The Value-at-Risk Methodology of Basel II and Basel III

This chapter examines the advantages and disadvantages of the risk estimate approach—Value-at-Risk (VaR) which has been extensively embraced by regulators and practitioners in financial markets under the Basel II & III framework as the basis of risk measurement, both for the purpose of ensuring regulatory capital adequacy, and risk management and strategic planning at industry level.

The “Smart” Regulatory Framework

Based on the recognition that neither the command-and-control nor the self-regulation mode based regulation can accommodate the ever growing complexity of the financial market, this chapter argues that a new regulatory regime is needed. This chapter discusses the four theoretical concepts -- governmentality, reflexivity, responsive regulation and ‘smart’ regulation – that anchor a proposed alternative “smart” regulatory framework.

Pre-GFC Bank Behaviour Change and Basel Accords

A most important consequence of de-regulation change has been the transit of banks’ behaviour from acting as financial intermediaries to taking the role as brokers in the structured finance market. The combined effects of financial deregulation, rapid technological change, the evolution of the banking function, and the increasing complexity and diversity of finance activities has left regulatory bodies grappling with the problem of designing appropriate prudential standards. This has been the rationale behind the evolution of capital regulation from the pre-Basel regulation to the 1988 Basel Accord (Basel I); the 1996 Basel I amendment; and then to the new Basel Accord (Basel II). The major thrust of this chapter is to discern the most appropriate and effective regulatory regime for the purposes of achieving financial stability of the system. Accordingly, the occurrence of the recent 2007-2008 financial crisis is raised to offer a preliminary appraisal of the effectiveness of Basel II.

Theories of Financial Regulation

There has been a long-standing debate about the pros and cons of two modes of financial regulation: command and control and self-regulation. These two regulatory modes have been favored by policy-makers and the dominant regulatory theories for decades in developed economies such as US, UK, and Australia. The design of financial regulations, consequently, has oscillated between these two modes during the pre-deregulation and financial deregulation periods in those developed economies. However, a third regulatory approach aimed at maintaining financial stability, which is the vital issue during post-GFC period, is introduced to policy-makers and a broad swath of other constituencies in this chapter.

History of Financial Regulation in Australia, United States, and United Kingdom

The economic hypotheses and policy stances of each of the various economic schools of thought carry over to theories of financial regulation. The empirical cases observed in the US, UK and Australia show the unravelling of financial stability by the see-saw between command-and-control and voluntary forms of self-regulation. This chapter traces the pertinent events with a focus on the regulatory changes during and after the 1980s.

Coherent Risk Measures

This chapter introduces some alternative risk measures to Vale-At-Risk (VaR) calculations: Extreme Value Theory (EVT), Expected Shortfall (ES) and distortion risk measure. It also discusses their more coherent characteristics useful for shoring up the weaknesses of VaR.

Universal Pragmatics and Communicative Action

This chapter introduces Habermas’ Universal Pragmatics and related Theory of Communicative Action as the most suitable philosophical framework through which to view the interview responses presented in the next set of chapters. This chapter is not intended as a detailed exposition of the philosophy, but rather serves to sketch how Habermas’ Universal Pragmatics with Communicative Action Theory provides useful insights for interpreting and understanding the interviewees’ comments.

Potential Issues from Basel II and Basel III

The evaluation of the effectiveness and superiority of Basel II compared to Basel I in the previous chapter foreshadowed a series of problems that arose during Basel II implementation. This chapter explores these issues, including alleged implementation burden due to the complex nature of its underlying risk-assessment methodology and strict data requirements; the possibility of competitive disadvantage deriving from the adoption of the IRB approach; pros and cons of retaining a system of external ratings within Basel II; the problematic nature of securitisation; cross-border supervision issues; and potential problems coming out from pillar two risk requirements.

Superiority of Basel II over Basel I

This chapter explores the presumed superiority of Basel II over Basel I, and assess the effectiveness of Basel II in empirical risk management and prudential supervision practices, as reflected in a series of 15 interviews undertaken with bank risk managers, senior analysts, and supervisors from regulatory authorities in Australia shortly before and after the 2008 global banking crisis. This chapter and the next represent an important contribution, as these experts and professional are charged with the implementation of the Basel framework, and so are well qualified to identify both its strengths and its weaknesses. In addition to providing an insider’s insight into the operation of the Basel II system, the interviews also permit an investigation of the degree of congruency in the approach and views of bank practitioners in one hand, and regulators on the other. The tendencies discovered may be at play also distorting communicative practices in risk management and supervision under the Basel III framework.

The “Smart” Regulatory Features of Basel II and Basel III

This chapter explores the regulatory attributes of Basel II and Basel III. It demonstrates that the frameworks of Basel II and Basel III possess each of the benchmark attributes of the “third-way” regulatory approach to financial regulation. Owing to the demonstrated congruence between Basel II and Basel III and the benchmark attributes, this chapter concludes that Basel II and Basel III can clearly be viewed as an example of ‘smart’ financial regulation in the field of banking prudential control.