ROLE OF BASEL II IN SUBPRIME CRISIS

Standards are intended to facilitate better-informed lending and investment decisions, improve market integrity, and reduce the risks of financial distress and contagion. Often these standards have been developed after a crisis in the global financial markets. The development of these standards led to a set of globally accepted rules. The Basel Accord has been amended throughout the 1990ies and changed in order to cover other banking risks as well. The New Capital Adequacy Framework consists of three pillars: Minimum capital rules Supervisory review of capital adequacy Market discipline based on the provision of reliable and timely information

Minimum capital rules have been put forth depending upon the Asset quality of the banks. Every loan category has been assigned with a risk weight and Risk weighted average of the assets determine the capital adequacy of the institution. Instead of assigning fixed weights to the asset classes, the institutions have been encouraged to develop internal framework to rate the borrowers. Based on this rating the riskiness of the borrower and the interest rate spread applicable over and above the benchmark (BPLR/ Base Rate) is determined. Indeed, major international banks, particularly in the US, have gradually changed the nature of their operations from a traditional business model, where they grant loans to customers and hold them in their balance-sheet (buy and hold), to a model where loans are originated and then securitised. On the one hand, it implied that assets that would have been otherwise held up to maturity are sold to a large number of operators, generating a high volume of funding and thus giving a thrust to the economy as a whole. On the other hand, it favoured a high level of leverage and a possible reduction of the intermediaries incentives to monitor the quality of their portfolios. The Basel Accord encouraged banks to push unrated loans off the balance sheets. Banks were required to hold less capital against rated positions than against unrated positions, making it optimal to invest in rated notes, rather than a comparable portfolio of unrated assets. Thus rating agencies became an essential tool to risk the default probability of assets and thus essential to determine the correct amount of capital held by banks. The subprime financial crisis showed the weakness of the existing rating system. Conflict of interests by

the three main rating agencies (S&P, Moodys, Fitch) has been considered as one of the reasons for providing higher ratings to tranches that were not that healthy after all. Even when the subprime defaults began to rise and sudden rise in houses available for sale caused prices to decline, the banks had not kept the subprime loans in their books. They merged them according to several risk classes and sold them again in the financial markets. These so called Collateralized debt obligations (CDOs) were bought in large quantities by the speculative branches of large banks primarily based on the good rating given to them by the agencies. These CDOs, although highly-profitable because of the constant cash-flow in times of low interest rates, received rankings that did not represent the underlying risks. This was realized by the markets throughout the summer and fall of 2007. Because banks could not easily identify how their subsidiaries were affected by the default of subprime credits and how much additional liquidity would be needed, the banks became increasingly wary to lend to each other through the Interbank lending market. Thus we see that the Basel II norms could not take into account the off balance sheet risks undertaken by the banks and the regulations were inadequate to monitor the new risks emanating from the new practices adopted by the industry. The main responsibilities ascribed to Basle II in connection with the financial crisis are the following: i) In the Basel II framework, the assessment of credit risk was delegated to nonbanking institutions, such as rating agencies, subject to possible conflicts of interest; ii) The new Capital Accord, interacting with fair-value accounting, had 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) The average level of capital required by the new discipline is inadequate and this was one of the reasons of the collapse of many banks; v) The new Framework provided incentives to intermediaries to deconsolidate from their balance-sheets some very risky exposures.