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Top1. Introduction
The global financial crisis of 2008 had its origins in the interaction of an asset price bubble with complex financial derivative instruments that masked the inherent risks (Baily, Litan & Johnson, 2008). This asset price bubble was fuelled by years of unabated lending without commensurate deliberation of ensuing risks. The crisis finally capitulated, resulting in a near frozen credit market globally. The initial crisis in the financial markets then percolated to the real economy and ultimately manifested itself through the sovereign insolvency of European peripheral countries (2010 through 2012). This whole episode became a harbinger of an emergent distrust in the accuracy and efficacy of Credit Ratings and the existing Regulatory Capital Directives. (Sorkin, 2010)
At the time when the financial crisis erupted, central banks globally had just begun with the phased implementation of Basel II regulatory capital accord that was finalised by the BCBS under the aegis of BIS in 2006. The Basel II accord was conceptualised as an improvement to the then existing Basel I accord. It was expected to be more effective in forewarning and to a certain extent in preventing any impending economic crisis, by ensuring the soundness of the global banking system (BCBS, 2006). But on the contrary, the magnitude of the financial crisis, forced the market perception of Basel II to be viewed as “inadequate” in dealing with the critical issues brought to the fore during the unravelling of this financial meltdown.
While Basel II was being perceived to have many short comings, however regulatory capital requirement was still considered to be the main pillar of banking sector regulation. Maintaining optimum capital adequacy greatly reduces the probability and severity of financial crisis. But the determination of this Optimum level of capital, if left entirely to the individual banks, may result in inadequate level of capital being maintained in the banking system. Thus, there was a consensus on prescribing minimum regulatory capital standards. These earlier stipulated regulatory capital requirements were to a large degree static, and thus were well suited to address the more permanent systemic risk. However, even before the financial crisis unfolded, there was a lot of deliberation on whether it may be desirable to have capital requirements that vary over time, in proportion to the perceived level of systemic risk, that were known to vary over time and also deal with pro-cyclicality.
In order to address the perceived shortcomings of the Basel II accord, BCBS in 2010, came out with further enhancements in the Basel framework, which came to be known as Basel III accord. The 3 pillars as envisaged in Basel II were carried forward into Basel III along with enhanced level and quality of capital, enhanced capital for trading book, introduction of leverage ratio and the liquidity framework. In the run up to Basel III, in December 2009, the BCBS also published a consultative document that considered a series of measures to address pro-cyclicality (BCBS, 2009), with the following four key objectives:
- 1.
Remove or reduce excess cyclicality of Basel capital requirements.
- 2.
Endorse provisions that are forward looking and hence useful.
- 3.
Preserve bank capital during periods of excess and release buffers during stress.
- 4.
Shielding overall banking system from the vagaries of credit cycles.
The third and the fourth objectives gave rise to the Capital Conservation Buffer (CCB) and Counter Cyclical Capital Buffer (CCCB) which are now an integral part of the Basel III regulatory framework.
The BCBS proposal stressed on identifying a macro-economic variable or group of variables, which may be used to assess the level of systemic risk in a given jurisdiction, owing to excessive growth of credit. They proposed, that for each jurisdiction, when the identified variable would breach certain predefined thresholds, the additional buffer requirements could be activated. One of the variables being considered for this purpose was Credit-to GDP gap (difference between the aggregate credit-to-GDP ratio and its long term trend). But, the BCBS also emphasised that this proposal could not be implemented as a strict rules-based regime, unless there was very high degree of confidence that the variable under observation would not generate false signals under any circumstances. This level of confidence did not seem to be possible.