Basel

Question 1

problems with basel 1

Answer 1

Exclusive focus on credit (default) risk to the exclusion of other sources of risk (market, cash flow).

Poor risk classification – e.g. non-OECD China (rated A2) versus OECD members Turkey (Ba3) or Mexico (Baa1).

Limited recognition of well-diversified portfolios and link between maturity and default risk (longer maturities more likely to be defaulted on).

Little attention to uniformity in supervisory protocols and practices and disclosure rules.

Question 2

problems with basel 2

Answer 2

Implementation of Basel II was delayed
The rules were too complex, made it costly to implement

The ratings-based approach to measuring credit risk gave too much influence to credit rating agencies (refer to the sub-prime crises)

RBA and MMA were pro-cyclical: in good times, banks enjoyed high credit ratings and the book value of their assets was high so could leverage themselves more, but in bad times they were forced to deleverage, making the credit crunch worse.

In any case, Basel II was not fully implemented when the crisis struck

Question 3

basel 1

Answer 3

It focused on capital adequacy, setting a minimum ratio between a bank’s own capital (equity) and the value of its risk-weighted assets (RWA).

The ratio was set at min 8% capital to RWA

Only credit (default) risk was subject to regulation, not other sources of risk

Question 4

basel 2

Answer 4

Replaced risk weights with a ratings-based approach (RBA) in measuring credit risk.
Added market risk and operational risk to the set of risks against which capital was to be held
Market risk could be measured using a standardised framework or via a bank’s own internal value-at-risk (VaR) model. The latter required mark-to-market accounting (MMA).
Added “pillars” which covered supervisory process and disclosure regulation respectively.