Cracks Growing in Basel II Pillars

The set of risk management regulations that are currently gaining steam globally, the Basel II standards, are increasingly falling under critical eyes as the system gains worldwide support. The bureaucracy that drives the development and implementation of Basel II is headquartered at the Bank for International Settlements in Basel, Switzerland. Representative from member nations regularly met to discuss practical solutions to the management of bank activities in an attempt to promote stability. Standards are set on the amount of regulatory capital a bank should maintain, and a framework managing risks associated with liquidity are among the ‘pillars’ of Basel II. A third pillar deals with disclosure and transparency practices. The system has its share of critics. Most recently Fitch Ratings, which recently tightened criteria for collateralized debt obligation risks, argues that as part of the proposed Basel II enhancements under Pillar 1 the risk weights for ‘re-securitizations’ will be increased relative to the risk-weights on other forms of securitization exposure. Basically, when re-organizing risky or unpopular structured finance platforms (or both, in the case of CDOs), Basel II does not regulate concentration risk, those associated with pooling according to vintage or geographic area, effectively. This may negatively impact ratings. “In concept, similar risk exposures should face similar capital charges, irrespective of the form that the exposure takes. When layering the higher proposed Basel II re-securitization charges onto the additional conservatism of Fitch’s SF CDO criteria, our analysis indicates that the Basel II capital charges on the full SF CDO capital structure could be several multiples higher than the Basel II charges on the entire underlying pool of structured finance collateral, even though the risk exposure is essentially the same,” says Ian Linnell,  a director in the Fitch Structured Finance group. Despite Linnell’s criticism, Fitch remains an ardent supporter of Basel II, which recently invited Brazil, Russia, India and China (BRIC nations) as well as Australia, Korea and Mexico to adopt the standards. The present crisis demonstrates the disruptive effects of procyclicality on banks — where the interconnection between the financial and real estate sectors boosts macroeconomic contraction that extends to retail, industry, commodity etc. – and critics say Basel II must quickly evolve to address and, going forward, prevent this phenomena. Their fear is that Basel II will be moot by the time it is formally adopted. A prime example of this in action is that in its current, revised form Basel II does not adequately address counterparty risks. Such a tool would be necessary to avert the widespread damage caused by the collapse of Lehman Brothers, which happened more than six months ago. Write to Jacob Gaffney at

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