BASEL II—WHAT REGULATORS DIDN’T FORESEE.

BASEL II–WHAT REGULATORS DIDN’T FORESEE. I have posted on the remarkably small percentage of liquid reserves that financial institutions were maintaining before the current crisis. But those institutions were not the only ones that did not foresee the risks. The Lex column in the Financial Times for November 14 points out that under the Basel II accord, “even when playing within the rules, the most conservative banks still became ridiculously geared. Under the most basic version of Basel II, triple A corporate bonds have a 25 per cent risk weighting. That means banks can theoretically ramp up their exposure to this asset class by 50-fold and still not breach the required capital ratio of 8 per cent.” Basel II was adopted (and is still in the process of being implemented), as this Economist article points out, “[u]nder the auspices of the Bank for International Settlements (BIS), a central bankers’ central bank in Basel, in Switzerland.” In other words, top thinkers from all the world central banks were involved in formulating Basel II. The Economist article concludes that “[The chief failing of Basel II] is its reliance on rating agencies and the banks’ own models of the risks that they are carrying—an idea that has been discredited by the way banks have been caught out.” What happened with this latest regulatory reform should make us cautious about formulating sweeping new regulations going forward.