Literature Review On Debates Behind Basel II
This review is on Basel II
, focusing on debates and progressive discussion about its
importance and significance to the Banking industry and the overall macroeconomic needs
of the countries incorporating it into their banking system.
It utilises various Academic articles and journals in a balanced discussion of critical issues
about its effective implementation and development among developed countries like
Europe (EEC) through the CRD directives; India (emerging economies) and a developing
In achieving this, consideration is given to some of the importance and critical problems and
key fundamental issues within the various pillars such as the Pillar I (Credit risk: LGD;
Operations risks; Market risks).
Pillar II: supervisory Review and Pillar III: Market discipline and disclosure matters and how
it has impacted the current financial crisis around the world; especially among G-10
countries, and the urgency of regulatory reforms to make it better in the near future.
Conclusive analysis on this review looks into some of the loopholes and areas that need
further research and general problematic areas that could be reformed in the future Basel III
Basel II Accord published in 2004 is centred on banking laws supervision and regulatory
framework issued by the Basel committee on Banking supervision as an international
banking standards and improvement to the existing Basel (I) for the purpose of creating
capital adequacy and correlating its sensitivity to bank’s activity; regulating and mitigating
banking risks more prudently and rigorously, supervising and effectively regulating
international banks to avoid re-occurrence of persistent bank failures due to the increasing
level of sophistication in the banking sector in this new economic era.
Basel II is the second face of the Basel I accord establishing standards to assist in regulating banks capital
adequacy supervision and disclosures. Refer to International Convergence of Capital measurement and Capital
standards June 2004 (Basel Committee on Banking Supervision).
In fulfilling these summary objectives among others three foundational pillars have been
erected to categorise and address various challenges that confront banking sectors
operations and to promote effective regulation based on these new recommendations.
The overarching objective of the Basel II was to overcome the shortfalls of Basel I by:
Strengthening the capital adequacy, and making it more risk sensitive and
appropriate to protect the banking activity in case of financial crisis and to mitigate
banks exposure to risks such as Credit risk, operations risks; market risks;
Providing supervisory review and transparent disclosures in banking practices so as
to be able to tackle any potential crisis arising before it worsens and weakens
investor’s confidence; protection; public and international confidence in the system.
About 25 Academic author’s literature are reviewed for the purposes of examining the
significance of Basel II; its developments, current status; and critical arguments on
various elements of the subjects in today’s Banking regulations.
Pillar (I) Minimum Capital Requirements:
According to Van Roy, Patrick, (25, 2005); Banks have better knowledge; measure and
control of sophisticated risks they face with the inception of the Basel II. Key risks that fall
under these are Credit risks; Operational risks; and Market risks. Each of these risks has
defined approaches of measuring them with varying levels of complexity in its calculation.
Operation risks uses basic indicator approach (BIA); internal Measurement Approach (AIRB)
and Standardised approach whilst Market risks mostly adopts Value at Risk (VaR)
As a means of managing minimum capital requirement most banks have adopted the
Standardised approach in credit risks and capital adequacy from Basel II. Survey of about
294 banks has shown that 38% of banks were resorting to the Standardised approach
(KPMG 2003). Other banks are using advanced internal rating approach which requires
banks to develop their own internal rating system in deciding their risk exposure to lending
activity and setting of capital reserves. It has a better assessment for various loan portfolios
to corporate bodies, interbank lending, businesses and individuals, using a more risk
sensitive mechanism from Basel II and the extensive use of Credit assessment agencies to
measure the sensitivity of risks and exposure of the bank’s lending activity to risks.
Significantly; Banking institutions have overcome regulatory capital arbitrage which was a
common problem under Basel I with the introduction of Basel II and further consideration
had been given to other areas of risks supported by supervisory review.
This new approach significantly alarms the banks of possibility of risks and gives them lead
time to adjust to lending risks exposures appropriately depending on the volatility of the
assets involved and markets.
He further clarifies that although different credit rating agencies risks-weighting gives
different indications of risk percentage to the banks, none of the percentages has gone
Contrasts to this; Til Schuermann of Federal Reserve Bank of New York in his publication: ‘What
Do We Know about Loss Given Default? (2004); has different views on the overall
assessments and definition of some of the fundamental key components in credit risks such
as the Loss Given Default. (LGD)
and questions the appropriateness of the credit risks under
Basel II. He is of the view that borrowers whom the LGD is used on can range from individual
borrowers, business borrowers (who can go bankrupt) mortgage loans, bonds secured and
unsecured loans among others and therefore banks need substantial knowledge about
these creditors business environment, changing status as well as the risks they face to
reflect it in the sensitive weightings of the LGD for effective judgement.
