Lester Henry and Michelle Majid

Financial Crisis and the Implementation of Basel II:

Potential Economic Impact for Trinidad and Tobago

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• IntroductionIntroduction• Overview of Basel I & IIOverview of Basel I & II• Financial Crisis and Basel II: Are they Financial Crisis and Basel II: Are they

linked? linked? • The TnT Financial System The TnT Financial System • Some issues of concern to T&TSome issues of concern to T&T• The way Forward for T&TThe way Forward for T&T• Summary and ConclusionSummary and Conclusion

Roadmap of the PaperRoadmap of the Paper

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IntroductionIntroduction• Financial Crisis partly seen as regulatory failure.Financial Crisis partly seen as regulatory failure.• Basel I and Basel II were supposed to prevent suchBasel I and Basel II were supposed to prevent such• Many Caribbean Countries were expected to adopt Many Caribbean Countries were expected to adopt

Basel II over the next few years (from 1 or 2 in Basel II over the next few years (from 1 or 2 in 2007 to 4-6 between 2010 – 2015)2007 to 4-6 between 2010 – 2015)

• Examine Basel II’s role in the crisis Examine Basel II’s role in the crisis • Identify issues arising from possible adopting Basel Identify issues arising from possible adopting Basel

IIII• determine the extent to which Basel II may impact determine the extent to which Basel II may impact

T&T and by extension the regionT&T and by extension the region• Inform policymakers whether focus should be on Inform policymakers whether focus should be on

getting Basel I right or introducing Basel II or not getting Basel I right or introducing Basel II or not adopting any at all.adopting any at all.

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Overview of Basel IOverview of Basel I

Basel I

Pillar 1:

Minimum capitalrequirements

Risk-weightedAssets

(Denominator)

Definition ofCapital

(Numerator)

Credit Risk(1988)

Market Risk(1996)

StandardizedApproach

ModelsApproach

Regulatory capital

Risk-weighted assets8%≥

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Shortcomings of Basel IShortcomings of Basel I

• Capital required did not mirror a Capital required did not mirror a bank’s true risk profilebank’s true risk profile

• Too simple for advanced banksToo simple for advanced banks• Inflexible against new developmentsInflexible against new developments• Covers only credit and market risksCovers only credit and market risks• Only quantitative in natureOnly quantitative in nature• Limited recognition of collateralLimited recognition of collateral

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Basel II in a NutshellBasel II in a Nutshell

ThreePillars

Minimum capitalrequirements

Supervisory reviewprocess

Market discipline

Risk weightedassets

Definition ofcapital

Credit risk Operationalrisk

Marketrisks

Standardized Approach

InternalRatings-based

Approach

BasicIndicatorApproach

StandardizedApproach

AdvancedMeasurementApproaches

StandardizedApproach

ModelsApproach

CoreCapital

SupplementaryCapital

Basel IIPillar 1 Pillar 2 Pillar 3

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Objectives of Basel IIObjectives of Basel II• Greater emphasis on banks’ own Greater emphasis on banks’ own

assessment of riskassessment of risk• Comprehensive framework for credit, Comprehensive framework for credit,

market and operational riskmarket and operational risk• Encourages rigorous bank supervisionEncourages rigorous bank supervision• Ensures market transparency, Ensures market transparency,

disclosuredisclosure• More risk sensitive; better align regulatory More risk sensitive; better align regulatory

capital with actual risk exposurecapital with actual risk exposure

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Basel II and the Financial CrisisBasel II and the Financial Crisis• I. the average level of capital required by the new I. the average level of capital required by the new

discipline is inadequate and this is one of the reasons discipline is inadequate and this is one of the reasons of the recent collapse of many banks;of the recent collapse of many banks;

• II. the new Capital Accord, interacting with fair-value II. the new Capital Accord, interacting with fair-value accounting, has caused remarkable losses in the accounting, has caused remarkable losses in the portfolios of intermediaries;portfolios of intermediaries;

• III. capital requirements based on the Basel II III. capital requirements based on the Basel II regulations are cyclical and therefore tend to reinforce regulations are cyclical and therefore tend to reinforce business cycle fluctuations;business cycle fluctuations;

• IV. in the Basel II framework, the assessment of credit IV. in the Basel II framework, the assessment of credit risk is delegated to non-banking institutions, such as risk is delegated to non-banking institutions, such as rating agencies, subject to possible conflicts of interest;rating agencies, subject to possible conflicts of interest;

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Basel II and the Financial Basel II and the Financial Crisis….continuedCrisis….continued

• V. the key assumption that banks’ internal V. the key assumption that banks’ internal models for measuring risk exposures are models for measuring risk exposures are superior than any other has proved wrong;superior than any other has proved wrong;

• VI. the new Framework provides incentives VI. the new Framework provides incentives to intermediaries to deconsolidate from to intermediaries to deconsolidate from theirtheir

balance-sheets some very risky exposuresbalance-sheets some very risky exposures

Source: Source: Francesco Cannata Mario Quagliariello (2009)Francesco Cannata Mario Quagliariello (2009)

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In Defense of Basel IIIn Defense of Basel II• Only recently implemented Only recently implemented • In US only applies to top tier banks operating In US only applies to top tier banks operating

internationally -- most of system is exemptedinternationally -- most of system is exempted• Pillar II and Pillar II have been given very little Pillar II and Pillar II have been given very little

attention, a careful application would involve;attention, a careful application would involve;– Remuneration packages in investment banking and of Remuneration packages in investment banking and of

management boards; management boards; – Transparency of a bank's risk profile; Transparency of a bank's risk profile; – Management's true understanding of both the bank's risk profile Management's true understanding of both the bank's risk profile

and its risk positions. and its risk positions. • source Van Kemper, Cris (2009)source Van Kemper, Cris (2009)

