involved when engaged with “businesses and structured
credit products.”57 The fact that banks “did not adhere
to the fundamental tenets of sound financial judgement
and prudent risk management” was also Iiighliglited.58
Greater efforts have been undertaken to involve
market participants by encouraging them to assess a
bank’s risk profile. Such proactive efforts are more desir-
able than “allowing markets to evolve and decide.”59 As
identified by the Basel Committee, “improvements in
risk Iiianagenient must evolve to keep pace with rapid
financial innovation.60 Furthermore, it states that** this is
particularly relevant for participants in evolving and rap-
idly growing businesses.61 Innovation has increased the
complexity-’ and potential illiquidity of structured credit
products—which in turn, could make such products
not only more difficult to value and hedge, but also lead
to inadvertent increases in overall risk.”62 “Further, the
increased growth of complex investor specific products
may result in thin markets that are illiquid—which could
expose a bank to large losses in times of stress, if the asso-
ciated risks are not well understood and managed in a
timely and effective manner. Stress tests have been iden-
tified as means whereby investors’ uncertainty about the
quality of bank balance sheets, could be eliminated.65
The Committee’s acknowledgement of negative
incentives arising from the use of external ratings to
determine regulatory capital requirements and proposals
to mitigate these incentives 64 is well—founded—how-
ever, regulators will also be able to manage, with greater
ability, systemic risks to the financial system during
such periods when firms which are highly leveraged
become reluctant to lend where more market partici-
pants such as credit rating agencies, could be engaged
in the supervisory process.65 The Annex to Pro cycli-
cality in the Accompanying Document amending the
Capital Requirements Directive66 not only importantly
emphasises the fact that regulatory capital requirements
do not constitute the sole determinants of how much
capital banks should hold, but also highlights the role of
credit rating agencies in compelling banks to increase
their capital levels even where such institution may be
complying with regulatory requirements.
Further as rightly acknowledged by the Committee,
“recent experience has shown that banks’ internal
credit models have not performed well. Permitting
banks to use their own internal models to estimate the
capital requirements for securitisation exposures could
increase pressure to permit the use of such models in
Basel II more broadly.Thus, while there have been con-
cerns expressed about the use of external ratings under
the Basel II framework, including that reliance on
external ratings could undermine incentives to conduct
independent internal assessments of the credit qual-
ity of exposures, the removal of external ratings from
the Basel II framework could raise additional issues for
determining regulatory capital requirements/*67
C. Conclusion
As well as the inability’ of bank capital adequacy
requirements, on their own, to address funding and
liquidity’ problems, the need for greater focus on Pillar
3 of Basel II, namely, market discipline, and growing
justification for greater measures aimed at extending
capital rules to the securities markets, are factors which
are becoming more apparent.
Even though markets should be allowed to evolve,
checks and controls should exist to ensure that such
market activities are effectively managed and con-
trolled. Management information systems (MIS) and
banks’ credit risk models should be flexible (and not
overly sensitive) in order to adapt to the evolving mar-
ket whilst providing for some element of control. The
Basel Committee furthermore, acknowledges the role
assumed by management information systems and risk
management processes in assisting the bank ‘‘to identify
and aggregate similar risk exposures across the firm,
including legal entities, and asset types (eg loans, deriva-
tives and structured products).”68
The operation of risk mitigants in bank institu-
tions does not justify a reduction in the capital levels
to be retained by such banks—since banks operating
with risk mitigants could still be considered inefficient
operators of their management information systems
(MIS), internal control systems, and risk management
processes. The fact that banks possess risk mitigants
does not necessarily imply that they are complying
with Basel Core Principles for effective supervision
(particularly Core Principles 7 and 17). Core Principle
7 not only stipulates that “banks and banking groups
satisfy supervisory requirements of a comprehensive
management process, ensure that this identifies, evalu-
ates, monitors and controls or mitigates all material risks
and assesses their overall capital adequacy in relation to
32 ∙ banking & Financial Services Policy Report
Volume 30 ∙ Number 9 ∙ September 2011