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Authored and vetted by Mr. Ambarisha Nanda, Former CGM, United Bank of India
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Global Financial Crisis and Basel III
8.0 OBJECTIVE
Soon after the launching of Basel 2 , the financial world plunged into one of the worst recession in human history . As with every crisis , the Global Financial Crisis ( GFC ) also revealed many weaknesses in contemporary banking practice , risk management systems , and supervisory oversight . In response , the Basel Committee came up with an improved version of the existing regulatory framework . In this chapter , we will cover
i. Causes of the financial crisis
ii. Supervisory and regulatory deficiencies
iii. Basel Committee response
8.1 INTRODUCTION
Financial Crisis
A situation where asset prices fall sharply , institutions face losses , and liquidity dries up across the financial system .
The Global Financial Crisis ( GFC ) refers to the period of extreme stress in global financial markets and banking systems between mid - 2007 and early 2009 During the GFC , a downturn in the US housing market acted as a catalyst for a financial crisis that spread from the United States to the rest of the world through linkages in the global financial system . Many banks worldwide incurred substantial losses and relied on government support to avoid bankruptcy . The S & P 500 lost more than 50% of its value between 2007 and 2009 . Millions of individuals lost their jobs as the major advanced economies experienced their deepest recessions since the Great Depression of the 1930s . Recovery took a significantly longer time . It is worthwhile
to examine the factors that led to the financial crisis and the lessons we can glean from them Below , we briefly mention some of these factors
8.2 CAUSED OF GLOBAL FINANCIAL CRISIS
In the following table we have summarised the main causes that contributed to the Global Financial Crisis ( 2007-2009 )
Cause
i Excessive Risk - Taking in a Favourable Macroeconomic Environment
ii . Sub-prime Mortgage Lending
iii . Increased Borrowing by Banks and Investors ( Leverage )
iv . Securitization of Mortgage Loans ( Mortgage-Backed Securities - MBS )
v . Shadow Banking System Growth
vi . Financial Integration & Interconnectedness
Description Impact
Before the crisis , the economy was strong , with low interest rates and inflation . Banks and borrowers believed housing prices would continue rising , leading to overconfidence .
Banks issued loans to borrowers with poor credit histories (subprime loans), assuming real estate prices would keep rising. Borrowers often lacked sufficient income or assets to repay .
Banks and investors borrowed heavily ( high leverage ) to expand lending and purchase MBS products
Banks packaged risky mortgages into securities ( MBS ) and sold them to investors , spreading risk across the financial system.
Non - bank financial institutions (investment banks, hedge funds) engaged in banking-like activities without regulation or deposit insurance .
Encouraged banks to extend risky mortgage loans , increasing financial instability .
When home prices declined, default rates soared , leading to massive losses in mortgage-backed securities ( MBS ).
Amplified both potential gains and losses , making financial institutions highly vulnerable to market downturns
Investors underestimated the risk , leading to overvaluation and market collapse when mortgage defaults surged
Created systemic risks as these institutions were heavily exposed to risky mortgage securities but lacked government protection .
Global financial markets were highly interconnected , with foreign banks and investors holding large amounts of U . S . mortgage - related assets . Losses in the U . S . housing market spread globally , affecting European and emerging market banks .
Cause Description Impact
vii . Deficiencies in Risk Management & Ratings Agencies
viii . Regulatory and Policy Failures
Banks and rating agencies underestimated the risk of MBS and complex derivatives . Risk models were based on the assumption of stable markets Investors misjudged the true risk of these products, leading to excessive exposure and market collapse
Weak regulation allowed banks to engage in reckless lending and excessive leverage . Regulators failed to impose strict capital and risk requirements . Created a fragile financial system, unprepared for the shock of rising mortgage defaults .
ix . Short-Term Wholesale Funding Dependency
x Panic & Contagion Effect
Banks relied on short - term funding ( overnight loans , repo markets ) to finance long - term mortgage investments . When the crisis hit, funding sources dried up , leading to liquidity crunches and bank failures .
The failure of major financial firms ( e . g ., Lehman Brothers , Bear Stearns ) triggered panic across financial markets . Investors rushed to withdraw funds .
Liquidity disappeared , credit markets froze , and economies worldwide entered a severe recession.
8.3 REGULATORY SHORTCOMINGS
The regulation of subprime lending and Mortgage-based Securities (MBS) products was too lax . In particular , there was insufficient regulation of the institutions that created and sold the complex and opaque MBS to investors . Not only were many individual borrowers provided with loans so large that they were unlikely to be able to repay them , but fraud was increasingly common such as overstating a borrower ’ s income and overpromising investors on the safety of the MBS products they were being sold .
