Saturday, March 1, 2008

Time to remove Basel II?

Most service management professionals hold up Basel II as an example in the financial sector of a specialized framework designed to ensure clean and open governance.

However, it may be time to take Basel II off the powerpoint. A recent report in the Financial Times (Feb 28, 2008) explained in simple terms that Basel II may be the cause of recent financial turmoil.

Financial institutions (banks and other lending bodies) take risks. The simple fact is that when you give money to someone, there is a part of you that expects you won't get it back!

In a financial sense the amount of risk you're prepared to take will determine how much you will lend someone and then how much you will want them to pay (the interes rate). These decisions are reached through the application of risk models.

When you are a large bank you will have stricter regulations imposed upon you, even to the point where a "regulator" (Government or government appointed watchdog) will tell you what type of risk model you should be using.

Under the Basel I this system worked, but then large banks and financial institutions started to develop sophisticated risk models that were seen as superior to the ones they had to use.

So under Basel II regulators gave the green light for these organizations to start to use their own models. The problem begins here.

The risk models are used to calculate how much money should be held in reserve in case there is a major issue with the people who have been lent money. This is a protection mechanism for shareholders.

However, banks do not want to hold a lot of money in reserve - idle cash returns no profits. So these large banks - using their own models, and under the rules allowed by Basel II started to lend out more and more. They also lent the money to people who may not have qualified under the Basel I model - the subprime market.

The banks all made fundamental errors in judgement - they were optimistic about peoples ability to repay.

They got it wrong!

The moral of the story - "beware of good ideas that encourage unwanted behaviors!"

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