Basel II and the global financial crisis

The GFC began to take hold in 2007. Its origins can be traced to a boom in US housing prices between 2002 and 2005 and the rapid growth of sub-prime housing loans following a doubling of the amount of prime loans between 2001 and 2003. Consequently, the crisis largely preceded the introduction of Basel II, which in Australia was at the start of 2008 whereas in the USA it was introduced over 2008 in parallel with the current requirements and applied only to the large internationally-active banks.

Sub-prime loans are those made to borrowers with a weak capacity to make their loan payments (compared with prime loans) and thus an increase in such lending represents a decline in lending standards. Sub-prime loans though were encouraged in the US as a way of democratising lending by providing loans to those who were not eligible for prime loans, including minorities. The loans business model, though, was flawed because it depended on continuously rising prices for the mortgaged properties. The assumed capital gain served to compensate the lender for losses from loan delinquencies or encouraged delinquent borrowers to refinance with the lender at a higher interest rate.

The growth in lending for housing promoted an increase in the supply of housing that resulted in the stock of housing exceeding the demand. This led to a fall in housing prices that was exacerbated by the high (and rising) rate of mortgagee sales from the sub-prime loans. The crisis quickly spread to the securities markets because most of the sub-prime loans were securitised through asset-backed commercial paper (short-term securities that provided initial finance for the loans) and MBSs (long-term bonds that ultimately funded the loans). The value of the highest-rated (AAA) of these securities (surprisingly, most MBSs based on sub-prime loans were rated AAA) halved between July 2007 and March 2008, which created a major credit crisis for two reasons. First, new issuers could not borrow because they could not afford the resulting higher interest rate and, second, investors only wanted to sell the securities; and so liquidity in both the primary and secondary markets for MBSs dried up.

The crisis spread to the related markets for structured securities such as collateralised-debt obligations (the collateral for which was sub-prime loans) and for credit-default swaps, drying up liquidity in these markets. A related feature of the credit crisis was the retreat by investors to US Treasury and other safe bonds, driving down their yields and further widening the credit spreads between them and those for structured and similar securities. The crisis spread to the large US investment banks (they were not subject to prudential supervision) as well as commercial banks when it became clear that they held large amounts of these (toxic) securities on their balance sheets and this contracted the flow of funds by banks (and even more disturbingly) between banks. The global nature of the affected financial markets and a surprising lack of information about banks exposures (which spread fear) meant the credit crisis quickly became global in scope.

The BCBS, along with other pan-national agencies (Knight 2008), has analysed the causes of the threat the GFC poses for global financial stability and the Committee announced (in March 2008) it was developing four amendments to Basel II in response:

1. In relation to Pillar 1 it was examining the adequacy of the capital charge for structured securities given their highly correlated risk exposure (being backed by assets of the same type) which led to their sudden downgrading. The value-at-risk method of assessing the capital requirement for such securities during periods of low volatility did not adequately reflect their credit risk when volatility suddenly increased. Concern had been expressed when Basel II was being developed about the shortcomings of value-at-risk models in the context of financial system instability. (Goodhart, Hofmann and Segoviano 2004: 598)

2. The Committee was also developing a credit-default risk charge on assets held in banks trading books. This is in recognition of the credit risk posed by structured credit products that do not have a liquid secondary market.

3. In relation to Pillar 2 the BCBS is proposing that regulators widen their stress tests of banks risk-management systems to include contingent credit exposures such as those that arose when banks took back securitised (or collateralised) assets for reputation reasons.

4. The BCBS is also reviewing its disclosure requirements (under Pillar 3) in relation to securitisations, conduits and the sponsorship of off-balance sheet vehicles (Wellink 2008; BCBS 2008b).

Prior to the crisis the BCBS had began a review of liquidity-risk management and supervision, but given that market and funding illiquidity are core aspects of the credit crisis, the work was given greater priority. The intention is to strengthen its standards for liquidity-risk management and supervision, especially in relation to liquidity stress testing that includes off-balance sheet exposures and for funding capacity during periods of wholesale market funding illiquidity; as well as its reporting and disclosure standards relating to liquidity (BCBS 2008a). APRA has responded by intensifying its monitoring of bank liquidity and by strengthening its liquidity-management requirements on banks.

