A credit rating tells the lender or investor the probability of a subject being able to pay back the loan. In the U.S the ratings are widespread, 94% of the S&P 500 are rated, so this approach are thought to improve capital allocation.In Europe, only 53% of DAX-30 firms obtained a credit rating.Therefore credit ratings definitely will not work in this setting. Moreover, firms of lower credit ratings such as BB- and below, require 150% for the risk weight whereas unrated firms only incur a 100% risk weight. This creates an incentive for firms who believes they will achieve a lower credit rating to remain unrated in order to achieve cheaper financing. Credit rating agency has been subjected to many criticisms themselves. One of the most important criticisms which partly led to the financial crisis is the errors in their method for rating structured products, particularly in assigning AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted.Many argued that it is because rating complex structured products is very difficult. However,if it is just difficult there should be a balance of overrated and underrated structured products. There had been persistent bias which shows the rating seems to systematically over-estimate the creditworthiness of the rated instrument. One of the reasons that SEC found out in their 10 month investigation is because of conflict of interest as they were paid by investment banks and other firms that organize and sell structured securities to investors. This has cause problems for financial institiutions as shown in financial crisis when ratings dramatically fall from AAA to below investment grade during the subprime crisis. Under Basel II, banks who initially only required capital allocation of only 0.6% due to an AAA rated securitization now requires 52% capital allocation as it downgrades to BB- rated securitization. Financial institiutions who did not hold enough money in reserves to safeguard themselves from downgrades would have to be bailed out by governments. Credit agencies do not downgrade the companies promptly enough. For example, Enron's rating remained at investment grade four days before the company went bankrupt, despite the fact that credit rating agencies had been aware of the company's problems for months. This lag can be explained by the agencies reliance on accounting data, their inability to monitor all issuers continuously and their willingness to change only when they know the decision on the issuer will not change in the near future.However to forecast risk under Basel II, banking supervisors should not use past months ratings to rate their own credit risk as it will be inaccurate. Therefore credit rating agencies had to improve by constantly updating their rating system and improve their credibility before being able to be used to evaluate credit risk for firms effectively.
Value at Risk measurement inapprorpriate to measure market risk Basel II requires financial institutions to use the 10 day VaR at 99% confidence interval as a risk metric to measure market risk. VaR is communicated as the maximum loss of a particular portfolio at a particular point (confidence interval) in an underlying asset returnsâÃ¢â€šÂ¬Ã¢â€žÂ¢ distribution, over a given timeframe (the holding period).Since it is only measured to 99% confidence interval, losses beyond the region will not be accounted for in the minimum capital requirement.. Our group believes bank shareholders and managers uses this measurement as they do not bear losses above and beyond bankâÃ¢â€šÂ¬Ã¢â€žÂ¢s capital. However this is not appropriate for bank regulators, as the losses in excess are funded by public authorities. Critics believe not incorporating the tail VaR destabilizes the economy and induced the crashes in the financial system . However we feels that if tail VaR is accounted for, the capital requirement for the banks will be too large and this will slow down the economy as investments will decrease.
Ineffective implementation of own risk models Under the Basel II framework, regulators allow large banks with sophisticated risk management systems to do risk assessment based on their own models to determine the minimum amount of regulatory capital. This is allowed because Basel II regulators believe own bank supervisors know their bank best. However the recent financial crisis proves otherwise. The need of recapitalization reveals that the internal risk models of many banks performed poorly and greatly under-estimated risk exposure, forcing banks to reassess and reprice their credit risk. This happens because there are no independent measures to assess the bank risk model. The banks could do what they thing is reasonable and it would be hard for anyone to fault them. By underestimating risk exposure, it allows the bank to increase their lending limits and thus earn more revenue for the company. However, we have to take note that mathematical models have limited predictive power in finance and the difficulties in accounting for low probability but high losses events.
Procyclical Basel II is being criticized of being procyclical. During the boom times, credit ratings will be better as their probability of default is lower. This allows the bank to have lower capital requirements under Basel II thus even the badly managed banks with inadequate capital and provisions initially can expand their business, resulting in overlending . However during the bad times, banks require a higher capital requirement as the credit ratings dropped due to increased risk. Difficulties in raising new capital further add on to their capital constraints during downturns. This causes institutions to reduce credit to firms and households and thus forced to cut lending when it is most needed. Faced with higher interest rates and lack of alternative sources of finance, firms will cutback on investment spending thereby aggravating the downturn. This is evident during the global economic recession whereby international trade has been severely affected, with trade volumes actually contracting by about 12% in 2009.This is associated due to the massive decline in trade financing . Inconsistency in implementation of Basel II Basel II is being applied inconsistently around the world, and even within individual markets, leading to very different risk weights and capital charges for identical assets. Basel II is too accommodating on certain risk categories, especially trading risk and sub-prime mortgage. It fails to recognize that the enforcement of a common approach to risk management enhances the homogeneity of the behavior of market participants and hence exacerbates financial crisis.