Loss Given Default (LGD): It refers to the amount of money or funds bank losses when a
borrower defaults on loans. It is a sensitive component of the advanced internal Based
approach which banks are allowed to develop and apply subject to regulatory criteria and
He further clarified that with the level of freedom and the rate at which banks prefer to
perform their own internal risks assessments on risk exposure, supervisory review will be
effective if the supervisors will obtain their own independent data on LGD of bank’s clients
in accordance with Basel II in order to offer independent advice and supervision to banks
This is due to the varying nature of factors to consider in developing the model and the level
of accurate knowledge and availability of information about the borrowers.
Acharya, Bharath and Srinivasan (2003) revealed that in times of economic recession there is
increase in LGD whilst during economic recovery seasons there is reduction in LGD. The
implications of this is such that banks will have to hold back lending to the various economic
sector ( to mitigate risks) in recession times when financing will be needed most and rather
lend when there is economic growth.
Sabato, Gabriele, et al (2008) in his research pointed out a problem in Vasicek Model
(Vasicek, 2000), applied in Basel II risks assessment on LGD. He clarified an underestimation
in the model of credit risks banks face especially when many firms are defaulting and there
are low recoveries on bank lending thereby giving inadequate information for risks
Significantly Acharya and Til both hold Views that there is no connection between risk
modelling; supervisory review; and disclosure; to warrant effective intervention like bank
takeover or closure indicating that banking risks information is not put to relevant use.
This progresses us into relevant issues under pillar II and Pillar II deliberations.
Basel II pillars are imbalanced:
Critiques such as Koehn; Thakor (1996) Foot and Stein (1998) are of the strong view that
there is lack of sufficient and equal consideration for the pillar II and Pillar III of the Accord
as more consideration was given to the pillar I to the detriment of the other two pillars. Also
they are of the view that there is no proper link and coherence between pillar one and the
other two pillars, making it weak and incapable of sustaining the banking system.
Jean-Charles Rochet further suggests the need for rebalancing the three pillars for
PILLAR (II) SUPERVISORY REVIEW:
(Stigler, 1971) and most recently Beck et al. (2006) hold the view that supervisors vested
with strong powers to supervise banking activity can in the long term improve the corporate
governance of banking institutions, reduce corruption in bank lending activity and improve
the financial activities of the banks. However Becker et al, 1983 to the contrary sees power
of supervision in the hands of supervisors as a means to seeking their own private welfare
rather than social welfare of banks and the economy. This is further expanded by Barth et al
2004 indicating the following adverse factors:
Political influence: politicians may influence supervisors by persuading banks to lend to
their group of favoured clients to their political advantage; they may then embark on this to
lend to some favoured regions; solicit bribes and donations (Djan kov et al., 2006).
The intention of Basel II supervision and the compliance to risk- return and risk sensitivity
completely fails if politicians negatively influence bank lending to their advantage and
supervisors take undue advantage to help their selves with banks capital.
According to Levine, (2003), efficiency in banks credit allocation will fail and there will be
decrease in integrity of the financial system.
Fernandez Gonzalez (2005) finds out that countries that has low or weaker accounting and
auditing framework tends to have a very effective and productive banking supervision and
management discipline and sound banking system.
Excess delegation of supervisory discretion:
David VanHoose (2007) is of the strong view that the supervisory process pillar does
nothing but over delegate discretionary powers to banks without any consideration for rules
based approach to banking regulation. This leads to a compromise of the long term safety
and soundness of the financial system and potential bank crisis as there is not enough to
counteract abusive use of such wide discretion. Potential consequences of this pillar will be
exacerbating incentive perverse outcomes and increase in moral hazards.
Tax Burden to Citizens: there is statistical indication that the consequences of wide
discretionary practices as opposed to rules based between 1970 to 1900’s lead to regulatory
forbearance when such banks landed in trouble and the resulting effects of financial bail
outs which was passed on unfairly to the tax payer like the US tax payer who has to cough
out huge billions of US dollars to redeem and recapitalise insolvent banks and protect savers
Barth et al: in their cross country study of banks and financial institutions adds to this
criticisms indicating that nations where banks supervisor have wide discretionary powers
tends to be the most undeveloped financial systems with large corruption rate and banking
crisis whilst countries with less supervisory discretionary control have stronger economies,
low corruption and stronger and safer system. It is therefore seen as a failed element of the
Basel II accord.
Lack of International Coordination of Supervisory Standards according to Gilbert (2006) is
incompatible with Basel II Accord. Most countries such as USA Europe Hong Kong in
implementing Basel II have a huge regulatory divergence from the main objective of the
pillar II. Different countries are adopting different capital leverage ratios and allowing capital
levels to change to their own satisfaction as long as its still linked to risk sensitivity
requirement. This means total capital requirement in US could rise whilst that in Europe
may be falling. This has the effects of banks moving into different territories with favourable
capital requirements or engaging in cross border mergers with other banks thereby igniting
regional regulatory arbitrage
Pointing to the four principles under the BIS 2006
documents, he further clarifies the
second pillar is weak to sustain the banking system especially among the inventors of the
Basel II accord.
