Self-delusion in Basel II

The Second Basel Accord was put in place to more effectively prevent bank failures. The first one imposed some rather rigid rules that where not taking into account the true risk exposure of the banks, which obviously varies according to the particular activities of the bank and overall economic conditions. Basel II is more flexible in that it allows banks to used their risk models and scenarios to determine how much capital they need to secure. The goal is to have sufficient capital in 99.9% of cases of unexpected losses, or a failure once every 1000 years. That is pretty safe.

Except it is not. The first exhibit is of course what happened during the last recession. The second is a paper by Ilkka Kiema and Esa Jokivuolle that shows that in fact only a fraction of the regulatory capital needs to be loss absorbing capital. Indeed, half can be subordinated debt and thus not available when needed. According to the authors, this means that the true risk of bank failure is every 20 to 100 years. Not very reassuring, and Basel III does not seem to really address this.