For starters, Basel II is the second set of recommendations on banking laws and regulations published by the Basel Committee on Banking Supervision. It is the most important framework that is focused primarily on Financial Institutions. The key principles of Basel II can be summarized in its three pillars - minimum capital reserves, supervisory review, and market discipline. Widely followed in Europe, it is becoming the standard in the United States.
The intent of Basel II is to reduce excessive leverage (and therefore financial risk) in the banking industry. By regulating how much capital a bank must keep in reserve (as a percentage of total assets), it has helped to ensure that banks would have sufficient reserves on hand to meet their normal customer needs. In this sense, it has helped to reduce financial risk in many banking institutions.
In general, do regulations weaken the economy?
Some people will tell you that all regulations and government oversight unnecessarily weigh down companies with red tape and cost, therefore negatively affecting the overall economy. Arguments to this effect are nothing new. Others will tell you that the better business processes provided due to thorough evaluation of each business process more than pay for the increased costs that they bring. The reality is that there is an appropriate level of oversight that is necessary in order to provide and maintain confidence on the part of the public and to make sure certain industry standards are met.
How Basel II is different than most regulations
The effect of this regulation can be significant especially because of the Capital reserve requirements (Pillar 2). These requirements could necessitate behavior which could accelerate a downturn once one starts. The general nature of having a reserve is pro-cyclical, which means it magnifies what is already going on in the economy. In good financial times, capital reserve requirements have less impact due to the increased value of the assets. Unfortunately, in less prosperous times, the Risk Management Pillar of Basel II can actually dictate the need to be more conservative with investments. This shift in thinking is exactly what the broader economy does not want to have happen. For this reason, Basel II can, if not managed, make a shaky economy worse, and therefore be an overall negative for the economies of the world.
This same phenomenon occurs within our personal financial situations. If there is news of a downturn in the economy, it is common to start being concerned with your job. This concern may force you to delay new purchases. These delays impact the people who sell those products and those that manufacture them, causing concerns on their parts about job security. At some point, fear of a financial downturn can be a self-fulfilling prophecy.
Was Basel II responsible for last year’s financial crisis?
The answer to that is a resounding no. First off, the flashpoint for the credit problems was the sub-prime real estate market in the United States. Basel II, though coming to America, has not been fully adopted. For that reason, it can’t be blamed for the current economic situation. In fact, there is a case to be made that the kind of Risk Analysis mandated by Basel II should help situations such as these. Additionally, there is a wonderful opportunity to take advantage of our recent misfortune and use the extreme experiences of the past year to provide excellent stress testing for Basel II efforts. Evaluating risk programs against real world scenarios should provide excellent value. Through this backward looking analysis, it will likely be clear that Basel II and Risk Management programs as a whole will need modifications. Whether this will usher in the movement for a Basel III, a full rewrite of Basel II, is not likely. Though time for Basel II ½ may be upon us.