IIs procyclical effects. Regulators are able to respond
and to manage with greater efficiency, systemic risks to
the financial system during periods when firms which
are highly leveraged become reluctant to lend. This
being particularly the case when such firms decide to
cut back on lending activities, and the decisions of such
firms cannot be justified in situations where such firms’
credit risk models are extremely sensitive—hence the
level of capital being retained is actually much higher
than minimum regulatory Basel capital requirements.29
The European Central Bank’s report on “Credit
Default Swaps and Counter Party Risk” identifies
asymmetrical information as constituting a challenge
for non-dealer market participants since in its view,
price information is currently limited, as dealer prices
are typically set on a bilateral basis and are not available
to non-dealers.30 Furthermore, the Report also identi-
fies the role played by credit default swaps in the recent
financial crises, highlights the contribution of counter
risk management in the collapse of Bear Stearns and
Lehman Brothers, and also the challenges relating to
the management of counter party risk exposures which
arise from Credit Default Swaps (CDSs) and other
(“over the counter”) OTC derivatives.31
Furthermore, the ECB recently highlighted that “no
disclosure requirements currently exist within the IASB
accounting standards with respect to the main counter-
parts for derivative transactions.” It also states that “added
disclosures for large counter parties and those that exceed
certain thresholds would be useful in order to enable
market participants to better assess their counterparty32
risk and the potential for systemic spill over effects.”
The Basel Committee will introduce a leverage
ratio as a supplementary measure to the Basel II risk
based framework with a view to changing to a Pillar 1
treatment based on appropriate review and calibration.
This should help to contain the build up of excessive
leverage in the banking system, introduce additional
safeguards against attempts to “game” the risk based
requirements, and help address model risk. In order to
ensure comparability, the details of the leverage ratio are
to be harmonised internationally.—making full adjust-
ments for residual accounting differences.
The Committee will introduce a series of measures
aimed at promoting the build up of capital buffers
during good times—which could be drawn upon
during periods of stress. A counter cyclical capital
framework will contribute to a more stable banking
system which will help dampen, instead of amplify, eco-
nomic and financial shocks. In addition the Committee
will be promoting a more forward looking provisioning
which is based on expected losses, and which captures
actual losses with greater transparency and which is also
less pro cyclical than the present model (the “incurred
loss” provisioning model).
As was highlighted under the introductory section,
the promotion of financial stability through more risk
sensitive capital requirements, constitutes one of Basel
I Is primary objectives.33 However some problems
identified with Basel II are attributed to pro cyclicality
and to the fact that not all material credit risks in the
trading book are adequately accounted for in the cur-
rent capital requirements.34 The pro cyclical nature of
Basel II has been criticised since “capital requirements
for credit risk as a probability of default of an expo-
sure decreases in the economic upswing and increases
during the downturn”35—hence resulting in capital
requirements which fluctuate over the cycle. Other
identified36 consequential effects include the fact that
fluctuations in such capital requirements may result
in credit institutions raising their capital during peri-
ods when its is costly for them to implement such a
rise—which has the potential of inducing banks to cut
back on their lending. It is concluded that “risk sensi-
tive capital requirements should have pro cyclical effects
principally on undercapitalised banks.”37
According to the Financial Stability Forum (FSF), an
earlier recognition of loan losses, which could have been
facilitated by relevant disclosures about loan loss provi-
sioning, could have reduced pro cyclical effects which
occurred during the recent crisis.38 Not only does the
FSF propose that amendments be made to the Basel II
framework—amendments which are aimed at reducing
banks’ disincentives to increase their level of provisions
for loan losses, it is also of the opinion that measures
aimed at improving market discipline could also help
in reducing procyclicality and diversity.39 Furthermore,
incentives which would encourage banks to retain
Hquidity could be introduced—however , such incen-
tives should be granted whilst striving to comply with
the aims and objectives of Basel—particularly those
aimed at enhancing a regulatory framework which is
Volume 30 ∙ Number 9 ∙ September 2011
Banking & Financial Services Policy Report ∙ 29