Essay: Basel III

1.0 Abstract
This paper tries to understand the reasons that led bankers in establishing Basel III agreement and, examine whether it would bring about prudent risk management in banking. Basel III is a set of regulations, developed in response to the financial crisis, following Basel I and Basel II. The procedures developed by BCBS meant to strengthen banks liquidity and protecting from systemic risks using set of regulations (Siskos, 2014).
The problems that were responsible for the global financial crisis had been identified with Basel I and Basel II, but were not sufficient in providing solutions. Basel III was created to address some of these problems, but not all and inherited the weaknesses that existed in Basel II. The issues that still need attention are risk assessment, too low capital requirements, unregulated shadow banking, and insufficient regulations on systemic institutions. Therefore, we can conclude that Basel III was a necessity but more regulations will be needed ahead to address the pending issues mentioned above.
2.0 Introduction
Banks have been viewed as delicate institutions that need government help to progress in an unharmed environment. Market failures like incomplete markets, moral hazard between banks owners and depositors, and negative externalities like contagion are the main reasons for this fragility. Thus, regulatory measures such as entry barriers, reserve requirements, and capital adequacy requirements are introduced by the government regulatory agencies/central banks (Tchana, 2008).
Groups of international banking establishments work towards strengthening the regulations, supervisions and practices of banks to improve the financial stability. This organization is called BCBS. The BCBS proposes a discussion for regular cooperation on banking supervisory matters to enhance key understanding of supervisory issues and improve the quality of banking supervision worldwide (Datey & Tiwari, 2014). Basel I, II, and III regulations were created by BCBS to stabilize the banking system worldwide.
The financial crisis of 2007-2008 involved both liquidity and capital. Many banks engaged in a short term funding regime that was excessively volatile and wholesale liabilities were invested in non-liquid assets, which became a prime factor in the crisis. The significant concerns raised were the quantity and quality of bank capital. As a result, the creation of Basel III occurred. This new set of regulations, Basel III, addressed the challenges of improving the quantity and quality of bank capital and the need for a potent liquidity buffer to counteract periods of financial market stress (BMA, 2015). The potential flaw that could occur would increase material capital charges and make certain activities in banks more capital intensive (Datey & Tiwari, 2014).
2.1 History
BCBS was established in the 1960s in Basel, Switzerland, to help banks deal with the emerging phenomenon of globalization. The activities of the BCBS focus on exchanging information, develops banking guidelines and supervisory standards, and various supervisory issues, approaches and techniques. It does not have any formal authority, and its decisions are not backed by legal force. The Basel Committee on Banking Supervision’s work is organized under main subcommittees (Datey & Tiwari, 2014):
‘ The Standards Implementation Group (Datey & Tiwari, 2014).
‘ The Policy Development Group (Datey & Tiwari, 2014).
‘ The Accounting Task Force (Datey & Tiwari, 2014).
‘ The Basel Consultative Group (Datey & Tiwari, 2014).
Basel I was in effect since 1988 whose objective was to to achieve significant capital reduction with little or no risk transfer by strengthening the stability of the international banking system and decrease competitive inequality among the banks. Basel I’s achievement was to define bank capital and capital ratio. Three types of credit risks were identified in this system: a) The on-balance sheet risk; b) The trading off-balance sheet risk. These are derivatives, interest rates, foreign exchange, equity derivatives and commodities; and c) The non-trading off-balance sheet risk. These include general guarantees like forward purchase of assets, or transaction-related debt assets (Datey & Tiwari, 2014). The main shortcoming of Basel I, was the lack of diversification in credit risks. The range of 100% category Risk Weighted Regulatory Capital resulted to a higher risk appetite. Banks shall choose an investment within the range of 100% category Risk Weighted Regulatory Capital to optimize the return on equity. This shortcoming caused an increase in the vulnerability of the bank balance sheet. To figure out this effect, the improved Basel II was introduced (Liang, n.d.).
Basel II was in effect since 2004 whose objective was to treat both exposures and banks very unequally and sensitive to risk. Three requirements of this agreement were: a) Mandating capital allocations by institutional managers are more risk sensitive; b) Separating credit risks from operational risks and quantifying both; and c) Reducing the possibility of regulatory arbitrage by attempting to align the real or economic risk with regulatory assessment. This was an upgrade from Basel I and the flaw in this system was that it profoundly altered bank behaviour but contained ‘GAPS’ that banks exploited resulting in financial crisis of 2007 (Datey & Tiwari, 2014).
3.0 Discussion
The G20 Summit held in Seoul, South Korea, in 2010, sanctioned the Basel III agreement and proposals for capital and liquidity implementation. Basel III proposals have two main objectives: a) To strengthen global capital and liquidity regulations with the goal of promoting a more durable banking sector; and b) To improve the banking sector’s ability to absorb shocks arising from financial and economic stress which would lessen the risk of an overflow from the financial sector to the real economy. The above is classified into capital reform , liquidity standards , and systemic risk and interconnectedness (KPMG Report, 2011).
