the Basel I en with its lack of sensitivity and inflexibility to rapid innovations, could have created perverse regulatory incentives to simply move risky exposures off balance sheet, without really assessing the adequacy of capital to meet the risk exposures. Those who say "yes" feel that the financial crisis merely exposed the deficiencies in the vastly improved Basel II. What were the limitations of the Basel ? One, it made a quantum lcap from the relatively simple Basel I to include a degree of complexity that proved a challenge to both the regulators as well as the banks Two, external ratings provided by rating agencies played a critical role in Basel II. Since rating agencies were assigned specific blame, for the financial crisis, the basic premises of Basel II were also questionable Three, the standardized and advanced approaches operated under certain assumptions may not be applicable to all countries adopting the Accord. Hence, the onus was on the regulator of each country to assess if the risk weights assigned were applicable to the country's context. Four, the Accord allocated higher to higher credit risk. This led to the concem that small businesses and the less prosperous sections of society, typically considered high credit risk segments, would attract affordable rates of interest. This concern is especially true for developing countries Five, the risk modelling approaches in the advanced approaches had limitations. It is unclear whether maintaining capital based on these risk models would ensure adequate amount capital to cover risks Six, the level of technological and computational competence that the approach presupposes may not be available with all banks and banking systems Seven, aligning disclosures under Pillar III to international and domestic accounting systems will be a challenge Eight, effective implementation of Basel II would require tremendous upgrading of skills of beth supervisors and banks Finally, an issue that has been discussed widely is that of pro-cyclicality. When economies are doing well, the banks will lend more probably to take more risks for better returns and maintain adequate capital. However, when business cycles take a downturn, banks downgrade the borrowers due to increased likelihood of default and therefore, have to maintain more capital. This leads to capital shortage, as well as restriction in credit and therefor, leads to further deterioration in the economy, The Basel Committee acknowledges that risk based capital requirements could inevitable lead to pro-cyclicality, but this problem could be addressed by different instruments In November 2008, the Basel Committee admitted that its proposed Accord had to be more comprehensive to address the fundamental weaknesses exposed by the financial crisis related to regulation, supervision and risk management of internationally active banks. In 2009, the committee had already brought out documents amending Basel II Accord REQUIRED: 1. Why is the set of rules like Basel II blamed as the cause for a global financial meltdown? (8 marks 2. How can another set of rules like the Basel III remedy the situation? (12 marks) 3. How successful will Basel III be in averting future financial crisis? (10 marks) (30 MARKS)

Answer 1

Q1: Why is set of rules like Basel 2 blamed as global financial meltdown?

• It exposed deficiencies in the basel 2 accord along with more complexicity faced by regulators as well as for banks.
• The rating given by credit rating agencies played critical role , which proved to be blamed for basel 2 accord as the premises of it was confusing.
• The high credit risk fact of basel 2 put pressure on small banking organisation to face loss.
• The standardised and advanced approach had limitation.
• The risk modelling approach was not proper.
• The level of technological and computational competancies were not available for banks.
• Effective implementation of basel 2 required tremendous skills and practices.

Q 2: How can another set of rules like basel 3 remedy the situation?

• The another set of rules like BASEL 3 if it removes the limitations and restrictions which were in the BASEL 2. The update of Basel 2 required in order to face financial crisis in 2008 which was financial collapase of Lehman brothers:- A global Finance service company.
• The new set of rules in basel 3 removes the risk management difficulties and increased the management control over credit busts.
• It also established a standard leverage ratio which enabled or saved banks from high lending and settled a minimum amount of loss absorbing capital for banks.
• It created a safe zone by setting a high liquidity ratio which was essential for banks to maintain high cash available for fund needs and established net stable funding ratio.
• The new set of rules finally created some cross border resolution and supervision along with supplementary capital and contingent capital for banks for future.

Q3:How successful will be the basel 3 in averting future financial crisis?

• The Basel 3 rules was the update of Basel 2 to remedy the financial crisis situation. The rules stated in the accord are improvement over risk management complicacies and control of system.
• It specified additional buffer of equity that must be maintained by banks, which will reduce the credit risk of all banks in providing credit to institutional customers and individual customers.
• Basel 3 added some macroeconomic environmental factors which are very strategic for banks to manage arising risk factor in the economy.So macroeconomic risk analysis are efficiently done.
• It settled liquidity ratio need to be maintained by banks to avoid risk due to cash availabilty for future needs.This rules establised a net stable funding ratio that regularly set a confirmed stability for banks.
• In this way set of rules in basel 3 can save from future financial crisis.