The Impact of Basel II Standards on the Financial Crisis of 2007-2009

The problems which are to be studied in this research are that despite the development of regulatory and supervisory standards from Basel I to Basel II, a financial crisis severely hit the global economy in 2007-2009. The research will include assessment of the successes and failures of regional and international financial regulation and the difficulties in achieving collective action across countries, and also try to explain how Basel II influenced the crisis and moreover whether it provoked and aggravated the crisis or mitigated the effects of a crisis.

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Global financial integration and technological development drove countries toward financial liberalization in the 1970s as a result of collapse and end of the Bretton Woods System. Freer markets and economies achieved through weakening government involvement through re-regulation in order to ensure financial market stability and regulations which are newly-implemented included tighter forward-looking regulatory standards, such as capital adequacy requirements, investor protection measures, and enhanced risk management schemes.
Regional and international organizations also played a vitally important function in this re-regulation process.
When individual and temporary policy coordination by the governments of large economies failed to manage financial policies, A series of institutional congregation and forums such as the Basel Committee on Banking Supervision (BCBS), the International Accounting Standard Board (IASB) and the International Organization of Securities Commissions (IOSCO) were established and launched subsequent to several failures by the governments of large economies in coordination of individual and temporary policy to manage financial strategy as well as policy.
The necessity for collective cooperation was bigger at the level of European Union due to the Economic and Monetary Union (EMU) and single market policy consequently contributing to a larger role of European institutions in determining financial regulation. The EU’s rules often preceded international decisions and facilitated the implementation of more stringent standards.
On the other hand, the 2007-2009 financial crisis raised questions about the effectiveness of financial supervisory systems and international cooperation in monitoring financial market risk. First, the crisis unveiled the limited ability of Basel II to maintain financial market stability and its fundamental flaws, such as over-reliance on market monitoring, pro-cyclicality and insufficient calculation of market and liquidity risk. Second, the shortage of effective international policy coordination in the financial supervisory and controlling processes delayed identifying and addressing new global risks which had arisen due to recent financial developments. The 2007-2009 financial crisis developed as a result of lack of appreciation of the interconnectedness among financial institutions and transactions, and consequent correlations of risks.
However, the degree of interconnectedness and the distribution of correlated risk have not been homogeneous across nations: although all countries have suffered badly from reduced demand and prolonged recession, the extent of financial losses in the financial sector has been quite heterogeneous. In particular, it has been the transatlantic region which has been most severely hit by the financial crisis and which has suffered the greatest losses. In addition, if one leaves aside the US (epicentre of the sub-prime mortgage loan crisis), financial losses have been most heavily concentrated in Europe.
Background
FINANCIAL CRISIS
The global financial crisis of 2007-2009 is without a precedent by history’s account even though economists tend to compare it to the Great Depression in 1929, the Russian crisis of 1992 and the Asian one in 97-98, etc. There is almost universal agreement that the fundamental cause of the crisis was the combination of a credit boom and a housing bubble and which in turn triggered a liquidity shortfall in the United States banking system.
It has resulted in the collapse of large financial institutions, the bailout of banks by national governments, and downturns in stock markets around the world. In many areas, the housing market has also suffered, resulting in numerous  evictions,  foreclosures and prolonged vacancies. It is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s.  In the last five to seven years the ratio of debt to national income has gone up by 100% from 3.75 to 4.75 to one. During this same period, house prices grew at a record rate of 11% per year. A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil. Financial institutions have written off losses worth many billions of dollars and are continuing to do so. Liquidity has virtually disappeared from important markets and stock markets have plunged. Central banks have provided support with hundreds of billions, intervening to support the markets and provide liquidity and to prevent the breakdown of individual institutions.
Economies worldwide slowed during this period as credit tightened and international trade declined. Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that governments did not adjust their regulatory practices to address 21st century financial markets. Both market-based and regulatory solutions have been implemented or are under consideration, while significant risks remain for the world economy over the 2010-2011 periods.