PILLAR III (MARKET DISCIPLINE AND DISCLOSURE):
Pillar (III): is designed to work as the third pillar holding the Basel II foundation in the areas
of ensuring qualitative and quantitative information disclosure that will enable all the
market participants to carry out a comparative analysis and assessment of the key
Refer to Documents Bank for International Settlement 2006 recommendation on capital adequacy; review
and bank evaluation; supervisory intervention of banks; minimum capital standards.
information on capital adequacy requirement and adherence to risk exposure rules. It
stands to place checks and balances on the wide discretionary work by the supervisory
is to enhance market discipline through release of certain
information such as the Accounting and auditing reports of the institution, details of rating
and risk exposure calculations that bring out the internal or external mechanism adopted to
maintain minimum capital requirement rules.
Significantly, it forms a good framework with more provisions for banks especially in
developing countries to adopt it and use it as a yard stick to promote better banking
regulations that create good governance financial and operational soundness in the banking
industry. Abijit Sarkar and L H Bhole (November 25, 2008). The further establish that
effective market discipline has the potential to reinforce minimum capital standards
however they believe is not a mechanism that can replace the supervisory review and the
supervision pillar has to ensure reliable and accurate accounting standards promoted
minimum moral hazards and better credibility.
Adverse to this David VanHoose 2007) argues that the disclosure and market discipline pillar
is only useful for developing countries. However, it does not meet the complex regulatory
needs of the advanced countries that propagated them. He further brings across the
‘Market Discipline’ is a misleading caption and does not do much among the developed
countries who promoted it: BIS 2006 raises the need for consistency in disclosure of banking
information with risk management however, there are no clearly defined and transparent
guidelines for penalizing banks that fail to such information.
Distortions in Disclosure Requirements: He further clarifies that BIS page 227 offers wide
discretionary and voluntary disclosure statement which allows for individual countries to
Refer to full information in BIS (2006, p. 226) spells out key pillar of Basel II framework
adopt what they consider to declare and disclose under the concept of accounting
He is also against the proposition that managers of the banks have to decide and implement
appropriate assessment for disclosure measures as well as the frequency of their
disclosures. This will give room to inconsistency in reporting.
Flannery (2001) stated that the essence of market discipline is to enable suppliers of funds
and equity owners influence the market by withholding or withdrawing funds, or demanding
higher returns due to risks banks are engaging in. This has to be revealed by accurate
information made available to market participants beyond the mere issue of annual and
periodical financial reports.
Hamalainen, Hall, and Howcroft are of the view that the Basel (II) market discipline is just
first positive step towards proper future disclosure, however the true intention is not to
over engage the activities of fund providers as that may affect the soundness and liquidity of
the banks. As a result they only provide limited information focused on balance sheet and
final accounts in relation to banks capital at given periods just to allow some degree of
From the above review couple of issues comes to mind.
The Basel II is instrumental and a useful banking regulatory tool that enhances and sets a
developed regulation and capital adequacy, bank supervision an disclosure policy for the
banking institutions among the G-10 countries and rest of the world almost about 100
countries are implementing it to enhance their banking practices, It is a better improvement
over the Basel I giving it a wider risk sensitive and analytical strength.
Information will be considered here a material provided its omission affects the user of the accounting
information on it to make strategic decision .A misstatement or alteration can lead to mislead assessment of
However, it is also perceived that there is lack of Effective enforcement Mechanism and
clarity in some areas: It cannot compel the countries applying it to enforce or implement its
Has no proper legal Structure: Unlike the USA and Europe, financial regulation that is
supported by codified rules and Directives respectively, Basel two does not on its own have
effective judicial powers over its users or implementers. It therefore rely on the full
countries to give it the force of law by incorporating it into the financial regulation example
is the CRD Directives in UK ( use of European directives) to enforce it in UK.
There are discrepancies in the risk assessment and modelling despite tremendous research
in the area. Example is the LGD computation.
Supervisors have too much discretionary power that can lead to political abuse and render
the whole regulation ineffective.
Banking Crisis that occurred is attributed to the implementation of the Basel to especially in
the area of systemic risk due to the high risk sensitivity it has among other factors like
unsupervised risks from the sub-prime mortgage market.
The way forward is a revision and reforms for a new Basel accord that will have a better
enforcement capability and involve other banking institutions from the developed and less
There is room for research into creating an international Legal framework that can be
directly applied in various economic countries with international legal enforcement
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