Lester Henry and Michelle Majid

1. Financial Crisis and the Implementation of Basel II: Potential Economic Impact for Trinidad and Tobago Lester Henry and Michelle Majid

2. Roadmap of the Paper • Introduction • Overview of Basel I & II • Financial Crisis and Basel II: Are they linked? • The TnT Financial System • Some issues of concern to T&T • The way Forward for T&T • Summary and Conclusion

3. Introduction • Financial Crisis partly seen as regulatory failure. • Basel I and Basel II were supposed to prevent such • Many Caribbean Countries were expected to adopt Basel II over the next few years (from 1 or 2 in 2007 to 4-6 between 2010 – 2015) • Examine Basel II’s role in the crisis • Identify issues arising from possible adopting Basel II • determine the extent to which Basel II may impact T&T and by extension the region • Inform policymakers whether focus should be on getting Basel I right or introducing Basel II or not adopting any at all.

4. Regulatory capital Risk-weighted assets 8% ≥ Pillar 1: Minimum capital requirements Risk-weighted Assets (Denominator) Definition of Capital (Numerator) Credit Risk (1988) Market Risk (1996) Standardized Approach Models Approach Overview of Basel I Basel I

5. Shortcomings of Basel I • Capital required did not mirror a bank’s true risk profile • Too simple for advanced banks • Inflexible against new developments • Covers only credit and market risks • Only quantitative in nature • Limited recognition of collateral

6. Pillar 1 Pillar 2 Pillar 3 Basel II in a Nutshell Basel II

7. Objectives of Basel II • Greater emphasis on banks’ own assessment of risk • Comprehensive framework for credit, market and operational risk • Encourages rigorous bank supervision • Ensures market transparency, disclosure • More risk sensitive; better align regulatory capital with actual risk exposure

8. Basel II and the Financial Crisis • I. the average level of capital required by the new discipline is inadequate and this is one of the reasons of the recent collapse of many banks; • II. the new Capital Accord, interacting with fair-value accounting, has caused remarkable losses in the portfolios of intermediaries; • III. capital requirements based on the Basel II regulations are cyclical and therefore tend to reinforce business cycle fluctuations; • IV. in the Basel II framework, the assessment of credit risk is delegated to non-banking institutions, such as rating agencies, subject to possible conflicts of interest;

9. Basel II and the Financial Crisis….continued • V. the key assumption that banks’ internal models for measuring risk exposures are superior than any other has proved wrong; • VI. the new Framework provides incentives to intermediaries to deconsolidate from their balance-sheets some very risky exposures Source: Francesco Cannata Mario Quagliariello (2009)

10. In Defense of Basel II • Only recently implemented • In US only applies to top tier banks operating internationally -- most of system is exempted • Pillar II and Pillar II have been given very little attention, a careful application would involve; • Remuneration packages in investment banking and of management boards; • Transparency of a bank's risk profile; • Management's true understanding of both the bank's risk profile and its risk positions. • source Van Kemper, Cris (2009)

11. Can Basel X work? A Minskyian alternative View • Can help in some cases but ultimately limited in preventing crises • Sources of instability are “built-in” to the system • During expansions managers competence will be questioned if they don’t go after higher returns • In normal times the “three-six-three” rule applies • During Busts credit supply dries up regardless of any stimulus policy

12. Snapshot of TnT Financial System:Asset Growth • Eight commercial banks and 19 NBFIs

13. Snapshot of the Financial System:Capital Adequacy

14. Snapshot of the Financial System:Asset Quality

15. FSAP (2005): T&T’s deficiencies • Inadequate financial sector laws • High-levels of connected exposures across banking and insurance companies • BCP Non Compliance with Market Risk, Large and related exposure limits • 0% risk weighting all sovereign debt

16. Some Areas of Concern • Credit Risk Assessments • Macroeconomic Issues • Capital Requirements • Distortion of allocation of credit • Interbank Lending • Regulators in emerging economies • Home-host Issues • Local Banks in T&T • BCP Compliance

17. Credit Risk Assessments • Shallow credit rating market (reduced to flat rate) • Rating linked to level and volatility of capital flows • Prohibitive cost and incentive to become rated • Who will rate the rating agency? • Potential pro-cyclicality and circularity (Powell, 2002)

18. Macroeconomic Issues • Three factors indicate that tighter regulatory capital requirements are likely to cause a domestic credit crunch: * economies are shallow * banking sector concentrated * presence of government in the real economy

19. Regulators • Deficient regulators can be an important determinant of banking crisis (much more than adequate capital provisions) (Barth, Caprio and Levine (2001)) • Increased skills of examiners • Shift from generalists to specialists (BCBS, 2004)

20. Local Banks in T&T • Banks would need to improve infrastructure for measuring and monitoring risk – COSTS!!!! • Foreign-banks within T&T can piggy-back on parent • Where does that leave T&T local banks?

21. Limitations and Areas of Further Research • Limitations: Lack of data to do QIS Basel I shortfalls to address Credit rating assessments Regional workshop to resolve common issues

22. The Way Forward for T&T • Get the Vision combined with preconditions right • Create detailed and specific gap assessments • Produce detailed plans to address gaps with sufficient lead times • Establish a process to oversee and deploy Basel II implementation • There is no substitute for extreme vigilance on the part of regulators

23. Selected References • Francesco Cannata and Mario Quagliariello (2009) “The role of Basel II in the subprime financial crisis: guilty or not guilty?”, CAREFIN Working paper 3/09. • Wray, Randall can Basel II enhance financial stability? A Pessimistic View”, Working paper 84, Jerome Levy Institute.

24. Thank You and enjoy the rest of the show!!!