May 2009


The current global credit crisis: a paradigm shift in the implementation of Basel II?

By Garikai Matarirano

The current global credit crisis has threatened to undermine the three pillars of Basel II, with potentially serious implications for the South African banking regulator. Many of the world’s major commercial and investment banks have had to write-down huge losses caused by what has been referred to as exposure “toxic assets” on their balance sheets. Many of these banks have since been forced to replenish their balance sheets with funding from governments in order to avoid an economic crisis. This crisis has therefore exposed fundamental fault lines in the regulation of the banking system in countries that had not properly implemented Basel II.

Has the South African regulator done enough to address these fundamental weaknesses revealed by the financial market crisis related to the regulation, supervision and risk management of internationally-active banks?
The Basel I framework of capital adequacy allowed banks to shift risky activities off balance sheet through the use of structured investment vehicles. The creation of these off-balance sheet entities allowed banks to reduce the capital associated with a given risk profile. In addition, it reduced the transparency of risky activities and hid them from regulatory scrutiny. Unsurprisingly, these innovations encouraged excessive risk taking, inadequate transparency, and weak regulatory scrutiny.

However, Basel II creates an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such 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.

In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. 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.

To promote greater stability in the financial system, Basel II uses a "three pillars" concept which deals with minimum capital requirements to address risk, supervisory review and market discipline.

South Africa has implemented Basel II through the Banks Amendment Act, 2008. The Amendment Act seeks to implement Basel II by, inter alia:

clarifying the responsibilities of banks, banking groups, boards of directors of banks and banking groups;
increasing the reporting requirements of and providing comprehensive disclosure requirements for banks and banking groups;
facilitating the various options available to banks and banking groups in calculating minimum capital requirements in respect of credit risk exposure, market risk exposure and operational risk exposure; and
elaborating the supervisory review process in order to, amongst other things, assess the capital adequacy and control environment of banks and banking groups.

In effect, the amendments referred to above seek to ensure that South Africa’s banking system remains stable in these turbulent times through the introduction of mechanisms for better risk management and monitoring, capital adequacy, transparency and accountability.

Notwithstanding these measures, the current global contagion may require the following proactive action by the South African regulator:

strengthening the risk capture of the Basel II framework in particular for trading book and off-balance sheet exposure (This may not be strictly applicable to South African banks who have largely desisted from engaging in risky off-balance sheet activity. However, this may be relevant to our banking system considering the procyclicality of banking);
an important regulatory step would be to enhance the quality of Tier 1 capital by setting stricter guidelines for determining what constitutes Tier 1 capital;
building additional shock absorbers into the capital framework that can be drawn upon during periods of stress in the banking system;
evaluating the need to supplement risk-based measures with simple gross measures of exposure in both prudential and risk management frameworks to help contain leverage in the banking system;
strengthening supervisory frameworks to assess funding liquidity at cross-border banks and leveraging Basel II to strengthen risk management and governance practices at banks. This will discourage banks from any activity giving rise to behavioural risk and which encourages banks to engage in short-term financial gain at the expense of stakeholders in the communities in which they operate;
strengthening counterparty credit risk capital, risk management and disclosure at banks in order to enhance trust and confidence amongst internationally active banks; and
promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles. This is important for South African banks in view of initiatives that are underway to promote regional economic integration in the Southern African Development Community.

An even more important measure is for the South African regulator to ensure that the spirit of Basel II and the Amendment Act is implemented holistically. This will help make the capital base more relevant to banks' changing risk profiles and that supervisory review institutions closely monitor its impact. Such a framework will also create incentives for better risk measurement and management, including for ongoing and future securitisation exposures and liquidity lines for asset-backed commercial paper programmes.

South African banks have spent substantial financial resources preparing their systems for the implementation of Basel ll and the Amendment Act. However, the jury is still out on whether these measures will mitigate the adverse systemic effects of the global credit crisis on the South African banking system.

As John Maynard Keynes observed in 1931 during the Great Depression: "A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him."

 
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