Under Basel II, capital requirements vary according to the assessed risk of the assets held - this means that, as the economy worsens, assets become more risky and capital requirements go up, even though the worsening economy will also make raising capital more difficult. However, a European regulator said Basel II might not necessarily lead to a worsening of bad economic situations if banks have taken prudent steps to prepare for these periods.
“In additional to institutions keeping aside a minimum level of capital according to the regulations, they should maintain a cushion of capital on top of this to weather bad economic situations. These additional buffers are based on banks' long-run data and their internal judgement of risk,” added a spokesperson from the regulator.
Under Pillar I of Basel II, banks need to assess the risk on their portfolio of assets. If banks have their own risk assessment modelling, the amount they need to hold is dependent on the feedback from their internal models. If banks do not have these models, they have to take the standardised approach, which means the amount of capital they need to hold is determined by external credit ratings provided by ratings agencies.
“The standardised approach in the regulatory system is highly dependent on rating agencies,” Penn says.
Ratings firms provide independent opinions on the probability of a security or debt instrument defaulting. Some of them have said they should not have been placed in this situation, saying this was not the original purpose of their role within financial markets.
“It was never the intention or desire of ratings agencies, such as Standard & Poor’s, to be part of Basel II regulation. Our role is to provide independent research and opinions on the credit worthiness of assets and companies, not to be a part of financial regulation,” said Martin Winn, a spokesperson for Standard & Poor’s in London.
Basel II was created to deal with the inconveniences in Basel I, such as the flat 8% capital requirement for all financial institutions - which had the consequence of banks having to hold unnecessary amounts of money aside when their assets were safe. One regulator observed the new set of regulations had little choice but to use credit ratings to categorise levels of risk under the standardised approach.
“Using ratings agencies' opinions in the standardised approach of Pillar I of Basel II is an improvement over Basel I; there is no other benchmark out there for achieving risk differentiation for different securities,” said the regulator.