The GFC provides a real-life stress test of the stability of the financial system and the regulatory framework that is intended to promote the financial systems stability. Basel II forms a fundamental part of the prudential supervision of individual banks that serves to strengthen their individual stability through their capital buffer; but it does not aim to ensure financial system stability. Consequently, despite its recognised flaws, which the BCBS has moved to remedy, Basel II did not contribute to the emergence of the GFC. As noted above, the origins of the crisis pre-dated the introduction of Basel II in the USA. The same cannot be said about the anti-regulation political culture in the USA.

In the USA, sub-prime lenders included non-depository mono-line lenders (referred to in Australia as loan originators) and large banks, as well as community banks, consumer finance companies and thrifts, many of whom along with investment banks arranged the issue of MBSs (Ashcraft and Schuermann 2008). As noted above, Basel II has been applied in the US only to their internationally active commercial banks. The widespread use of originate-to-distribute lending in the US has been referred to as a shadow banking system that increasingly relied on a flawed originate-to-distribute model (Ashcraft and Schuermann 2008 detail the various flaws), which in the case of sub-prime loans was based on a business model that itself was seriously flawed (because of its reliance on ever-increasing housing values and its incentives for predatory lending and borrowing). It should be recalled that the process of securitisation that enabled the originate-to-distribute lending model was an acclaimed financial innovation that accessed investors funds for housing loans and so placed competitive pressure on bank lending.

The question for the prudentially-regulated banks that decided to undertake either sub-prime lending or underwrite the issue of MBSs (or otherwise establish an exposure to structured securities) is why their capital requirement (their capital ratios exceeded those of Basel I) did not motivate them to act more prudently. The answer appears to be that the motivation provided by their capital requirement to act prudently was outweighed by the pressure posed by competing institutions that were making profits from their appetite for risk taking; greed outweighed fear. The related question is: why did their prudential regulator tolerate their risk exposures? There is now a growing literature criticising the forbearance of financial and prudential supervision in the United States (Kane 2008; and Ashcraft and Schuermann, 2008). The role of ratings agencies and their supervision has also been criticised given the conflict of interest faced by the ratings agencies in assigning their AAA rating to securities based on sub-prime loans.

Fortunately, this debacle was not replicated in Australia. Sub-prime lending was largely confined to three smaller loan originators (Pepper, Bluestone and Liberty Financial) and Australias banking system had very little exposure to the toxic securities (Debelle 2008: 43). Consequently the banks were not under competitive pressure to enter this segment of the loan market. The initial impact in Australia was in the inter-bank market, where the Australian banks became reluctant to lend to each other, preferring instead to increase their balances held with the RBA.

The main impact in Australia has been via the higher credit spreads in overseas financial markets, which had a relatively greater impact on non-bank lenders (the loan originators) because domestic and overseas MBSs markets had been their funding source. Deprived of funds, these lenders switched into mortgage brokerage, leaving the banks with an even larger share of the housing-loan market. The Governments guarantee of ADI liabilities has further strengthened the position of the large banks within the Australian financial system (RBA 2008b: 2136).

APRAs review of credit standards for housing loans in 2006 (as well as the RBAs efforts to contain Australias housing prices in 2002 and 2003) represented a stricter regulatory environment than occurred in the US. APRAs Chairman concluded a speech made in June 2007 with the following observations:

In repeating our concerns about credit standards, I am conscious that APRA might be perceived to be crying wolf too often on housing lending. No one would welcome a continuation of Australias economic strength and the recent resilience of most housing markets from which ADIs have been major beneficiaries more than the prudential regulator. Nonetheless, the risk currents in housing lending have been moving, slowly but inexorably, in one direction only and this demands careful management by our regulated lenders, and constant vigilance on APRAs part. (Laker 2007)

The comparison between the US and Australias experience is instructive. Supervised banks in both systems employed similar levels of capital but many of the large US banks behaved less prudently than the large Australian banks and the Australian financial regulators displayed much more vigilance than the US regulators.