Regulating the banking system has always been one of the main challenges for most governments around the world. It is an crucial point of attention given the central role this system plays in modern economies.
Back in the 80’s the Basel agreement was established in order to allow for better control of the financial system. Nonetheless the banking world is in constant evolution. The Basel accords have thus been adapted numerous times throughout the past twenty years. In this article we will shed some light on the main changes of the Basel agreements.
Basel I (1988)
The main goal of Basel I was to reduce credit risk by forcing banks to subdue to a creditworthiness ratio (Cook’s ratio) of at least 8%. This ratio is defined as the percentage of the bank’s own capital, relative to its risk-weighted assets (RWA). Moreover, a system for the weighting of credit risk has been implemented that categorizes the bank’s assets based on credit risk.
As an illustration, if a bank under the Basel I agreement wants to give a loan of 1000$, it should “freeze” 80$ of its own funds in order to respect the 8% ratio. With regard to the weighting of credit risk, when giving a loan of 1,000$, the bank should owe either 0$, 16$ or 40$ if the debtor is respectively a member of the OCDE, a bank or a mortgagor.
To sum up, the weighting of risk credit thus differed as follows:
- 0% for member countries of the OCDE
- 20% for interbank lending
- 50% for mortgage credit
- 100% for the rest
Basel II (2004)
The Transition from Basel I to Basel II was motivated primarily by the fast growth of off-balance-sheet transactions. These transactions, i.e. options, credit derivatives and futures, involved a change in the definition of banks’ activities and consequently raised the need to modify preceding Basel agreements.
Basel accord II improved Basel I accords by taking debtor’s characteristics into account. Its aspiration was to improve the coverage of risks. In this context, banks have implemented internal management risk models in order to improve their management of credit risk, operational risk and market risk. Additionally, stress testing alerts the bank’s management about negative effects and provides information about how much capital could be needed in order to face losses in response to shocks.
Unfortunately, these measures were not sufficient because of the pro-cyclical effects of the agreement. Put simply, in a recovering or booming period, credit risk is much under control whereas it tends to increase in a recession period because of the lack of trusts among financial institutions and can potentially lead to a “credit-crunch” phenomenon with harmful impacts on economic growth.
As a result of that, a third agreement has been prepared in the aftermath of the crisis of 2008.
Basel III (2010)
Basel III was implemented as an answer to the subprime crisis of 2008 and sovereign debts crisis of 2011. This third agreement was based on both macro and micro prudential approaches:
1)Macro prudential approach: classifying credit risk worthiness in two separate groups:
- Individual creditworthiness of banks
- Systemic creditworthiness of banks
2)Micro prudential approach: enforcing creditworthiness ratio from 8 % to 12 % and implementing a handful of new ratios such as
- A leverage ratio (own funds divided by non weighted assets) which has to be at least of 3%.
- A liquidity ratio that would allow banks to have enough liquid assets to resist to potential stress during 1 month.
By implementing a liquidity ratio to strengthen stress tests, banking authorities were supposed to solve the existing liquidity problems in the economy that were flagrant at that time in 2008. However, 4 years and some bankruptcy cases later, it was obvious that the problem was not solved yet.
In an overheated economy, nobody has the intention to stop benefiting from the situation. So, in 2007, the consequences of a potential downturn were totally minimized because the origin of the economic crisis the world economy was going to face was hidden. In this particular context, banks started taking on more complex forms of risk which weakened their financial sustainability.
The hidden sources of this economic disaster involved finding better ways to point it out. Stress testing has been viewed as a potential solution to avoid triggering another crisis.
Before going any further let’s explain what a stress test is.
What is a stress test?
A stress test is a procedure used to determine the stability of a financial system by simulating different scenarios beyond what is considered as normal events of operational capacity banks could face.
Therefore, these tests would allow to determine whether or not a financial system could fail and to what extent. These exceptional events could lead financial institutions to minimize the probability that these events happen. It is all about a question of moral hazard. Stress tests have been implemented to cap this question of moral hazard and to set up harmonized rules on an international level in order to oblige banks to limit excessive risk-taking.
Stress testing practices have become an important risk management tool used by banks as part of their internal risk management through the Basel II accords and has been reinforced in the Basel III accords.
Results of the 2014 EU-wide stress test European Banking Authority implemented the 2014 EU-wide stress test on 123 banks. The 2014 EU-wide stress test is goal-oriented by understanding what could be some remaining vulnerabilities which still threaten the European economy. Increasing confidence in the EU banking finance is also the main objective of this test.
The EU-wide stress test is coordinated by the EBA and carried out in cooperation with the European Central Bank (ECB), the European Systemic Risk Board (ESRB), the European Commission (EC) and the Competent Authorities (CAs) from all relevant national jurisdictions.
The European Central Bank, which tested the Euro zone’s biggest bank, said “25 lenders have failed” and that the total capital shortfall is €24.6 billion.
A real solution to our problems?
Unprecedented levels of liquidity have been required from central banks to insure financial system’s stability and 5000 specialists have analyzed their balance sheet. According to the 2014 stress test, 25 banks could not face a recession. Is it a huge amount? What should we conclude from that observation?
Regarding the preceding economic crisis, which pushed our economy into a deep slump, authorities have to raise public confidence in banks through more transparency. Stress tests do show that banks are not cast adrift and that huge majority of them are ready to face the future. As a consequence, public confidence in the sector might improve.
Nevertheless the credibility of the efficiency of stress testing practices could come into question if banks do not learn from these tests. Even though a lot of banks have increased their capital base, reduced their risky capital and contributed to a stronger financial system, it should not be overlooked that these banks were also warned about these stress tests far before and that they adapted consequently by injecting millions of dollars to achieve public credibility.
Despite all the precautionary measures that can be taken by the authorities to avoid a new crisis, it thus seems that the world economy will never be enough protected to be void of risk.