Basel III highlights are as follows:
‘ ENHANCED CAPITAL REQUIREMENT: Banks require holding more reserves by January 2015, with common equity requirements raised to 4.5% from 2% (Datey & Tiwari, 2014, Thu & Cuza, n.d).
‘ CAPITAL CONSERVATION BUFFER: Introduced to meet the crises in the time of stress by adding 2.5% more to the reserve, which brings the total Tier I Capital Reserves to 7% (Datey & Tiwari, 2014, Thu & Cuza, n.d).
‘ COUNTERCYCLE BUFFER: If a nation’s economy credit is expanding faster in comparison to GDP, then Capital requirement can be increased with this Buffer, which varies between 0% -2.5% (Datey & Tiwari, 2014, Thu & Cuza, n.d).
‘ LEVERAGE RATIO: Basel III proposes that Tier I capital has to be at least 3% of the Total Assets even if no risk is weighting. It agrees to test a minimum Tier 1 leverage ratio of 3% by the year 2017 (Datey & Tiwari, 2014, Thu & Cuza, n.d).
‘ LIQUIDITY RISK MEASUREMENT: LCR is designed to ensure that a bank maintains an adequate level of unencumbered, high quality assets that can be converted to cash to meet its liquidity needs for 30 days time frame under acute liquidity stress. The standard requires ratio to be 100% (Datey & Tiwari, 2014, Thu & Cuza, n.d).
‘ NET FUNDING STABILITY RATIO: NFSR is the ratio, for a bank, of its ‘available amount of stable funding’ divided by its ‘required amount of stable funding’. The standard requires the ratio be no lower than 100% (Datey & Tiwari, 2014, Thu & Cuza, n.d.).
Basel III requirements are being introduced from 2013 but some areas are still subject to change and total compliance is not expected until 2019. The long lead-in is designed to prevent sudden lending freezes as banks improve their balance sheets. The regulations in Europe shall be implemented through alterations to the Capital Requirements Directive (CRD IV) and the introduction of a Capital Requirements Regulation (CRR). However, various observations and phase-in periods mean the standards will not be fully implemented until 1 January 2019.In Asia, regulators in each country will implement the regulations individually, taking their steer from the financial centers of Hong Kong, Singapore and Australia. In the US, consultations regarding the local implementation of Basel III are ongoing (Datey & Tiwari, 2014).
4.0 Analysis
Wallison (2007) quotes a famous scholar called Macey, ‘government regulation is necessary, sometimes in heavy doses, for private markets to function well.’ According to Laurens (2012), the potential effectiveness of the Basel III framework is to generally formulate regulations to mitigate future systemic risks associated with banking. To this effect, Basel III adds up to the existing regulations (Walter, 2009). The question posed by the analyst is whether Basel III is really a panacea for resolving financial crisis judging from the implementational and supervisory challenges facing the framework (Varriale, 2011). This phenomenon is making the implementation very difficult considering the fact that the framework does not wield the authority to enforce strict supervision but only provides an environment for corporation among its member countries (Laurens, 2012). It is worth noting that some member countries are yet to fully implement the requirement of Basel II (BCBS, 2009) thereby lagging behind the implementation of Basel III (Mawutor, 2014). One of the results contributed by Basel III accord is restructuring of the balance sheet (Thu & Cuza, n.d.).
Researchers are also questioning the reliability of the governance evidence based on methodological complications. One difficulty that may affect much of the research is that governance structures are heterogeneous, and thus should not be treated as if ‘one size fits all.’ Structures are determined primarily by investment opportunities and product markets and will thus differ across firms (Altinkilic, Hansen, & Hrnjie, 2007).
A Basel III accord was mainly established to address the issues of the financial crisis of 2008, which was the result of Basel II weaknesses. Although the new Basel framework came up with revolutionary capital and liquidity standards to strengthen the resilience of the banking sector, it is still insufficient. First, the framework imposed additional capital requirements, but did not revise risk assessment methods, Lehman brothers and Merrill Lynch collapsed in 2008 while their tier one capital ratios were relatively high, ranging between 12.3% and 16.1%, which means that the new capital requirements are still low and risk assessment methods are not accurate. Second, the framework is designed for commercial banks whereas hedge funds and special purpose vehicles (structured investments vehicles SIVs) are not subject to Basel III capital requirements. Third, large banks are not sufficiently regulated, they are still benefiting from ‘the too big to fail’ implicit guarantee (Kcharem, 2014).
