Basel II

The contribution of Basel II to the intensification of the Global Financial Crisis Student Name Institution of Affiliation Course Instructor Name Date The contribution of Basel II to the intensification of the Global Financial Crisis Basel II, presented by the Basel Committee on Banking Supervision in 2006, was developed as a comprehensive reform to strengthen the global banking system and simplify the regulatory capital requirement of inherent risks (Cao et al., 2024). However, a number of its core innovations, which were designed to introduce granularity and sensitivity to the regulatory system, gave rise to perverse incentives and structural defects that have increased the scale of the Global Financial Crisis of 2007-2008 substantially. Excessive Use of Internal Risk Models One of the most severe weaknesses of the Basel II model that greatly contributed to the occurrence of the Global Financial Crisis is the fact that it allowed banks to over-rely on their Internal Ratings-Based (IRB) models to calculate the level of capital required. A significant feature of Basel II advanced methodologies was the IRB approach, which was aimed at enabling sophisticated financial institutions to determine the risk weights of their assets to be calculated using their own internal quantitative models, and hence ensure that capital requirements are more precisely defined in the context of their own risk profiles (Basel Committee on Banking Supervision, 2006). Ideally, this was a step in the right direction of regulation that is more risk-sensitive. In reality, however, it left much of the regulation to the banks themselves and posed an inherent conflict of interest. These in-house models were flawed, per se, because they were founded on a small amount of historical data, which failed to include a country-wide slowdown in the housing market, and were based on idealistic assumptions of endless economic expansion (Cao et al., 2024). This rendered them vulnerable to systemic pressure and unable to hold the possibility of large, correlated losses, especially those related to off-balance-sheet exposures. These models failed to materialize as the crisis clearly showed when most of the institutions considered to be well-capitalized according to the Basel II rule-based framework later expe...