232 PA R T I I I GLOBAL Financial Institutions Basel 2: How Well Will It Work? Starting in June 1999, the Basel Committee on Banking Supervision released several proposals to reform the original 1988 Basel Accord These efforts have culminated in what bank supervisors refer to as Basel 2, which is based on three pillars: Pillar links capital requirements for large, internationally active banks more closely to three types of actual risk: market risk, credit risk, and operational risk It does so by specifying many more categories of assets with different risk weights in its standardized approach Alternatively, it allows sophisticated banks to pursue an internal ratings-based approach that permits banks to use their own models of credit risk Pillar focuses on strengthening the supervisory process, particularly in assessing the quality of risk management in financial institutions and evaluating whether these institutions have adequate procedures to determine how much capital they need Pillar focuses on improving market discipline through increased disclosure of details about banks credit exposures, amounts of reserves and capital, officials who control the banks, and the effectiveness of their internal rating systems Although Basel makes great strides toward limiting excessive risk taking by internationally active financial institutions, it greatly increases the complexity of the accord The document describing the original Basel Accord was 26 pages, while the final draft of Basel exceeded 500 pages The original timetable called for the completion of the final round of consultation by the end of 2001, with the new rules taking effect by 2004 However, criticism from banks, trade associations, and national regulators led to several postponements The final draft was not published until June 2004 and Basel started to be implemented at the end of 2007 by the Big Six internationally active banks in Canada, and at the beginning of 2008 by European banks American banks submitted plans for compliance with Basel in 2008, but full implementation did not occur until 2009 Only the dozen or so largest U.S banks are subject to Basel 2: all others will be allowed to use a simplified version of the standards it imposes There are several serious criticisms of Basel that cast doubts on how well it will work First, its complexity could make it unworkable Second, risk weights in the standardized approach are heavily reliant on credit ratings Since these credit ratings have proved to be very unreliable on subprime mortgage products during the recent financial crisis, there are serious doubts that the standardized approach will produce reliable risk weights Third, Basel is very procyclical That is, it demands that banks hold less capital when times are good, but more when times are bad, thereby exacerbating credit cycles Because the probability of default and expected losses for different classes of assets rises during bad times, Basel may require more capital at exactly the time when capital is most short This has been a particularly serious concern in the aftermath of the subprime financial crisis As a result of this crisis, banks capital balances eroded, leading to a cutback on lending that was a big drag on the economy Basel may make such cutbacks in lending even worse, doing even more harm to an economy