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Financial Crisis and the Implementation of Basel II: Potential Economic Impact for Trinidad and Tobago. Lester Henry and Michelle Majid. Roadmap of the Paper. Introduction Overview of Basel I & II Financial Crisis and Basel II: Are they linked? The TnT Financial System

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Financial Crisis and the Implementation of Basel II: Potential Economic Impact for Trinidad and Tobago

Lester Henry and Michelle Majid

roadmap of the paper
Roadmap of the Paper
  • 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
introduction
Introduction
  • 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.
overview of basel i

Regulatory capital

Risk-weighted assets

8%

Pillar 1:

Minimum capital

requirements

Risk-weighted

Assets

(Denominator)

Definition of

Capital

(Numerator)

Credit Risk

(1988)

Market Risk

(1996)

Standardized

Approach

Models

Approach

Overview of Basel I

Basel I

shortcomings of basel i
Shortcomings of Basel I
  • 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
basel ii in a nutshell

Pillar 1

Pillar 2

Pillar 3

Basel II in a Nutshell

Basel II

objectives of basel ii
Objectives of Basel II
  • 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
basel ii and the financial crisis
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;
basel ii and the financial crisis continued
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)

in defense of basel ii
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)
can basel x work a minskyian alternative view
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
snapshot of tnt financial system asset growth
Snapshot of TnT Financial System:Asset Growth
  • Eight commercial banks and 19 NBFIs
fsap 2005 t t s deficiencies
FSAP (2005): T&T’s deficiencies
  • 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
some areas of concern
Some Areas of Concern
  • 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
credit risk assessments
Credit Risk Assessments
  • 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)
macroeconomic issues
Macroeconomic Issues
  • 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

regulators
Regulators
  • 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)
local banks in t t
Local Banks in T&T
  • 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?
limitations and areas of further research
Limitations and Areas of Further Research
  • Limitations:

Lack of data to do QIS

Basel I shortfalls to address

Credit rating assessments

Regional workshop to resolve common issues

the way forward for t t
The Way Forward for T&T
  • 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
selected references
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.