Bank for International Settlements (BIS). Basel II Accord.
The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. The main objective is to enhance understanding of key supervisory issues and matters and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision.
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The Basel II Framework which was initially published in June 2004, (officially stands as “International Convergence of Capital Measurement and Capital Standards: a Revised Framework”) is a new set of international standards and best practices that define how minimum capital banks required to put aside to secure against the types of financial and operational risks banks face. That means that banks have to maintain a minimum level of capital, to ensure that they can meet their obligations, they can cover unexpected losses, and can promote public confidence which is vitally important for the international banking system. Basel II is believed to be as an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. The reason is that banks like to invest their money, not keep them for future risks. Regulatory capital (the minimum capital required) is an obligation. A low level of capital is a threat for the banking system itself: Banks may fail, depositors may lose their money, or they may not trust banks any more. This framework establishes an international minimum standard. The framework has been developed by the Basel Committee on Banking Supervision (BCBS), which is a committee in the Bank for International Settlements (BIS), the world’s oldest international financial organization (established on 17 May 1930). The Basel Committee on Banking Supervision was established by the G10 (Group of Ten countries) in 1974. These 10 countries (have become 11) are the rich and developed countries: Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. The G10 were behind the development of the previous (Basel I) framework, and now they have endorsed the new Basel II set of papers (the main paper and the many explanatory papers). Only banks in the G10 countries have to implement the framework, but more than 100 countries have volunteered to adopt these principles, or to take these principles into account, and use them as the basis for their national rulemaking process.
Why it is important
The importance of this research is to analyse the way of behaving Basel II recommendations in pre-crisis, crisis and post-crisis situations and further actions in modernization and improvement to Basel Accord especially to Basel III in the future. This study will throw more light at the reaction of rules in slump and depression in different countries and industries and the correlation of between them and Macro indicators. The aim in here is to make an effort be to establish the guide of main actions for participants and counterparts in the market to avoid losses while the crisis hits unexpectedly and via this to stop the chain reaction which may pull down the entire market.
Why is it worth solving?
As many economists and critics believe and criticise the Basel II as a main factor and cause of crisis which pushed the system to an obvious failure. This research should answer the issue whether all critics of Basel II are right and is there a necessity of introduction the totally new financial architecture for international business community. Moreover by evaluating and criticizing the weaknesses of Basel II, research will present the path Moreover by analysing and criticizing Basel II we will evaluate the weaknesses on this framework (Basel II) and research will show the clear path for professionals and academics who is doing a research on new, Basel III. Research is worth to conduct because at the end by comparing these two Accords final decision on Basel III could be taken.
What are some current approaches to this problem?
The current approaches to this problem have been straight forward causal-effect analysis and partial solutions i.e. the procyclical behavior of leverage and of the Basel capital adequacy criteria. George J Lekatis took the study further Basel II and the Financial Crisis by analyzing Stress Testing and the most important differences between the USA and the EU in implementation of Basel II. These approaches have examined whether a Stress Testing is an answer to problem and influences and dissimilarities of different markets behaviour in implementations of Basel II. The method which was given above cannot evaluate the problem and present the full picture in details of what happened.
Also I think that is worth to mention about the Alternatives to Basel II and these are: Retaining a Standardized Approach, Market Discipline: Mandatory Subordinated Debt Precommitment Approach, Establishing an International Supervisory Role.
Significance of the problem statement
There have been some theoretical and empirical studies in this field precisely studies Basel II and Credit Risk Management by (Shri V. Leeladhar 2007), Risk management during the 2008-09 financial crisis under the Basel II Accord by (Michael McAleer 2009), Dealing with the pro-cyclicality of Basel II Kashyap and Stein (2004) Basel III and Responding to the Recent Financial Crisis: Progress Made by the Basel Committee in Relation to the Need for Increased Bank Capital and Increased Quality of Loss Absorbing Capital by (Marianne Ojo  September 2010) also there were many studies and researches under the Basel II framework on liquidity risk, market risk, credit risk and etc. But to my best knowledge there was not taken any research in general, which investigated and analyzed the influence of Basel II framework as a international regulatory and supervisory standards on crisis 2007.
