Basel II was supposed to create a safer banking world. It failed miserably in that task which has now been acknowledged by the Bank of International Settlement (BIS) and its Basel II committee. It is of little consolation to investors in bank shares that the committee is now working on Basel III.
Among the things that caused the financial crisis was that the Basel II committee and banks underestimated both the risk of losses on their assets and their exposure to the failure of others. Requiring only the most threadbare of capital cushions for structured debt such as securitized mortgages, Basel II bank rules encouraged this obliviousness.
As it became clear losses potentially far exceeded banks’ capital, lenders tied their purses tight. Only massive taxpayer-backed intervention saved the financial system. This was necessary – but it may have made a new crisis more likely, as intervention is now the expected public response. Financial policy must be concentrated on ending this perverse situation. New proposals by the Basel Committee on Banking Supervision, published in December, are a good step in the right direction. They should be adopted – but they will not on their own suffice to address the full scope of the problem.
As the Basel Committee admits, current rules have failed to make sure banks are backed by enough capital and are not just gambling with creditors’ money. Towers of debt-funded assets could be erected upon 2 per cent slivers of common equity. Other types of capital, such as hybrid debt, are opaque or cannot easily be forced to absorb losses: rather than converting hybrids into equity, banks in trouble may prefer to sell off assets, putting pressure on liquidity and prices at the worst possible time. Source: financial Times