Basel II and the Capital Requirements Directive: Responding to the 2008/09 Financial Crisis

Ojo, Marianne (2009): Basel II and the Capital Requirements Directive: Responding to the 2008/09 Financial Crisis.

Abstract

This paper addresses factors which have prompted the need for further revision of banking regulation, with particular reference to the Capital Requirements Directive. The Capital Requirements Directive (CRD), which comprises the 2006/48/EC Directive on the taking up and pursuit of the business of credit institutions and the 2006/49/EC Directive on the capital adequacy of investment firms and credit institutions, implemented the revised framework for the International Convergence of Capital Measurement and Capital Standards (Basel II) within EU member states.

Pro cyclicality has attracted a lot of attention – particularly with regards to the recent financial crisis, owing to concerns arising from increased sensitivity to credit risk under Basel II. This paper not only considers whether such concerns are well-founded, but also the beneficial and not so beneficial consequences emanating from Basel II’s increased sensitivity to credit risk (as illustrated by the Internal Ratings Based approaches). In so doing it considers the effects of Pillar 2 of Basel II, namely, supervisory review, with particular reference to buffer levels, and whether banks’ actual capital ratios can be expected to correspond with Basel capital requirements given the fact that they are expected to hold certain capital buffers under Pillar 2. Furthermore, it considers how regulators can respond to prevent systemic risks to the financial system during periods when firms which are highly leveraged become reluctant to lend. In deciding to cut back on lending activities, are the decisions of such firms justified in situations where such firms’ credit risk models are extremely and unduly sensitive - hence the level of capital being retained is actually much higher than minimum regulatory Basel capital requirements ?

• Item Type: MPRA Paper
• Language: English
• Keywords: Basel II; Capital Requirements Directive; pro cyclicality; risk; regulation; banks
• Subjects: E - Macroeconomics and Monetary Economics > E0 - General; D - Microeconomics > D0 - General; K - Law and Economics > K2 - Regulation and Business Law; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit; E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles

References

Brief Summary of the De Larosiere Report <http://ec.europa.eu/commission_barroso/president/pdf/statement_20090225.pdf>

Brunnermeier M and others, ‘The Fundamental Principles of Financial Regulation: Geneva Reports on the World Economy 11’, Preliminary Draft 2009

Cociuba S ‘Seeking Stability: What’s Next for Banking Regulation?’ Chart 3 http://www.ideas.repec.org/a/fip/feddel/y2009iaprnv.4no.3.html

Commission Staff Working Document, Accompanying Document to the Proposal for a Directive of the European Parliament and of the Council, amending Directives 2006/48/EC and 2006/49/EC, Impact Assessment Document

Commission Staff Working Document, Accompanying Document to the Proposal for a Directive of the European Parliament and of the Council amending Capital Requirements Directive on trading book, securitization issues and remuneration policies

Commission proposes further revision of banking regulation to strengthen rules on bank capital and on remuneration in the banking sector’ <http://europa.eu/rapid/pressReleasesAction.do?reference=IP/09/1120>

Communication from the Commission on European Financial Supervision May 2009 < http://ec.europa.eu/internal_market/finances/docs/committees/supervision/communication_may2009/C-2009_715_en.pdf>

Four Key Principles of Supervisory Review < http://www.bis.org/publ/bcbs107c.pdf>

Grande M „Accounting and Procyclicality“, Conference on Financial Reporting in a Changing World

Gordy M and Howells B ‘Pro cyclicality in Basel II: Can We Treat the Disease Without Killing the Patient?” 2004

Heid F ‘Cyclical Effects of the Basel II Capital Requirements’ Journal of Banking and Finance Vol 31 Issue 12 2007 at pages 3885-3900 Jones D, ‘Emerging Problems with the Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues’ Journal of Banking and Finance 2000 24 (1-2) at pages 35-58

Kashyap A and Stein J ‘Cyclical Implications of the Basel II Capital Standards 2003 Federal Reserve Bank of Chicago Economic Perspectives, 1st Quarter, 18-31.

McCaw K and Walsh J ‘Basel II Big Bang: Full Implementation of the CRD’

Ojo M ‘Central Bank’s Role and Involvement in Bank Regulation: Lender of Last Resort Arrangements and the Special Resolution Regime (SRR)’ 2009

Report of High Level Group on Supervision in the EU, Chaired by J De Larosiere, February 2009

Shin HS ‘Reflections on Northern Rock: The Bank Run that Heralded the Global Financial Crisis’ forthcoming the Journal of Economic Perspectives

The Internal Ratings Based Approach’, Supporting Document to the New Basel Capital Accord 2001 http://www.bis.org/publ/bcbsca05.pdf

The Run on the Rock," House of Commons Treasury Committee, Fifth Report of Session 2007–08, vol. 1, January 2008