Why Basel II wasn’t good enough for reducing bank risks

Basel II’s drawbacks

Basel II was a comprehensive regulation that covered major sources of risks for banks. But it had a few major drawbacks.

Firstly, it provided incentive to a bank’s management to underestimate credit risk. Basel II norms allowed banks to use their own models to assess risk and determine the capital amount required to meet regulations. Most banks chose models that were overly optimistic to build risk models that allowed them to provide less capital for regulatory norms and to increase return on equity.

Secondly, Basel II’s effectiveness depended a lot on a strong regulator. Basel II gave banks a lot of room to decide how to implement the regulation’s spirit correctly. So it was always going to be a tool for those bankers looking to circumvent the rules.

This is where the role of a regulator was necessary to ensure that rules would be implemented in the right spirit. In countries like the U.S., where the regulator was often lax, this was a recipe for disaster as we saw in the subprime crisis.

Lastly, Basel II norms were not adequate in covering market risk. This was especially true for investment banks, which had large exposure to market-linked securities. Basel II often allowed bonds issued as part of securitization to be treated as AAA securities.

Securitization is the process of selling various types of loans like government, mortgage, auto, and card loans pooled together as bonds. However, most of these bonds contained assets that were junk grade.

Investment banks like Morgan Stanley (MS) and Goldman Sachs (GS), banks with major investment banking arms like JPMorgan (JPM) and Citibank (C), and other investment banks in an ETF like the Financial Select Sector SPDR Fund (XLF) benefited from the lower coverage on market risk under Basel II.

To mitigate the concern on market risk, Basel II.5 norms were introduced. We’ll know about Basel II.5 norms in the next article of the series.