Basel II, the invention of the Bank for International Settlements (www.bis.org), and more correctly entitled International Convergence of Capital Measurement and Capital Standards: a Revised Framework, has so clearly and substantially failed.
And yet this has received almost no publicity. The Banks fucked up. As did the Financial Regulator and the Central Bank.
For those of you who are interested Basel II was intended to ensure that banks made provision for risks more effective and sensitive. The original report is available here. It is quite readable with a little effort, even for a non-banking person. It included a detailed frame work for all types of risk: operational risk, credit risk and market risk. It was intended to manage what is called “regulatory capital” . The capital ratio is the percentage of a bank's capital to its risk-weighted assets (RWA). Weights are defined by risk-sensitivity ratios detailed in the Basel II document. The core idea of risk-weighted assets is a move away from having a static requirement for capital adequacy. The approach is intended to be more flexible and is based on the riskiness of a bank's assets. So loans of various types have different risks. Loans secured by a letter of credit would be weighted riskier than a mortgage loan that is secured with collateral, assuming that the collateral had a realisable value. In calculating risk the assumed value of such collateral is reduced by what is called a haircut based on its volatility.
Irish financial institutions spent between €1 billion and €2 billion on implementing Basel II. The lower number is derived from the pure costs – software licences, consulting fees, additional hardware and other direct costs. The higher value would include an allowance for the time of personnel of the institutions working on its implementation.
For consulting and software companies – Accenture, BearingPoint, IBM, SAP, SAS and so on, Basel II represented a sloshing, lumbering gravy train. It was a fee-earning bonanza along the lines of the Year 2000 problem. These companies parasitised and devoured the floundering corpses of the institutions while the institutions accepted the huge costs.
And all for absolutely nothing.
Basel II is based a "three pillars" concept:
1. Minimum capital adequacy requirement to handle risk
2. Supervisory review by the appropriate regulator
3. Market disclosure and discipline
It failed in all three:
1. Not enough capital to handle actual risk
2. Incompetent regulator that could not or did not understand or act upon the inadequate information being made available
3. A market that failed to examine the incorrect information being presented and the schemes to avoid capital adequacy
At a very high level, the basic structure of Basel II is:
And yet this has received almost no publicity. The Banks fucked up. As did the Financial Regulator and the Central Bank.
For those of you who are interested Basel II was intended to ensure that banks made provision for risks more effective and sensitive. The original report is available here. It is quite readable with a little effort, even for a non-banking person. It included a detailed frame work for all types of risk: operational risk, credit risk and market risk. It was intended to manage what is called “regulatory capital” . The capital ratio is the percentage of a bank's capital to its risk-weighted assets (RWA). Weights are defined by risk-sensitivity ratios detailed in the Basel II document. The core idea of risk-weighted assets is a move away from having a static requirement for capital adequacy. The approach is intended to be more flexible and is based on the riskiness of a bank's assets. So loans of various types have different risks. Loans secured by a letter of credit would be weighted riskier than a mortgage loan that is secured with collateral, assuming that the collateral had a realisable value. In calculating risk the assumed value of such collateral is reduced by what is called a haircut based on its volatility.
Irish financial institutions spent between €1 billion and €2 billion on implementing Basel II. The lower number is derived from the pure costs – software licences, consulting fees, additional hardware and other direct costs. The higher value would include an allowance for the time of personnel of the institutions working on its implementation.
For consulting and software companies – Accenture, BearingPoint, IBM, SAP, SAS and so on, Basel II represented a sloshing, lumbering gravy train. It was a fee-earning bonanza along the lines of the Year 2000 problem. These companies parasitised and devoured the floundering corpses of the institutions while the institutions accepted the huge costs.
And all for absolutely nothing.
Basel II is based a "three pillars" concept:
1. Minimum capital adequacy requirement to handle risk
2. Supervisory review by the appropriate regulator
3. Market disclosure and discipline
It failed in all three:
1. Not enough capital to handle actual risk
2. Incompetent regulator that could not or did not understand or act upon the inadequate information being made available
3. A market that failed to examine the incorrect information being presented and the schemes to avoid capital adequacy
At a very high level, the basic structure of Basel II is:
For example, under the Foundation Internal Rating-Based Calculation Approach for calculating Credit Risks banks are required to use regulator's prescribed LGD (Loss Given Default) parameters required for calculating the RWA (Risk Weighted Asset). Then total required capital is calculated as a fixed percentage of the estimated RWA. It is all very simple, if implemented, measured, monitored, reported on and understood correctly.
Banks estimate the PD (Probability of Default) for loans.
They also calculate Exposure at Default (EAD) or the extent to which a bank may be exposed in the event of a default.
It is a wonderfully complex framework that should be flawless in its structure and execution.
For example, for some details on how AIB approached the implementation of Basel II, see here.
What about all the commercial lending so extravagantly and incontinently indulged in by backs. This is called HVCRE or High-Volatility Commercial Real Estate
Paragraphs 227 and 228 of the BIS Basel II report contains the following:
Banks estimate the PD (Probability of Default) for loans.
They also calculate Exposure at Default (EAD) or the extent to which a bank may be exposed in the event of a default.
It is a wonderfully complex framework that should be flawless in its structure and execution.
For example, for some details on how AIB approached the implementation of Basel II, see here.
What about all the commercial lending so extravagantly and incontinently indulged in by backs. This is called HVCRE or High-Volatility Commercial Real Estate
Paragraphs 227 and 228 of the BIS Basel II report contains the following:
227. High-volatility commercial real estate (HVCRE) lending is the financing of commercial real estate that exhibits higher loss rate volatility (i.e. higher asset correlation) compared to other types of SL (specialised lending). HVCRE includes:
Commercial real estate exposures secured by properties of types that are categorised by the national supervisor as sharing higher volatilities in portfolio default rates;
Loans financing any of the land acquisition, development and
construction (ADC) phases for properties of those types in such jurisdictions; and
Loans financing ADC of any other properties where the source of repayment at origination of the exposure is either the future uncertain sale of the property or cash flows whose source of repayment is substantially uncertain (e.g. the property has not yet been leased to the occupancy rate prevailing in that geographic market for that type of commercial real estate), unless the borrower has substantial equity at risk. Commercial ADC loans exempted from treatment as HVCRE loans on the basis of certainty of repayment of borrower equity are, however, ineligible for the additional reductions for SL exposures described in paragraph 277.
228. Where supervisors categorise certain types of commercial real estate exposures as HVCRE in their jurisdictions, they are required to make public such determinations. Other supervisors need to ensure that such treatment is then applied equally to banks under their supervision when making such HVCRE loans in that jurisdiction.
Duh. Where was the regulator when all the HVCRE lending was taking place that has so endangered Irish banks? Where were the banks' risk departments? Will anyone take responsibility? Will they fuck?