I believe that the research will provide the mistakes, limitations in Basel II framework as well as errors and inaccuracies in operation of different financial institutions implementation. Furthermore one of the research objectives is the level of state on supervision and controlling by governments financial organizations in abiding the Basel II rules.
Research objectives
Problem statement
The Problem to be studied here is unique in that it considers the point which states as: There are huge amount of regulations, rules and laws as well as financial organizations and institutions that regulate and maintain control over all financial market participants. But despite all these efforts and measures against future crisis and fluctuations, crisis of 2007 was inevitable.
The question is whether these measures namely Basel II contributed for the counteract and to further improve the financial market, or vice versa, they pushed the system to an obvious failure.
What are the strengths and weaknesses of Basel II?
Finally what should be done to eliminate all problems and defects and not repeat those same mistakes in the new Basel III?
Several (additional) objectives to conduct the study are:

To study the Financial Crisis and Basel II.
To learn how a financial crisis affect the economy of a country throughout the world.
To reveal the effect and impact of Financial regulation (BASEL II) in financial crisis remedies.

What pushed or motivate banks and why there where cases when banks reduce their capital requirements by shifting exposures from the banking book to the trading book or simply writing-off balance sheet?
Literature review. Research methodology
To begin with the literature review tends to be the most important and vitally crucial part of any dissertation, research or working paper. The literature review is the backbone of your thesis proposal and finally your dissertation, because based on previous researches, you find certain points which were not studied and discovered by the author of the report, the scientific work. This gives you a huge field to study and further your opinion or inference theories and make a conclusion.
According to the existing theories, the main justification for capital regulations of banks is often given in terms of “moral hazard” problem. The problem states that in the presence of a mis-priced deposit insurance scheme, bank managers may not do enough to reduce risk. Instead they will opt for risky projects that are accompanied by higher return, which, if not stopped in time, may compromise banks’ solvency in the long run. Therefore, the theoretical reason for capital adequacy regulations is to counteract the risk-shifting incentives originating from deposit insurance 3.
Several strands of theoretical literature have emerged on the topic. A first strand uses the portfolio approach of Pyle (1971) and Hart and Jaffee (1974), where banks are treated as utility maximizing units. In a mean-variance analysis that allows banks’ portfolio choice to be compared with and without a capital regulation, Koehn and Santomero (1980) showed that the introduction of higher leverage ratios will lead banks to shift their portfolio to riskier assets. As a solution to such a situation, Kim and Santomero (1988) suggested that this problem can be overcome if the regulators use correct measures of risk in the computation of the solvency ratio. Subsequently, Rochet (1992) extended the work of Koehn and Santomero and found that effectiveness of capital regulations depended on whether the banks were value-maximizing or utility-maximizing. In the former case, capital regulations could not prevent risk-taking actions by banks. In the latter case, capital regulations could only be effective if the weights used in the computations of the ratio are equal to the systematic risk of the assets. A further theoretical ground argued that banks choose portfolios with maximal risk and minimum diversification.
Subsequently, Marshal and Prescott (2000) showed that capital requirements directly reduce the probability of default and portfolio risk and suggested that optimal bank capital regulations could be made by incorporating state-contingent penalties based on banks’ performance. At the same time, Vlaar (2000) found that capital requirements acted as a burden for inefficient banks when assets of banks are assumed to be fixed. However, such regulations increased the profitability of efficient banks. In short, whether imposing harsher capital requirements leads banks to increase or decrease the risk structure of their asset portfolio is still a debated question and, at least for now, it seems, there is no simple answer to this question.
