Basel Committee Revisiting Basel II Accord in Light of Financial Crisis

As the market turmoil associated with securitization deepens, the Basel Committee is looking at making improvements to certain aspects of the Basel II Accord. In remarks, at a recent Basel II Implementation Summit in Singapore, Basel Committee Chair Nout Wellink said there are no simple measures that will capture the complex risks now facing global financial institutions. Multiple perspectives on risk are an imperative, he noted, as provided under the three pillars of Basel II.

Concomitant with the Basel chair’s remarks, FSA Chair Callum McCarthy told the International Institute of Bankers that any failings in Basel II revealed by the ongoing financial market crisis must be identified and corrected. There are both specific issues, like the capital charge for trading book credit loss, and the more general issue of how ratings are used, which are central to Basel II, noted the FSA chair, and where the problems in ratings of structured securities instruments should ``make us thoughtful.’’

The Basel II Accord has three mutual reinforcing pillars. The first pillar is the minimum regulatory capital charge. The second pillar deals with risk management, while the third pillar enhances disclosure.

Under the first pillar of Basel II, noted Chairman Wellink, the committee is examining the treatment of highly rated securitization exposures, especially asset-backed securities and collateralized debt obligations. These securities have recently been the source of the greatest losses across the banking sector and they have an unusual feature in that losses can build very rapidly. This feature explains the unprecedented downgrades of triple-A super senior tranches, which exceed anything yet seen in traditional corporate bonds. These structured securities are highly correlated with systematic risk, said the Basel chair, and the Basel Committee will look at whether the capital charges for these types of exposures are calibrated appropriately in relation to their risks and complexity.

The committee has decided to introduce a credit default risk charge for the trading book. There has been a rapid growth of less liquid, credit sensitive products in banks’ trading books, he said, including structured credit assets and leveraged lending. The VAR-based approach is insufficient for these types of exposures, he posited, and needs to be supplemented with a default risk charge.

In addition, Mr. Wellink said that it is critical that banks conduct rigorous Pillar 2 stress testing of their trading book exposures. They must factor in liquidity horizons and reflect these results in their risk limits, economic capital and concentration management strategies. Many structured credit products are tailored for individual investors and have a limited or no secondary market. The Basel II framework has guidelines for what should and should not go into the trading book, he emphasized, and these need to be reviewed by banks.

Under the second pillar of the Basel framework, regulators will be reinforcing the importance of banks’ stress testing practices. Basel II already requires banks to conduct stress tests of their credit portfolios to validate the adequacy of their capital cushions at all points of the credit cycle. However, it is important that banks also conduct scenario analyses and stress tests of their contingent credit exposures, both contractual and non-contractual. These contingencies have implications for balance sheet growth and capital. Banks have taken significant exposures back on the balance sheet for reputation reasons. Being better prepared for such scenarios going forward can help make banks more resilient to stressful conditions.

Turning to Pillar 3, the chair said that there are opportunities to further leverage off the types of disclosure required under Basel II. In particular, regulators need to monitor the type of information that banks make available for structured credit products. The committee will determine whether improvements are needed, particularly related to securitizations, conduits and the sponsorship of off-balance sheet vehicles.