8.3.1 Governance and supervisory failures
Even where regulations existed , supervisory enforcement was weak :
i. The “light touch” regulatory philosophy that prevailed in the US and UK actively discouraged intrusive examination n the years leading up to the crisis, both the United States and the United Kingdom had embraced a regulatory culture that was, by design, non-intrusive. The prevailing political and intellectual consensus held that excessive regulation stifled financial innovation and economic growth.
ii. Regulators were captured by the efficient market hypothesis — a theoretical belief that markets self-correct and price risk correctly. Perhaps the deepest intellectual
failure of the pre-crisis era was the near-universal faith among regulators, policymakers, and central bankers in the Efficient Market Hypothesis (EMH). This theory, dominant in academic and policy circles since the 1970s, held that financial markets are rational and self-correcting — that prices always reflect all available information, and that if something were genuinely dangerous, the market would price that danger correctly and discipline the reckless actors.
iii. Supervisory stress testing was rudimentary or non-existent. Before the crisis, supervisory stress testing as we understand it today — rigorous, forwardlooking, scenario-based assessment of whether a bank can survive severe economic shocks — simply did not exist in any meaningful form.
The Fed , despite having authority to regulate mortgage lending standards under HOEPA since 1994 , failed to exercise that authority until it was too late
8.3.2 Procyclicality embedded in regulation
In essence , the regulatory framework was designed for fair weather and broke down in the storm and worse , it actively intensified the storm rather than providing shelter from it :
i. Basel Capital Requirement
Basel II tied the amount of capital a bank needed to hold to the perceived riskiness of its assets. In good times, risk models showed low risk, so banks were allowed to hold less capital — precisely when they should have been building buffers. When the crisis hit and risk surged, banks were suddenly required to hold more capital — at the worst possible moment when raising capital was nearly impossible.
ii. Fair value/Mark-to-market accounting
When asset prices started falling, banks were forced to immediately revalue their holdings at those depressed prices, which wiped out their capital on paper. To restore their capital ratios, they had to sell assets — but everyone was selling at the same time, which pushed prices down even further. It was a vicious downward spiral.
Procyclicality
Tendency of financial variables to move in line with economic cycles , amplifying booms and downturns .
In essence , the regulatory framework was designed for fair weather and broke down in the storm and worse , it actively intensified the storm rather than providing shelter from it .
i. Basel Capital Requirement
Basel II tied the amount of capital a bank needed to hold to the perceived riskiness of its assets. In good times, risk models showed low risk, so banks were allowed to hold less capital — precisely when they should have been building buffers. When the crisis hit and risk surged, banks were suddenly required to hold more capital — at the worst possible moment when raising capital was nearly impossible.
ii. Fair value/Mark-to-market accounting
When asset prices started falling, banks were forced to immediately revalue their holdings at those depressed prices, which wiped out their capital on paper. To restore their capital ratios, they had to sell assets — but everyone was selling at the same time, which pushed prices down even further. It was a vicious downward spiral,
8.3.3 Shadow banking
Shadow Banking
Non - bank financial intermediaries that perform banking functions without full regulation .
Shadow banks are financial entities other than regulated institutions ( commercial banks , NBFCs ) that serve as intermediaries to channel savings into investment . They include securitisation vehicles , money market funds , investment banks , mortgage companies , and a variety of other entities . Before the crisis , the shadow banking system had become a major player in global finance ; with hindsight , we can see that shadow banking was also the source of some key vulnerabilities . Before the crisis , shadow banks held over $ 10 trillion in assets Unlike traditional banks , they operated outside prudential regulation which made them vulnerable
i. They had no access to central bank liquidity support
ii. No capital adequacy requirements
iii. No liquidity buffers mandated
iv. No deposit insurance or lender-of-last-resort backstop
v. When confidence evaporated in 2007–08, the shadow banking system faced a classic bank run with no regulatory safety net
8.3.4 Derivatives markets - dark and unregulated
The over - the - counter ( OTC ) derivatives market , particularly Credit Default Swaps ( CDS ), was almost entirely unregulated :
i. No central clearing, no margin requirements, no position limits. AIG wrote $440 billion in CDS protection with virtually no capital backing — a ticking systemic time bomb
ii. Regulators had no visibility into interconnectedness and counterparty exposure across the system
iii. The Commodity Futures Modernisation Act (2000) had explicitly prohibited regulation of OTC derivatives — a legislative failure of historic proportions
8.3.5 Over-reliance on credit rating agencies (CRAs)
Regulators embedded CRA ratings deeply into regulatory frameworks — capital requirements , investment mandates , and eligible collateral rules all referenced ratings . This created catastrophic consequences :
i. CRAs suffered from severe conflicts of interest — issuers paid for ratings
ii. Complex CDOs and CDO-squared instruments received AAA ratings that were fundamentally flawed
iii. Regulators had outsourced their credit judgment to private agencies with misaligned incentives
iv. When ratings were mass-downgraded in 2007–08, forced selling created catastrophic market dislocation
The 2008 financial crisis was not caused by one bad decision or one reckless bank . It was the result of many small failures — in rules , in oversight , in incentives , and in thinking — that built up quietly over years and then collapsed all at once , like a wall that looked solid from the outside but had been crumbling from within for a long time .