Van Roy (2003) studied the impact of capital requirements on risk taking by commercial banks of seven OECD countries within the framework of the simultaneous equations framework. He found that changes in capital and credit risk were negatively related over the period studied, which supported the argument that stringent capital requirements went hand in hand with greater financial stability in addition to imposing a higher capital buffer against unexpected credit risk losses. However, they also found evidence indicating that the regulation was ineffective in raising the capital ratio of undercapitalized banking institutions in France and in Italy, which leaves room for the validity of the argument presented above. Actually this was one of the pioneers in studying Basel in general. While John Hull in his book Risk management and financial institutions pointed out and described several approaches such as Cooke Ratio which was a key regulatory requirement and it consider both on-balance-sheet and off-balance-sheet items to calculate bank’s total risk-weighted asset. A standardized approach for measuring the charge for Market risk was assigned capital separately to each of debt security, equity securities, forex risk, commodities risk and options. The more sophisticated banks with well established risk-management functions were allowed to use an “internal model-based approach” for setting market risk capital. This involved a calculating a value-at-risk measures and converting it into a capital requirement using a formula specified in 1996amend. To Credit risk capital requirement three choices were given to banks: the standardized approach, the foundation internal ratings based (IRB) approach and the advanced IRB approach. Capital obligations on Operational risk also have three approaches: the basic indicator approach, the standardized approach, the advanced measurement approach. I did not go as detailed into these risks as I think that the information which is given here describes it generally.
A working paper by F. Cannata about the role of Basel II in the financial crisis describes the pros and cons of the regulatory framework. So in the first part author wrote about all accusations to Basel II .
Main accusations
The main responsibilities ascribed to Basle II in connection with the financial crisis are the following:
I. the average level of capital required by the new discipline is inadequate and this is one of the reasons of the recent collapse of many banks;
II. The new Capital Accord, interacting with fair-value accounting, has caused remarkable losses in the portfolios of intermediaries;
III. Capital requirements based on the Basel II regulations are cyclical and therefore tend to reinforce business cycle fluctuations;
IV. In the Basel II framework, the assessment of credit risk is delegated to non-banking institutions, such as rating agencies, subject to possible conflicts of interest;
V. the key assumption that bank’s internal models for measuring risk exposures are superior than any other has proved wrong;
VI. The new Framework provides incentives to intermediaries to deconsolidate from their balance-sheets some very risky exposures.
There are all according to the author charges that Basel is one of the main defendants in crisis. However that there are argument that in most cases, it is not correct to link the financial crisis to the Basel II accord that some of the main drivers of the crisis cannot be completely attributed to the new regulation. All pros and cons will be studied in details and the full analysis of this will be presented in dissertation.
Research design, methodology, sources of data, data analysis
In order to achieve the objectives which were mentioned above of the research will be taken and relied on secondary data from proven and academic websites, academic forums and all web sites which are related to risk management and Bank for international settlements, international regulatory institutions, EU parliament, annual and quarterly reports of central banks of leading countries as well as main Federal reserve and ECB, additional and supportive data will be taken from world recognized rating agenises such as S&P, Moody’s , Fitch and also facts and figures of Bloomberg, Thomson Reuters will be used. It is worth to mention that the same news might be interpreted differently in different websites and newspapers thus probability of distortion of information might a bit high.
The research will be based on more qualitative however quantitative research also will be done which helps to make more profound analysis and compare the papers with the secondary data and academic researches. The research which will be done will be deductive that takes a theory and comes to a result while after investigating and analysis of this results it is quite possible that it comes to a new theory.
Limitations
Limitations which were faced some usual constraints during the course of my preparation for the proposal. The major limitations are as follows: Lack of enough time: though we were given almost a month to prepare the proposal but the time was not enough for the volume of task we had to complete. Lack of theoretical and practical experience in doing a independent research in such big scale. Shortage of advices and guidelines by world-experienced tutors and supervisors.