Bassel 3

What was the paradigm shift from Basel I to Basel II? The paradigm shift was that while Basel I had a ‘one-size-fits-all’ approach, Basel II introduced risk sensitive capital regulation. The main charge against Basel II is that it is precisely this risk sensitivity that made it blatantly procyclical. In good times, when banks are doing well, and the market is willing to invest capital in them, Basel II does not impose significant additional capital requirement on banks. On the other hand, in stressed times, when banks require additional capital and markets are wary of supplying that capital, Basel II requires banks to bring in more of it. As we saw during the crisis, it was the failure to bring in capital when under pressure that forced major international banks into a vicious cycle of deleveraging, thereby hurtling global financial markets into seizure and economies around the world into recession.

The second charge against Basel II was that even as it made capital regulation more risk sensitive, it did not bring in corresponding changes in the definition and composition of regulatory capital to reflect the changing market dynamics. The market risk models failed, in particular, to factor in the risk from the complex derivative products that were coming on to the market in a big way. These models demanded less capital against trading book exposures on the premise that trading book exposures could be readily sold, and positions rapidly unwound. This gave a perverse incentive for banks to park banking book exposures in the trading book to optimize capital. And as we now know, much of the toxic assets and their securitized derivatives, which were the epicenter of the crisis were parked in the trading book.

So, the second charge against Basel II was that even as it was supposedly risk sensitive, it failed to promote modelling frameworks for accurate measurement of risk and to demand sufficient loss absorbing capital to mitigate that risk.

The third charge against...