8.4 BASEL COMMITTEE’S RESPONSE TO THE GLOBAL FINANCIAL CRISIS
The Global Financial Crisis ( GFC ) revealed significant weaknesses in the global banking system , including inadequate capital , excessive leverage , poor risk coverage , and weak liquidity management . In response , the Basel Committee on Banking
Supervision ( BCBS ) introduced a comprehensive reform framework known as Basel III , aimed at strengthening both the resilience of individual banks and the stability of the financial system as a whole .
8.4.1
Micro-prudential (Firm-Level) reforms
Micro - Prudential Regulation
Regulation focused on the safety and soundness of individual financial institutions .
At the micro - prudential level , Basel III focused on improving the ability of banks to absorb shocks arising from financial and economic stress
i.
Raising the Quality and level of Capital
At the micro-prudential level, Basel III focused on improving the ability of banks to absorb shocks arising from financial and economic stress. A key reform was the emphasis on higher quality capital, particularly common equity, which is the most effective form of loss-absorbing capital. The framework also raised the minimum capital requirements, requiring banks to maintain stronger capital buffers to withstand adverse conditions.
i. Enhancing Risk Coverage
In addition, Basel III enhanced the coverage of risks within the capital framework. The crisis had shown that certain exposures, especially off-balance sheet items and complex financial instruments, were not adequately captured. By expanding risk coverage, the new framework aimed to ensure that capital requirements more accurately reflected the true risk profile of banks.
ii. Containing Leverage
Another important reform was the introduction of a leverage ratio, a nonrisk-based measure designed to limit excessive borrowing. This acted as a supplementary safeguard to the risk-based capital requirements and helped prevent banks from building up high levels of leverage.
iii. Strengthening Liquidity
Standards
Recognising the importance of liquidity, Basel III introduced global liquidity standards in the form of the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). While the LCR ensures that banks hold sufficient liquid assets to withstand short-term stress, the NSFR promotes stable funding over a longer horizon.
iv. Improving Market Discipline
The framework also strengthened market discipline by requiring improved disclosures. Greater transparency in banks’ financial and risk positions enables
market participants to better assess the strength of institutions and encourages prudent risk management.
8.4.2 Macro-prudential measures
Basel III also introduced measures to address risks at the system-wide level, recognising that stability of individual banks alone is not sufficient
Macro - Prudential Regulation
Policies aimed at safeguarding the stability of the entire financial system
i. Addressing Procyclicality
Measures were introduced to reduce procyclicality, i.e., excessive lending during economic booms and sharp contractions during downturns. This helps moderate fluctuations in the financial system.
At the macro-prudential level, Basel III addressed risks affecting the financial system as a whole. One key focus was on reducing procyclicality, where excessive lending during economic booms and sharp contractions during downturns amplify financial instability. To address this, the framework introduced mechanisms such as capital buffers and the use of stress-based measures.
ii. Capital Buffers
The introduction of capital buffers—including the capital conservation buffer and the countercyclical buffer—ensures that banks build up additional capital during good times, which can be drawn down during periods of stress. This helps maintain the continuity of banking operations and supports economic stability.
u Capital Conservation Buffer (2.5%), and
u Countercyclical Buffer (0–2.5%)
iii. Systemic Risk and Too Big
To Fail Banks
Finally, Basel III addressed the issue of systemic risk and interconnectedness, particularly the risks posed by large, systemically important banks. Such institutions were required to maintain higher levels of loss-absorbing capital to reduce the impact of their potential failure on the broader financial system.
