Basel Committee outlines potential changes to Basel II

The devastation wreaked upon financial institutions could, according to the International Monetary Fund, lead to losses of $1.4 trillion. Furthermore, the turmoil has led to suggestions that Basel II - which took years to construct and for which implementation only began at the start of 2007 - is inadequate as a risk management framework in its current form.

Over the past year, the Basel Committee has released several consultative documents to address weaknesses in the financial sector. These included a study of economic capital models in August, proposed revisions to the market risk framework and charging of capital for incremental risk in the trading book in July, and revised principles for liquidity risk management in June. A paper on stress-testing practices is expected to be released by the end of this year.

However, the committee's announcement yesterday suggested a complete overhaul is on the cards, which could mean additional capital charges, and initiatives to reduce leverage and risk concentrations.

"The primary objective of the committee's strategy is to strengthen capital buffers and help contain leverage in the banking system arising from both on- and off-balance-sheet activities," said Nout Wellink, chairman of the Basel Committee. "Ultimately our goal is to help ensure the banking sector serves its traditional role as a shock absorber to the financial system, rather than an amplifier of risk between the financial sector and the real economy."

Specifically, the committee says it will look to strengthen the risk culture of Basel II, particularly for trading book and off-balance-sheet exposures; enhance the quality of tier-one capital; and build additional shock absorbers into the framework that can be used during periods of stress to mitigate pro-cyclicality.

In addition, the committee will look at whether there is a need to supplement risk-based measures with simple gross measures of exposures in the framework in an effort to contain leverage. It also intends to strengthen supervisory frameworks to assess liquidity at cross-border banks, and boost counterparty credit risk capital and transparency.

The committee expects to issue proposals on a number of these topics for consultation in early 2009, and the remainder through the course of the year.

At Risk's Quant Congress Europe in London on November 6, Peter Praet, executive director in charge of financial stability at the National Bank of Belgium and co-chair of the Basel Committee's research task force, explained the logic behind the committee's new focus on leverage ratios and revenue growth.

"Supervisors will look closely at growing businesses within institutions as they might be the areas that present problems down the line," said Praet.

He added that other issues being discussed by the Basel Committee were nominal limits to counterparty exposure, liquidity buffers, through-the-cycle loss provisions and a move away from point-in-time probability of default measures.

See also: Quant Congress Europe: Regulatory focus to switch to leverage
Stress testing next focus for Basel