Shock losses at some of the world's biggest banks have left some people asking whether new global bank risk rules have failed their first test of fire.
The new rules, known as Basel II, prescribe a complex series of risk and safety measures to cushion big banks from a surprise blow-up that could strain or even shut down the international financial system, and many banks have already implemented them ahead of their official launch.
So as big banks line up to reveal massive losses on risky investments, critics are asking aloud whether the Basel accord rewrite -- the biggest change to global banking rules in a generation -- has failed before it has started.
Questions are being raised whether Basel II is out of touch with the markets, said analyst Luis Maglanoc at bank UniCredit in a recent note.
Banks have been preparing for its implementation for years. Yet it appears that the Basel II framework has been limping behind the innovative power of the structured credit markets.
Critics, for example, charge that Basel II allows lower risk charges for some packaged assets -- such as asset- or mortgage-backed securities -- than for the same assets unpackaged.
Bundling assets smoothes irregularities and creates instruments with predictable behavior where risky elements are stripped out and quality elements remain to win lofty ratings from credit agencies.
But as the collapse in the subprime market has shown, packaged securities are worth no more than the assets within them, which means banks took wild bets on niche markets thinking they had been tamed through securitization.
Garbage does not become gold just because it is wrapped nicely, says Maglanoc.
The rules are meant to take effect in Europe next year and in the United States one year later, but already banks have largely implemented the rules in practice.
Defenders of the new accord say it has made banks more risk-aware and spread best practices throughout the industry. Whereas Basel I was the automotive equivalent of installing sturdy bumpers, Basel II prescribes additional airbags, speed controls and dashboard lights.
Without the Basel II deadlines looming, big banks would likely have been on a weaker footing during the current crisis, which has seen many systemically critical institutions rattled but none so far approach failure, defenders say.
However, one source with knowledge of the workings of the Basel Committee on Banking Supervision -- the global standard-setter for financial regulators -- points to a veritable laundry list of items that need scrutiny in the wake of the crisis:
* Aggregate exposure: measuring not just credit exposure but exposure through business lines, off balance sheet vehicles, reputational risks, or knock-on exposure stemming from associated activities;
* Stress testing: theoretical models designed to predict asset behavior in dire circumstances will need revision using real world data derived from the current crisis;
* Market dynamics: markets dried up during the crisis, making valuations of many assets practically impossible. Globalization means defaults in a minor U.S. housing sector have sent shockwaves worldwide;
* Prominence of ratings agencies: Moody's and Standard & Poor's are elevated to a quasi-official status under Basel II, yet the agencies are under fire for not offering sharper warnings earlier;
* Transparency: Basel II forces banks to report details of their credit exposure. This measure is likely to be reinforced in the wake of the crisis;
* Banks' internal credit ratings: These receive newfound importance under the new accord and are also likely to come under renewed scrutiny after regulators have already spent years backtesting banks' own risk measures.