An Academic Response to Basel II
By

Jón Daníelsson, Paul Embrechts,
Charles Goodhart, Con Keating, Felix Muennich,
Olivier Renault and Hyun Song Shin

SPECIAL PAPER NO 130

LSE Financial Markets Group an ESRC Research Centre

Special Paper Series
May 2001
ISSN 1359-9151-130

Submitted* in Response to the Basel Committee for Banking
Supervision’s Request for Comments

by

Dr. Jón Daníelsson (LSE/FMG)+
Prof. Paul Embrechts (ETHZ)
Prof. Charles Goodhart (LSE/FMG)
Con Keating (Finance Development Centre)
Felix Muennich (LSE/FMG)
Dr. Olivier Renault (LSE/FMG)
Prof. Hyun Song Shin (LSE/FMG/CEP)

May 31, 2001

*

The views expressed in this response do not necessarily reflect those of any of the wider groups with which the authors are associated and are in each case personal views. This document is not to be circulated or quoted without permission.
+
Corresponding Author: Jón Daníelsson, London School of Economics, London WC2A 2AE, UK; Tel.
+44-207-955-6056; e-mail: j.danielsson@lse.ac.uk; www.riskresearch.org

An Academic Response to Basel II

Executive Summary
It is our view that the Basel Committee for Banking Supervision, in its Basel II proposals, has failed to address many of the key deficiencies of the global financial regulatory system and even created the potential for new sources of instability. In this document we present the following arguments:
• The proposed regulations fail to consider the fact that risk is endogenous.
Value-at-Risk can destabilise an economy and induce crashes when they would not otherwise occur.
• Statistical models used for forecasting risk have been proven to give inconsistent and biased forecasts, notably under-estimating the joint downside risk of different assets. The Basel Committee has chosen poor quality measures of risk when better risk measures are available.
• Heavy reliance on credit rating agencies for the standard approach to credit risk is misguided as they have been shown to provide conflicting and inconsistent forecasts of individual clients' creditworthiness. They are unregulated and the quality of their risk estimates is largely unobservable.
• Operational risk modelling is not possible given current databases and technology even if a meaningful definition of this risk were to be provided by
Basel. No convincing argument for the need of regulation in this area has yet been made.
• Financial regulation is inherently procyclical. Our view is that this set of proposals will, overall, exacerbate this tendency significantly. In so far as the purpose of financial regulation is to reduce the likelihood of systemic crisis, these proposals will actually tend to negate, not promote this useful purpose.

The document highlights our concerns that the failure of the proposals to address the above issues can have destabilising effects and thus harm the global financial system. In particular, there is considerable scope for under-estimation of financial risk, which may lead to complacency on the part of policy makers and insufficient understanding of the likelihood of a systemic crisis. Furthermore, it is unfortunate that the Basel Committee has not considered how financial institutions will react to the new regulations. Of special concern is how the proposed regulations would induce the harmonisation of investment decisions during crises with the consequence of destabilising rather than stabilising the global financial system.
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An Academic Response to Basel II

1. Introduction
We welcome the opportunity to respond to the Basel Committee for Banking
Supervision’s new proposals for changes to the Capital Adequacy Accord of 1988. This response arose out of a conference on the new proposals, organised on Wednesday, May
16th, 2001, by the Financial Markets Group and the Centre for Economic Performance, both of the London School of Economics. Most of the views articulated in this response reflect comments