8.5 CONCLUSION
The Global Financial Crisis (GFC) of 2007-2009 revealed critical weaknesses in financial regulation , risk management , and banking practices , resulting in a global economic downturn . The crisis emphasised the dangers of excessive leverage , inadequate risk
assessment , and the interconnectedness of financial markets . In response , the Basel Committee on Banking Supervision (BCBS) introduced Basel III, a regulatory framework designed to strengthen the resilience of banks by improving capital adequacy, liquidity management , and risk supervision . Basel III established higher capital requirements , leverage ratio constraints , liquidity standards , and systemic risk buffers to ensure financial stability . The Basel Committee also introduced macroprudential measures to address procyclicality and systemic risks . Looking ahead , ongoing regulatory enhancements and prudent risk management will be essential in preventing future financial crises and ensuring the long - term stability of the banking sector .
8.6 KEY DEFINITIONS
Financial crisis : In a financial crisis , asset prices see a steep decline in value , businesses and consumers are unable to pay their debts , and financial institutions experience liquidity shortages .
Spill - over Effect : The spillover effect is when an event in a country has a ripple effect on the economy of another , usually more dependent country .
Procyclical : Procyclicality means ( comparative more procyclical , superlative most procyclical ) ( economics ) moving in the same direction as the overall state of an economy .
Macro -prudential: Macroprudential policies are financial policies aimed at ensuring the stability of the financial system as a whole to prevent substantial disruptions in credit and other vital financial services necessary for stable economic growth
Micro - prudential : In contrast , microprudential supervision and regulation focus on the safety and soundness of individual financial institutions , not the financial system as whole
Leverage Ratio : A measure of a bank ’ s financial health , indicating the proportion of capital to total assets , aimed at controlling excessive leverage .
Countercyclical Buffer : A capital buffer banks must maintain during periods of economic growth to absorb potential losses during downturns
Systemic Risk : The risk that the failure of a single financial institution can trigger a widespread financial collapse .
Shadow Banking: Non-bank financial intermediaries that engage in banking activities without being subject to traditional banking regulations
Market Discipline: The process by which investors, analysts, and regulators influence financial institutions through transparency and risk disclosures .
Capital Buffers : Additional capital reserves that banks must maintain to absorb losses and enhance resilience .
KEYWORDS
Global Financial Crisis , Basel III , Capital Adequacy Ratio , Systemic Risk , Contagion Effect , Macroprudential Regulation , Microprudential Regulation , Leverage Ratio , Countercyclical Buffer, Shadow Banking, Procyclicality, Liquidity Coverage Ratio, Net Stable Funding Ratio , Moral Hazard , Financial Interconnectedness, Market Discipline , Mortgage - Backed Securities , Stress Testing , Capital Buffers , Spill - Over Effect
SUMMARY
i. In the years leading up to the GFC, economic conditions in the United States and other countries were favourable. It was believed that house prices would continue to rise in the future. Many borrowers purchased houses with bank loans even if they did not have the capacity to repay them loan. Evenbanks and other investors in the United States and abroad borrowed increasing amounts to expand their lending and purchase MBS products. Borrowing money to purchase an asset (known as an increase in leverage) magnifies potential profits but also magnifies potential losses
ii. As the crisis unfolded, many central banks and governments did not fully recognise the extent to which bad loans had been extended during the boom and the numerous ways mortgage losses were spreading throughout the financial system. Financial integration had increased dramatically over the 1990s, heightening the risk of transmitting financial shocks across borders. Banks’ risk management also often failed to keep pace with financial innovation. A significant example is the extension of the traditional originate-to-distribute business model, which became popular among bankers in the late 90s.
iii. The Basel Committee responded sensibly to the deficiencies noted in the regulatory and risk management framework. It strengthened the quality and increased the level of capital that banks are required to maintain. Another key element of the Basel III regulatory capital framework is the introduction of a non-riskbased leverage ratio. Strong capital requirements are a necessary condition for banking sector stability, but by themselves are not sufficient. Equally important is the introduction of stronger bank liquidity, as inadequate standards were a source of both firm-level and system-wide risks stress.
iv. While procyclicality amplified shocks over the time dimension, excessive interconnectedness among systemically important banks also transmitted shocks across the financial system and economy. Systemically important banks were required to have more loss absorbing capacity beyond the minimum standards.
QUESTION:
1. Leverage ratio indicates which of the following
( a ) How much borrower has borrowed money?
( b ) How much a borrower is worth?
( c ) How much a borrower is liquid?
