It took a long time for the economies to realist the problems associated with such types of system. For example, in such a framework a commercial bank was permitted to keep aside no liquid capital if it had all government bonds or gold as assets. This was so because such assets were considered safe. Further, it was required of them to keep aside small percentages of capital for every mortgage, commercial loan or bonds they Issued. With the introduction of Basel 2, the list was expanded to bonds backed by debts like ar or property loans and yet had to keep only a 2 percent of spare capital.
Flip side to this was that the bonds ought to have AAA or AAA credit ratings from the government. Statistics tell that Just prior to the recession, 81 percent of all Mortgage backed securities held by the commercial banks had AAA credit rating. Further, 93 percent of all mortgage-backed securities held by these banks had AAA credit rating or held bonds Issued by a government-sponsored enterprise. Now this Is where the role of moral hazard comes Into play.
When Basel I and abstinently Basel II accords were Introduced, the primary aim of the developed economies was to encourage consumer spending and Investments by the banks. It was not completely unforeseeable for everyone to realize that backing debt or junk manipulating credit ratings, economies tried to create a self-fulfilling system that provided for feed as well as fed upon its own. The bankers were in turn incentives to take risks of high magnitude, with all the depositors' money in hand, believing that there is a government always backing them.
Soon the entire system gave away. This created a bigger moral hazard. How to minimize such problems? TO reduce such a problem of Principal Agent problem leading to recession, it is imperative that the regulators are on their toes. In USA, SEC did not take proper steps to ensure that the Rating agencies don't rate securities high without any strong backing to do so. Also the FIDE, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision relied blindly on the ratings given by the Credit rating agencies.
Therefore, all rules and regulations given under law should be implemented properly and Justly by the regulators. The government should also ensure the timely passage of relevant legal provision and bills. Also, although Basel Ill accords have been adopted and implemented by most of the countries and the deadline is 2019 for it, the present market conditions show that the Minimum Capital requirements need an overhaul as well. Hence, Basel 4 could be started to be worked upon with refined changes and the governments should follow the rules under such requirements.