Basel

Some very basic assumptions by financial institutions and regulators were proven incorrect during the crisis of 2008. The belief that housing prices would continue to rise (indefinitely) was the ground for business of subprime lending by financial institutions. Today, we all know the belief was proven wrong, the housing sector was hit hard and prices decreased sharply. This caused a chain reaction that submerged the global financial crisis.

Many incentives in the financial system encouraged risk taking- excessive risk taking. Some of them were: transfer of risk through securitization, reliance of credit ratings that were paid by issuers, compensations of executives based on growth, revenue, and profit that were not risk adjusted. Basically, greed.

When loan defaults began impacting the balance sheets of the banks, we discovered we have a systemic problem- one bank’s problem becomes every other banks problem and thus a direct effect on our economy. From quarter to quarter, losses increased by billions of dollars, which created the crisis of confidence. Every one ran to the bank the to withdraw their money, liquidity was sucked out from the system.

The majority of financial institutions, banks at large, were exposed to risky assets in many forms: subprime loans, use of derivatives and securitizations, excessive use of leverage. Quality and quantity of bank’s capital could not absorb losses at time of emergency where system risk was threatening the system- no one wanted to borrow money to those institutions where funding was needed more than ever. Then the Bailout came to the rescue. The rest is history.

This is the evidence that Basel II rules and guidelines were extremely weak.

http://www.infosys.com/industries/financial-services/white-papers/Documents/base-way-forward.pdf

http://www.moodysanalytics.com/~/media/Insight/Regulatory/Basel-III/Thought-Leadership/2012/2012-19-01-MA-Basel-III-FAQs.ashx...