( d ) How much a borrower is successful
2. Failure of a single bank can give rise to
( a ) Business risk
( b ) Strategic risk
( c ) Model risk
( d ) Systemic risk
3. Basel II provisions were procyclical which means
( a ) Banks keep introduce more products during boom phase
( b ) Bank gives more loan during boom period
( c ) Default rate goes up during boom period
( d ) Recovery rate goes up during downturn
4. A Which of the following is not important for long term viability of a bank
( a ) Adequate minimum capital
( b ) High liquidity
( c ) High leverage
( d ) High capital buffer
5. Shadow banks refer to
( a ) Bank like institution not regulated by any regulatory body
( b ) Banks which are not very famous
( c ) Banks not systemically important
( d ) Banks which are not financially sound
ANSWER
RISK MANAGEMENT
AUTHOR : Indian Institute of Banking & Finance (IIBF)
PUBLISHER : Taxmann
DATE OF PUBLICATION : July 2026
EDITION : 2026 Edition
ISBN NO : 9789375611974
NO. OF PAGES : 824
BINDING TYPE : Paperback
Rs. 1,245
DESCRIPTION
Risk Management is the official courseware prescribed by the Indian Institute of Banking & Finance (IIBF) for Paper II of its examination in Treasury, Investment and Risk Management (DTIRM). Revised for the 2026 Edition and mapped to the latest syllabus, this 800-plus-page volume builds a complete, working command of how modern banks identify, measure, price, and control risk—from board-level governance to the arithmetic on a dealer's blotter. It is not a high-level summary. Across four modules and 25 chapters, each topic is built from first principles and carried through to fully worked numerical solutions, decision tables, and regulatory application. Readers don't just learn what Value at Risk or duration is—they compute it: pricing a 10-year zero-coupon bond to ₹456.39, deriving 99% VaR and Expected Shortfall from a 1,000-day P&L series, computing portfolio PVBP, and settling a quarterly swap cash flow. Coverage reaches frontier material—Expected Shortfall and the Fundamental Review of the Trading Book (FRTB), Extreme Value Theory, Monte Carlo simulation, coherent/sub-additive risk measures, LCR/NSFR, ICAAP, and climate-related and conduct risk—well beyond a minimum syllabus. Pairing conceptual clarity with a practitioner's orientation, it serves as both an examination guide for DTIRM candidates and a desk reference for treasury and risk professionals, and is designed for self-study.
The book is written for a wide spectrum of readers across banking, treasury, and finance:
• DTIRM Candidates
• Treasury Professionals and Dealers
• Risk Managers and CRO Teams
• Internal Auditors, Compliance and Finance Officers
• Regulators and Supervisors
• Students, Faculty, and Researchers
In short, it suits anyone—from first-time candidate to seasoned practitioner—who needs both the theory and the applied, computational tools of banking risk management in one place.
The Present Publication is the 2026 Edition, authored and vetted by Mr Ambarisha Nanda, Former CGM, United Bank of India. Taxmann exclusively publishes this book for the Indian Institute of Banking and Finance (Certificate Examination in Treasury, Investment & Risk Management (DTIRM)—Paper II), with the following noteworthy features:
•[Official Courseware] Prescribed and copyrighted by IIBF and aligned to the Revised DTIRM Paper II syllabus
•[Updated 2026 Edition] Reflects contemporary banking-risk developments, evolving Basel/RBI frameworks, and international best practice
•[Expert Authorship] Written and vetted by a senior industry veteran—regulatory rigour with real-world banking judgment
•[Quantitative & Applied] Worked illustrations and step-by-step numerical solutions (in realistic ₹-crore terms), with dozens of decision and summary tables and formulas in full
•[Signature Market-risk Depth] A deliberate emphasis reflecting the rising importance of market risk in volatile rate, currency, and commodity environments
•[Frontier Coverage] Expected Shortfall and FRTB, Extreme Value Theory, Monte Carlo VaR, coherent/sub-additive measures, LCR and NSFR, ICAAP with stress testing, PCA, and climate/conduct/non-financial risk
•[Regulatory Grounding (India & Global)] Basel I → III evolution, RBI's supervisory framework, risk-based supervision, and risk-based internal audit
•[Exam-friendly Architecture] Each unit opens with an objective and closes with a summary and glossary; most carry objective-type 'Terminal Questions' with answer keys
•[Self-contained Study Design] Coverable without a teacher, while encouraging readers to track live RBI/Basel releases and the financial press
•[Dual Utility] Engineered as both examination preparation and a lasting professional reference