FINANCE: Basel II Notes and Thoughts

From RISK Net article:

One of those ideas would be to detach capital requirements from risk levels. Because risk is lowest at the peak of a business cycle, regulatory capital under Basel II should also be low, meaning there would be little constraint on a bank's ability to pile on risk - potentially exacerbating the pain of the next downturn, say critics. Conversely, at the market's nadir, risk would appear to be high, and capital requirements would also be high - biting into the industry's ability to lend and prolonging the slump. In short, the rules are seen as being pro-cyclical.
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The devil, of course, is in the detail - and Oliver Wyman's Kuritzkes says there is precious little detail: "There's a lot of easy talk about through-the-cycle PDs but, to my knowledge, no one has come up with a rigorous way to evaluate these dynamic time effects." There is also a trade-off to be made, he says. One of Basel II's main aims was to curb regulatory capital arbitrage, in which banks took advantage of the old regime's insensitivity by retaining more risk (and its associated higher returns) without having to hold an appropriate level of capital. Tying capital more closely to the underlying risk of an asset was supposed to curb this behaviour - but a through-the-cycle approach would again open the possibility that risk levels at certain points in time could become decoupled from capital requirements.
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The current credit crisis has come close to making disintermediation a dirty word - short-hand for the process through which exposure to US subprime mortgage loans was originated by banks but ended up distributed around the financial system, spooking investors and causing global panic. "It's bound to cause the originate-to-distribute model to be queried," says Charles Goodhart, director of the regulation and financial stability programme at the London School of Economics (LSE), and a former member of the Bank of England's rate-setting committee.

But this is a tricky issue. Although there is widespread acceptance that banks have embraced the originate-to-distribute model, not everyone thinks that is the same thing as disintermediation - while risk was distributed, much of it remained within the banking industry, they argue. And there is also little agreement on the extent to which the Basel Accord is to blame.