Does the Basel II Accord deser

Does the Basel II Accord deserve its share of the blame in therun up to the financial crisis of 2007?
Those who say “no” however point to shortcomings of Basel IAccord as the possible reason. At a time when countries had justbegun the implementation of the Basel II Accord, the remnants ofthe Basel I era, with its lack of sensitivity and inflexibility torapid innovations, could have created perverse regulatoryincentives to simply move risky exposures off balance sheet,without really assessing the adequacy of capital to meet the riskexposures.
Those who say “yes” feel that the financial crisis merelyexposed the deficiencies in the “vastly improved” Basel II. Whatwere the limitations of the Basel I?
One, it made a quantum leap from the relatively simple Basel Ito include a degree of complexity that proved a challenge to boththe regulators as well as the banks.
Two, external ratings provided by rating agencies played acritical role in Basel II. Since ratings agencies were assignedspecific blame, for the financial crisis, the basic premises ofBasel II were also questionable.
Three, the standardized and advanced approaches operated undercertain assumptions may not be applicable to all countries adoptingthe Accord. Hence, the onus was on the regulator of each country toassess if the risk weights assigned were applicable to thecountry’s context.
Four, the Accord allocated higher to higher credit risk. Thisled to the concern that small businesses and the less prosperoussections of society, typically considered high credit risksegments, would attract unaffordable rates of interest. Thisconcern is especially true for developing countries.
Five, the risk modelling approaches in the advanced approacheshad limitations. It is unclear whether maintaining capital based onthese risk models would ensure adequate amount capital to coverrisks.
Six, the level of technological and computational competencethat the approach presupposes may not be available with all banksand banking systems.
Seven, aligning disclosures under Pillar III to internationaland domestic accounting systems will be a challenge.
Eight, effective implementation of Basel II would requiretremendous upgrading of skills of both supervisors and banks.
Finally, an issue that has been discussed widely is that ofpro-cyclicality. When economies are doing well, the banks will lendmore, probably to take more risks for better returns and maintainadequate capital. However, when business cycles take a downturn,banks downgrade the borrowers due to increased likelihood ofdefault and therefore, have to maintain more capital. This leads tocapital shortage, as well as restriction in credit and therefor,leads to further deterioration in the economy. The Basel Committeeacknowledges that risk based capital requirements could inevitablelead to pro-cyclicality, but this problem could be addressed bydifferent instruments.
In November 2008, the Basel Committee admitted that itsproposed Accord had to be more comprehensive to address thefundamental weaknesses exposed by the financial crisis related toregulation, supervision and risk management of internationallyactive banks. In 2009, the committee had already brought outdocuments amending Basel II Accord.
1. Why is the set of rules like Basel II blamed as the causefor a global financial meltdown?
2. How can another set of rules like the Basel III remedy thesituation?
3. How successful will Basel III be in averting futurefinancial crisis?


1. Basel II was blamed because banksand firms financial health was based on the fact that they wererated at a good rate by ratings agencies, which is what Basel IIgave inportance for, but these banks ultimately failed even whenthey were graded at investment levels as per the ratings agencies,this showed deficiency. To summarise, Basel II was formed to ensurecredibility in the banking system and as a fullproof mechanism toavoid bankruptcies, but there were several limitations whichultimately led to the fall in the banking system.

2. Basel III addressed theshortcomings which were prevalent in the banking system and theprevious accord, the need to raise the quality of capital held bybanks which will allow the bank to remain solvent. More strongliquidity requirements such as holding more liquid capital whichwill be easily convertible to cash. An improved level of riskcoverage so that risk weights are assigned wherein they areconsidered low risk assets during normal conditions and high riskduring economic stress, such as trading book, repos. Capitalconservation buffer ensured that there is no inappropriatedistribution of capital dividends. Introduction of leverage ratioand countercyclical capital charge so that the credit growth rateis measured against the GDP growth rate. Higher levels of stresstesting on regular basis. This will ensure timely intervention andproviding relief or bankrupty opportunities on timely manner.

3. Basel III addresses liquidityconcerns and focuses on global liquidity ratio standards so thatglobal banks don’t face headwinds and shocks. But the successdepends on whether it is implemented globally and its steps arefollowed by everyone, there will be country specific inputs whichmight dent the complete implementation of this accord as severalcountries don’t adhere to it fully. If this is done, then itreduces the chances of its effectiveness, however banks would beable to address liquidity concerns once all banks in the ecosystemfollow these procedures and central bank maintains efficacy, whichwill hopefully avert global financial crisis if not nationwide.

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