more aligned with economic and regulatory capital. As
acknowledged by the Basel Committee, „certain incen-
tives which assume the form of capital reductions are
considered to impose minimum operational standards
in recognition that poor management of operational
risks (including legal risks) could render such risk ɪiuti-
gants of effectively little or no value and that although
partial mitigation is rewarded, banks will be required
to hold capital against residual risks”. Hence incentives
should also adequately account for situations where
poor management systems may operate in institutions
which are supposed to have risk mitigants.
As well as drawing attention to the fact that capital
buffers may not actually mitigate the cyclical effects of
bank regulation,40 regulators are also advised to give
due consideration to the effects of risk weights on bank
portfolio behaviour when implementing regulations.
As its fifth proposal, a global minimum liquid-
ity standard for Internationallv active banks is to be
introduced by the Committee. This will include a
30 day liquidity coverage ratio requirement which is
underpinned by a longer term structural liquidity ratio.
The framework will also incorporate a common set of
monitoring metrics to assist supervisors in their analy-
sis and identification of risk trends, both at the bank
and system wide level. Such standards and monitoring
metrics will serve to supplement the Basel Committee’s
Principles for Sound Liquidity Risk Management and
Supervision.
///. Other points highlighted by the Committee
The review of the need for additional capital,
liquidity or other supervisory' measures aimed at reduc-
ing externalities generated by systemically important
institutions.
Recognition that severity of the economic and
financial crisis is attributed to the fact that exces-
sive on- and off-balance sheet leverage had been
accumulated by banking sectors of many countries
whilst many banks were retaining insufficient liquid-
ity butlers. Consequences resulting from this include
the inability of the banking system to absorb the
resulting systemic trading and credit losses . Further,
the banking system was unable to manage the “re
intermediation” of large off balance exposures which
had accumulated.
Aggravation of the crisis owing to pro cyclical effects
and the interconnectedness of systemic institutions—
such interconnectedness being triggered by a range of
complex transactions.
Systemic risks and the central role assumed by banks
in relation to liquidity serves as greater
justification for regulation with respect to banks.
"The fundamental role of banks in the maturity trans-
formation of short-term deposits into long-term loans
makes banks inherently vulnerable to liquidity risk,
both of an institution-specific nature and that which
affects markets as a whole.”41
In relation to the securities markets, information
asymmetry appears to constitute a greater basis for
regulation. However, the existence of information
asymmetry’ within the banking42sector has the poten-
tial to generate systemic effects within the banking
sector—consequences whose effects, it could be said,
could have greater repercussions than if such were to
originate from within the securities markets.
The link between liquidity and systemic risks as
illustrated in the ECBs Financial Stability Review, is
attributed to the “destruction of specific knowledge43
which banks have about their borrowers and the
reduction of the common pool of liquidity.”44 The
importance of the link between liquidity risks and
systemic risks within the banking sector is highlighted
by the consequences attributed to the reluctance of
banks to retain liquidity—given the cost of holding
liquidity.45 The consequential shortfalls of liquid-
ity as reflected by on and off balance sheet maturity
mismatches accentuates the importance of the role
assumed by central banks in the funding of bank bal-
ance sheets.46
I. Mitigating the Procydical Effects of Basel Il
According to a report,47 the two principal solutions
which have been endorsed by the Turner Review and
the DeLarosiere Report, and which are considered
to have the potential to reduce pro cyclical effects48
induced by the CRD and Basel II, include: 1) The
requirement that banks "hold bigger reserves during
good times—hence limiting credit and risk expan-
sion in good times and storing up capital to be used
during bad times” (2) “Increasing risk-weighting on a
30 ∙ bonking & Financial Services Policy Report
Volume 30 ∙ Number 9 ∙ SeptemberlOII