Unreliable risk assessment
Even under Basel III accord, banks still calculate their capital ratios using flawed methods. In fact, banks are required to determine their regulatory capital based on the risk profile of their assets. Which means that the more banks?? asset’s risk exposures are underestimated the lower is the required capital to cover these risks. The methods suggested by the Basel Committee for calculating bank??s exposure to credit and market risks, like the VAR method used to assess market risk, provide an underestimated assessment of these risks which lead to a small capital reserve set aside by banks to cover potential losses. In fact, the VAR method which is used to estimate the probability of asset price movements is based on the assumption of the normal distribution of risk, which means that it assigns a decreasing weight to events becoming older and does not anticipate serious events which explain the failure of bank managers to anticipate the crisis of 2008 (Philippe Lamberts, 2010). It is also necessary to mention that capital requirement calculations are based on book valued capital which make them inaccurate, they must, instead rely on market valued capital (Kcharem, 2014).
Too low capital requirements
The new Basel III package fixes a risk weighted capital ratio of 13% (Core tier 1 + tier 1 + tier 2 + countercyclical buffer + conservation buffer) to be implemented fully by 2019, by when the world may know other financial crisis. Martin Wolf (2010) considers that capital requirements under Basel III remain very low to mitigate bank??s excessive risk taking, based on Admati et al. (2010) arguments against the idea that equity is expensive; he argues that equity requirements must be as high as 20 or 30%. These requirements could be applied only if banks reduce their lending activities which would affect negatively the financing of the economy. However, if regulatory authorities impose restrictions on the payments of dividends and bonuses to shareholders, banks would have the possibility to increase their capital without affecting the performance of the real economy (Philippe Lamberts, 2010) (Kcharem, 2014).
Unregulated shadow banking
Financial entities such as hedge funds and special purpose entities (structured investment vehicles SIVs) are not subject to capital requirements simply because they do not collect deposits from households. These institutions present serious systemic risk threat to the financial system since they borrow money in the short term on liquid markets in order to purchase long term illiquid assets such as securitized loans which are known to be very risky. These financial entities would collapse if they fail to refinance their short term debts (Philippe Lamberts, 2010). As investment banks were not subject to strict regulation before the recent financial crisis, they were also operating in the shadow banking system; for instance, they used to finance mortgages through securitization, however, the case of the two investment banks; Bear Sterns and Lehman Brothers in 2008 brought the largest investment banks into the regulatory sphere (Kcharem, 2014).
Inadequate regulation of systemic institutions
The systemic institutions issue, also known as the ‘too-big-to fail’ problem has always been the subject of many academic studies; however, the seriousness of this problem was revealed during the recent financial crisis. Once again, the Basel Committee does not properly address this issue. In fact, Basel III framework addresses the traditional incentives of managers to take excessive risk by setting minimum capital requirements to determine the regulatory capital; however, it does not capture the risk for the entire system arising from an individual banks?? failure. Therefore Basel III failed to reduce the likelihood of failure of the systematically important banks, to limit the impact of the failure of such institutions and to eliminate the competitive advantages from which these institution benefits in funding markets (Stephen G Cecchetti, 2011) (Kcharem, 2014).
5.0 Conclusions
In the absence of regulation or deposit insurance, one would expect to see banks hold sufficient capital for this purpose, simply because instability would result without it and instability would make it difficult for banks to acquire deposits. Therefore, if we see banks with low capital ratios, it is because something other than market forces is allowing them to do it. That something is deposit insurance and government regulation. In other words, banks have high leverage (i.e., low capital) today, not inherently, but because regulation and deposit insurance have created moral hazard, lulling depositors into the belief that they do not have to be concerned about the financial condition of banks. When market discipline is impaired, high leverage should not be a surprise (Wallison, 2007).
However, once again, Basel III is too strong to follow. It was criticized to harm the industry, increase systemic risk and limit credit availability. In context of stagnated crisis, a regulation that may reduce lending and economic growth is somehow unacceptable especially with some American banks. Therefore, the responsibility is one more time put on the regulators to find out a way to lead global economy to move on: strong but flexible. Credit risk is considered as the most grave and ‘difficult to deal with’ problem by most of the bank managers and is blamed for the most devastated financial crisis of the world. Both insufficient and excessive regulators are known to be main reasons of inefficient risk management in banking systems which makes regulators be aware of necessities to build a new regulation framework. Therefore, Basel III was born’ (Thu & Cuza, n.d.). Generally, the implementation of Basel III may well represent the most significant series of steps and challenges in managing risk. However, many elements of the agreement remain unfinished and many factors that are responsible for Basel II failure have jeopardized the recent efforts to raise international capital requirements in the form of ‘Basel III’ (Lall, 2009). Given the fact that Basel III did not alter the risk weighting regime and still, for example, allows banks searching for common equity against their risk weighted assets (Amediku, 2011), Basel Committee on Banking Supervision (BCBS) needs to monitor financial system development and risk, on a more regular basis. The complexity and demands of the banking world requires a flexible management solution that delivers speed, accuracy, and performance. Moreover, BCBS needs to examine shadow banking risks, to review whether external rating agencies implement the regulations and standards and to punish regulatory arbitrage (Siskos, 2014).
6.0 References
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