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Can Basel X work? A Minskyian Can Basel X work? A Minskyian alternative Viewalternative View

• Can help in some cases but ultimately limited in Can help in some cases but ultimately limited in preventing crisespreventing crises

• Sources of instability are “built-in” to the systemSources of instability are “built-in” to the system• During expansions managers competence will be During expansions managers competence will be

questioned if they don’t go after higher returnsquestioned if they don’t go after higher returns• In normal times the “three-six-three” rule appliesIn normal times the “three-six-three” rule applies• During Busts credit supply dries up regardless of During Busts credit supply dries up regardless of

any stimulus policy any stimulus policy

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Snapshot of TnT Financial Snapshot of TnT Financial System:System:Asset GrowthAsset Growth• Eight commercial banks and 19 Eight commercial banks and 19

NBFIsNBFIs

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Snapshot of the Financial Snapshot of the Financial System:System:Capital AdequacyCapital Adequacy

0

5

10

15

20

25

1999 2000 2001 2002 2003 2004 2005 -Mar

Regulatorycapital to RWA

Regulatory T ierI capital toRWA

Source: Financial Sector Assessment Program Report, 2005

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Snapshot of the Financial Snapshot of the Financial System:System:Asset QualityAsset Quality

NPL to Gross Total loans (% )

0

1

2

3

4

5

6

1999 2000 2001 2002 2003 2004 2005 -Mar

Source: Financial Sector Assessment Program Report, 2005

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FSAP (2005): T&T’s FSAP (2005): T&T’s deficienciesdeficiencies• Inadequate financial sector lawsInadequate financial sector laws• High-levels of connected exposures High-levels of connected exposures

across banking and insurance across banking and insurance companiescompanies

• BCP Non Compliance with Market Risk, BCP Non Compliance with Market Risk, Large and related exposure limitsLarge and related exposure limits

• 0% risk weighting all sovereign debt0% risk weighting all sovereign debt

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Some Areas of ConcernSome Areas of Concern• Credit Risk AssessmentsCredit Risk Assessments• Macroeconomic IssuesMacroeconomic Issues• Capital RequirementsCapital Requirements• Distortion of allocation of creditDistortion of allocation of credit• Interbank LendingInterbank Lending• Regulators in emerging economiesRegulators in emerging economies• Home-host IssuesHome-host Issues• Local Banks in T&TLocal Banks in T&T• BCP ComplianceBCP Compliance

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Credit Risk AssessmentsCredit Risk Assessments• Shallow credit rating market (reduced to Shallow credit rating market (reduced to

flat rate)flat rate)• Rating linked to level and volatility of Rating linked to level and volatility of

capital flowscapital flows• Prohibitive cost and incentive to become Prohibitive cost and incentive to become

ratedrated• Who will rate the rating agency?Who will rate the rating agency?• Potential pro-cyclicality and circularity Potential pro-cyclicality and circularity

(Powell, 2002)(Powell, 2002)1717

Macroeconomic IssuesMacroeconomic Issues• Three factors indicate that tighter Three factors indicate that tighter

regulatory capital requirements are regulatory capital requirements are likely to cause a domestic credit likely to cause a domestic credit crunch:crunch:* economies are shallow* economies are shallow* banking sector concentrated* banking sector concentrated* presence of government in the real * presence of government in the real economy economy

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RegulatorsRegulators

• Deficient regulators can be an Deficient regulators can be an important determinant of banking important determinant of banking crisis (much more than adequate crisis (much more than adequate capital provisions) (Barth, Caprio and capital provisions) (Barth, Caprio and Levine (2001))Levine (2001))

• Increased skills of examinersIncreased skills of examiners• Shift from generalists to specialists Shift from generalists to specialists

(BCBS, 2004)(BCBS, 2004)1919

Local Banks in T&TLocal Banks in T&T

• Banks would need to improve Banks would need to improve infrastructure for measuring and infrastructure for measuring and monitoring risk – COSTS!!!!monitoring risk – COSTS!!!!

• Foreign-banks within T&T can piggy-Foreign-banks within T&T can piggy-back on parent back on parent

• Where does that leave T&T local Where does that leave T&T local banks?banks?

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Limitations and Areas of Limitations and Areas of Further ResearchFurther Research• Limitations: Limitations:

Lack of data to do QISLack of data to do QISBasel I shortfalls to addressBasel I shortfalls to addressCredit rating assessmentsCredit rating assessmentsRegional workshop to resolve Regional workshop to resolve common issuescommon issues

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The Way Forward for The Way Forward for T&TT&T• Get the Vision combined with preconditions Get the Vision combined with preconditions

rightright• Create detailed and specific gap assessmentsCreate detailed and specific gap assessments• Produce detailed plans to address gaps with Produce detailed plans to address gaps with

sufficient lead timessufficient lead times• Establish a process to oversee and deploy Establish a process to oversee and deploy

Basel II implementationBasel II implementation• There is no substitute for extreme vigilance There is no substitute for extreme vigilance

on the part of regulatorson the part of regulators

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Selected ReferencesSelected References

• Francesco Cannata and Mario Quagliariello (2009) Francesco Cannata and Mario Quagliariello (2009) ““The role of Basel II in the subprime financial The role of Basel II in the subprime financial crisis: guilty or not guiltycrisis: guilty or not guilty?”, ?”, CAREFIN Working CAREFIN Working paper 3/09paper 3/09..

• Wray, Randall can Basel II enhance financial Wray, Randall can Basel II enhance financial stability? A Pessimistic View”, Working paper 84, stability? A Pessimistic View”, Working paper 84, Jerome Levy Institute.Jerome Levy Institute.

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Thank You and enjoy the Thank You and enjoy the rest of the show!!!rest of the show!!!

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