The current credit crisis threatens to undermine the three pillars of Basel II, with serious implications for those charged with compliance.

Basel II’s intent is to “ensure capital allocation is more risk-sensitive; separate operational risk from credit risk and quantify both; and align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.” Its effectiveness relies on three pillars: minimum capital requirements that address market, credit and operational risk; supervisory review; and market discipline.

Advocates of Basel II contend that it enables bank regulators to protect the international financial system from systemic risk due to the collapse of a major bank or banks. At the time of Basel II’s approval by the Fed in November 2007, Richard Spillenkothen, director in charge of Deloitte & Touche’s Financial Services Regulatory and Capital Markets Consulting practice, said: “Basel II establishes a more risk-sensitive, sophisticated and complex framework for calculating regulatory capital requirements, with important ramifications for risk management and measurement.”

Given market conditions, the first two pillars have proved woefully inadequate, but it may well be the third pillar, market discipline, that will undermine the effectiveness of Basel II’s principles-based framework. It is unclear whether an adjustment to banks’ risk-based capital requirements will help avert future crises—indeed, it may enable them—because institutions have too much discretion in determining what constitutes Tier 1 capital. FDIC chair Sheila Barr has said the Basel II framework was tantamount to “letting banks set their own capital requirements.”

Another problem: commercial banks answer to the Federal Reserve, while investment banks are subject to Securities and Exchange Commission oversight, opening debate over uniform interpretation of Basel II. This tension was recently evidenced by JPMorgan Chase CEO Jamie Dimon’s criticism of reported Tier 1 ratios by investment banks.

As the writedowns mount and the threat of more bank collapses looms large, Basel II detractors may be winning the argument, with investors in full agreement. Therein lies the issue: If investors have lost faith in the rule set to guard against such crises, then something has to change.

However, Boston College finance professor Edward J. Kane says “regulation-induced innovation” doesn’t work. “People being regulated are like termites. They go away from the poison and go after the wood. They’re intelligent,” he said at a recent financial risk roundtable hosted by Wharton and the Oliver Wyman Institute.

Even so, with $400 billion in writedowns globally as of mid-June and an expectation that the credit crisis tally could eventually hit $1.2 trillion by Goldman Sachs’ estimate, it’s obvious that what industry players can’t measure, they can’t manage. (c) 2008 Bank Technology News and SourceMedia, Inc. All Rights Reserved.

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