Thursday, 20 September 2007

Stepping back from Basel

It will be very interesting to see how bank supervisors react to the current credit crunch in the longer term. We are less than a year into the new Basel 2 Capital Accord, and already it looks flawed in a number of areas. This is hinted at in the FT today. At very least in the UK we will see a revision of the deposit protection regime. But (admittedly in the heat of the battle and without mature reflection) Basel 2 looks vulnerable too, especially in the areas of credit risk mitigation and the treatment of off balance sheet vehicles.

A related issue is the procyclicality of Basel. This has been around for a while in the context of VAR models (asset prices go down, vols go up, so VAR goes up, pushing banks over their risk limits and hence causing asset sales which further depress prices), but Basel 2 extends this to the banking book via bank's PD estimates in IRB models. The problem is, risk sensitivity goes hand in hand with procyclicality. It will be interesting to see if the supervisors can bring themselves to make Basel 2 less risk sensitive.

Here's a view towards Canary Wharf from the City of London.

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