Financial Crisis and the Implementation of Basel II:
Potential Economic Impact for Trinidad and Tobago
Lester Henry and Michelle Majid
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• Introduction
• Overview of Basel I & II
• Financial Crisis and Basel II: Are they linked?
• The TnT Financial System
• Some issues of concern to T&T
• The way Forward for T&T
• Summary and Conclusion
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• Financial Crisis partly seen as regulatory failure.
• Basel I and Basel II were supposed to prevent such
• Many Caribbean Countries were expected to adopt
Basel II over the next few years (from 1 or 2 in 2007 to 4-6 between 2010 – 2015)
• Examine Basel II’s role in the crisis
• Identify issues arising from possible adopting Basel II
• determine the extent to which Basel II may impact
T&T and by extension the region
• Inform policymakers whether focus should be on getting Basel I right or introducing Basel II or not adopting any at all.
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Basel I
Pillar 1:
Credit Risk
(1988)
Risk-weighted
Assets
(Denominator)
Minimum capital requirements
Definition of
Capital
(Numerator)
Market Risk
(1996)
Standardized
Approach
Models
Approach
Regulatory capital
Risk-weighted assets
≥ 8%
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• Capital required did not mirror a bank’s true risk profile
• Too simple for advanced banks
• Inflexible against new developments
• Covers only credit and market risks
• Only quantitative in nature
• Limited recognition of collateral
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Basel II
Pillar 2 Pillar 1 Pillar 3
Three
Pillars
Minimum capital requirements
Supervisory review process
Market discipline
Risk weighted assets
Operational risk
Credit risk
Definition of capital
Market risks
Core
Capital
Supplementary
Capital
Standardized
Approach
Internal
Ratings-based
Approach
Basic
Indicator
Approach
Standardized
Approach
Advanced
Measurement
Approaches
Standardized
Approach
Models
Approach
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• Greater emphasis on banks’ own assessment of risk
• Comprehensive framework for credit, market and operational risk
• Encourages rigorous bank supervision
• Ensures market transparency, disclosure
• More risk sensitive; better align regulatory capital with actual risk exposure
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Basel II and the Financial Crisis
• I. the average level of capital required by the new discipline is inadequate and this is one of the reasons of the recent collapse of many banks;
• II. the new Capital Accord, interacting with fair-value accounting, has caused remarkable losses in the portfolios of intermediaries;
• III. capital requirements based on the Basel II regulations are cyclical and therefore tend to reinforce business cycle fluctuations;
• IV. in the Basel II framework, the assessment of credit risk is delegated to non-banking institutions, such as rating agencies, subject to possible conflicts of interest;
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Basel II and the Financial Crisis….continued
• V. the key assumption that banks’ internal models for measuring risk exposures are superior than any other has proved wrong;
• VI. the new Framework provides incentives to intermediaries to deconsolidate from their balance-sheets some very risky exposures
Source: Francesco Cannata Mario Quagliariello (2009)
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In Defense of Basel II
• Only recently implemented
• In US only applies to top tier banks operating internationally -- most of system is exempted
• Pillar II and Pillar II have been given very little attention, a careful application would involve;
–
Remuneration packages in investment banking and of management boards;
–
Transparency of a bank's risk profile;
–
Management's true understanding of both the bank's risk profile and its risk positions.
• source Van Kemper, Cris (2009)
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Can Basel X work? A Minskyian alternative View
• Can help in some cases but ultimately limited in preventing crises
• Sources of instability are “built-in” to the system
• During expansions managers competence will be questioned if they don’t go after higher returns
• In normal times the “three-six-three” rule applies
• During Busts credit supply dries up regardless of any stimulus policy
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• Eight commercial banks and 19 NBFIs
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25
20
5
0
15
10
1999 2000 2001
Regulatory capital to RWA
Regulatory T ier
I capital to
RWA
2002 2003 2004 2005 -
Mar
Source: Financial Sector Assessment Program Report, 2005
13

NPL to Gross Total loans (% )
4
3
2
6
5
1
0
1999 2000 2001 2002
Source: Financial Sector Assessment Program Report, 2005
2003 2004 2005 -Mar
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• Inadequate financial sector laws
• High-levels of connected exposures across banking and insurance companies
• BCP Non Compliance with Market Risk, Large and related exposure limits
• 0% risk weighting all sovereign debt
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• Credit Risk Assessments
• Macroeconomic Issues
• Capital Requirements
• Distortion of allocation of credit
• Interbank Lending
• Regulators in emerging economies
• Home-host Issues
• Local Banks in T&T
• BCP Compliance
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• Shallow credit rating market (reduced to flat rate)
• Rating linked to level and volatility of capital flows
• Prohibitive cost and incentive to become rated
• Who will rate the rating agency?
• Potential pro-cyclicality and circularity (Powell,
2002)
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• Three factors indicate that tighter regulatory capital requirements are likely to cause a domestic credit crunch:
* economies are shallow
* banking sector concentrated
* presence of government in the real economy
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• Deficient regulators can be an important determinant of banking crisis (much more than adequate capital provisions) (Barth, Caprio and
Levine (2001))
• Increased skills of examiners
• Shift from generalists to specialists (BCBS,
2004)
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• Banks would need to improve infrastructure for measuring and monitoring risk – COSTS!!!!
• Foreign-banks within T&T can piggy-back on parent
• Where does that leave T&T local banks?
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• Limitations:
Lack of data to do QIS
Basel I shortfalls to address
Credit rating assessments
Regional workshop to resolve common issues
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• Get the Vision combined with preconditions right
• Create detailed and specific gap assessments
• Produce detailed plans to address gaps with sufficient lead times
• Establish a process to oversee and deploy Basel
II implementation
• There is no substitute for extreme vigilance on the part of regulators
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Selected References
• Francesco Cannata and Mario Quagliariello (2009) “ The role of
Basel II in the subprime financial crisis: guilty or not guilty?”,
CAREFIN Working paper 3/09.
• Wray, Randall can Basel II enhance financial stability? A
Pessimistic View”, Working paper 84, Jerome Levy Institute.
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