Basel II and Revisions to the Capital Requirements Directive

May 03, 2010: The primary objective of the Basel Committee on Banking Supervision (BCBS) reform program is to raise the resilience of the banking sector, thus promoting more sustainable growth, both in the near term and over the long run. The over-riding objective of the Committee’s reform agenda, as endorsed by the G20 and the FSB, is to deliver a banking and financial system that acts as a stabilising force on the real economy. As we now know, this clearly was not the case leading up to the recent financial crisis.

The pre-crisis financial system was characterised by the following weaknesses:

• too much leverage in the banking and financial system and not enough high quality capital to absorb losses;

• excessive credit growth based on weak underwriting standards and under pricing of liquidity and credit risk;

• insufficient liquidity buffers and overly aggressive maturity transformation, both direct and indirect (for example, through the shadow banking system);

• inadequate risk governance and poor incentives to manage risks towards prudent long term outcomes, including through poorly designed compensation systems;

• inadequate cushions in banks to mitigate the inherent procyclicality of financial markets and its participants;

• too much systemic risk, interconnectedness among financial players as well as common exposures to similar shocks, and inadequate oversight that should have served to mitigate the too-big-to fail problem.

In particular, the depth and severity of the crisis was amplified by a financial system that entered the crisis with too much leverage, insufficient liquidity buffers and capital levels, and poor incentives for risk taking. The banking sector therefore was too vulnerable to shocks, whatever their source. During the most severe episode of the crisis, the market lost confidence in the solvency and liquidity of many banking institutions. The weaknesses in the banking sector were transmitted to the rest of the financial system and the real economy, resulting in a massive contraction of liquidity and credit availability. I feel certain that had regulatory standards been higher, as the BCBS is now proposing, the crisis would have been less severe and the burden on the public sector and taxpayers would have been lower.

The BCBS reforms are intended to be forward looking, making the system more resilient to future crises, whatever their source. While certain banks and countries may not have “caused” the current crisis, everyone was affected. All countries and financial institutions benefited from the public sector interventions to stabilise the economy, the functioning of markets, and the resilience of counterparties. Moreover, past crises have emerged from all regions of the world, covering a wide range of products, and affecting all types of business models and asset classes (retail, commercial real estate, sovereign lending, corporate lending, trading activities, securitisations, and underwriting). While we cannot with certainty predict the source of the next crisis, we can however lay the groundwork to help mitigate or minimise the impact.

It is therefore critical that all banks and countries strengthen banking sector resilience, particularly given the global and diverse nature of financial markets and the speed with which shocks are transmitted across countries. This and previous crises have shown that the deepest and most prolonged downturns arise when the banking sector gets into serious trouble and no longer has the capacity to perform its core credit intermediation function.

(Extracts from the remarks of Stefan Walter, Secretary General, Basel Committee on Banking Supervision)

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