Building on Basel II

Editor's letter

The Basel Committee on Banking Supervision will embrace its expanded membership during the coming month. New members include Argentina, Hong Kong, Indonesia, Saudi Arabia, Singapore, South Africa and Turkey. As an expanded entity, the Basel Committee will have more representation from disparate parts of the world. But as a standards-setting body, its relevance may diminish.

Given the bad press received by the Basel Committee's main project - the capital Accord called Basel II - many market participants may not mourn the Committee's likely fate. However, officials in jurisdictions where Basel II was implemented, such as Japan, are far less critical of the Accord. Japanese bankers and regulators believe the introduction of Basel II was a good process that introduced incentives for Japanese banks to drastically improve their risk management capabilities. The country's supervisors engaged in a long dialogue with the leading three mega banks by stationing staff within the banks themselves to discuss risk management processes, study probability of default estimates and develop an updated bank capital risk framework in the country.

Japanese Financial Services Agency (FSA) officials believe the securitisation framework under Basel II forced its banks to better manage their exposures to securitisations. And it was a similar story for hedge fund investments. These types of investments had a zero weight under Basel I so long as the maturity of exposures was shorter than a year. Under Basel II, however, banks were hit with a capital charge, which made them more likely to appraise the real risks associated with securitisations - notably the junior and mezzanine tranches of structured investments. Rating agencies also had to explain their methodologies. In combination, this resulted in many banks putting capital aside or reducing their exposures to these instruments prior to March 2007 - well before the explosion in credit spreads later that year.

Japanese banks have also benefited from transparency requirements under Pillar 3 of Basel II, which was introduced simultaneously with Pillars 1 and 2 in the country. This resulted in analysts in Japan scrutinising probability of default estimates by comparing time series of banks. Meanwhile, when financial markets became jittery about the sheer scale of securitisation exposures on banks' books around the world post-September 2007, Japanese banks were able to provide details on their exposures in a timely manner, so dispelling concerns they were loaded up with the risky portions of securitisations.

Basel II has need for significant improvements. But it has had some positive effects for banking systems that fully embraced the process.

Christopher Jeffery.