Essay: Basel III

The banks play vital role in the smooth functioning of an economy. Banks must have adequate capital to meet the requirements of mass people especially its depositors. Thus, the banks should hold adequate capital to secure the interest of creditors. Capital adequacy is important factor for evaluating the soundness of the banking sector. As commercial banks collect large amounts of deposits from the general public. Therefore, to protect the interest of depositors and counterparties from the risks, like credit and market risks, it is important that banks must have competent deposits. Otherwise the banks will use all the money of depositors in their own interest and depositors will have to suffer a loss. The Banking sector has become a standby of the economy of the country (Rai, 2011). Banks that wish to increase their capital adequacy ratio to obey the minimum requirements or for other non-regulatory reasons can use three types of balance-sheet adjustments: they can increase their capital level, decrease their risk-weighted assets or sell off their assets (Roy, 2005).
Origin of Basel Committee on Banking Supervision
The Basel Committee on Banking Supervision was established as the Committee on Banking Regulations and Supervisory Practices by the central-bank Governors of the Group of 10 Countries. It was set up in 1974 after the serious interruptions in international currency and banking markets (Swaan, 2009).
It consists of senior representatives of bank supervisory authorities and central banks of Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. It usually meets at the bank for international settlements in Basel, Switzerland, where its permanent secretariat is located (BCBS, 2010).
1988 Basel I Accord
The committee created its first document to set up an international ‘minimum’ amount of capital that banks should hold. It was popularly known as Basel I Accord, which was confined to measure banks’ capital adequacy. The minimum percentage of the total capital of a bank is called the minimum risk-based capital adequacy (Zaher, 2009).The regulation of Basel I, was primarily focussed on credit risk.
Purpose of Basel I Accord
1. To prevent international banks from building business volume without adequate capital backing.
2. To focus on credit risk.
3. To set minimum capital standards for banks.
4. To strengthen the stability of the international banking system.
5. To decrease competitive inequality among international banks by setting up the fair and consistent international banking system (Zaher, 2009).
6. Basel I capital requirement was set at 8% and was adjusted by a loan’s credit risk weight.
7. Credit risk was divided into five categories: 0%, 10%, 20%, 50% and 100% (Ersel, 2011).
Criticism of Basel I Accord
Basel I Accord was criticized on following grounds such as :
1. It took too simplistic approach for setting credit risk weights.
2. It ignored other types of risk, i.e. operational risk and liquidity risk (Ersel, 2011).
3. There was limited differentiation of credit risk.
4. It was a static measure of default risk (assumes that a minimum 8% capital ratio is enough to protect the banks from failure).
5. It does not recognize the term- structure of credit risk (the capital charges are set at the same regardless of the maturity of a credit exposure).
6. Lack of recognition of portfolio diversification effects.
In a nutshell, The Basel I Capital Accord aimed to determine capital in relation to credit risk if a party does not fulfill its obligations. It just launched the trend toward increasing risk modelling research; however, its over-simplified calculations, and classifications have simultaneously called for its disappearance, paving the way for the Basel II Capital Accord. However, Basel I was the first international instrument evaluating the importance of risk in relation to capital, which will remain a milestone in the finance and banking history (Zaher, 2009).
Basel II Accord
After considering the weaknesses of Basel I and realizing the need for a more ample, broad-based and flexible framework, the BCBS decided to change the existing Basel into more risk perceptive framework (Balasubramaniam, 2013). So, it introduced the Basel II Accord in 2004 which was deliberate to be the refined and rectified version of Basel I Accord. It provides better calibration of regulatory capital with underlying risk and also, addresses the risk arising from financial innovation, thereby contributing to improved risk management and control (Akhtar, 2006). The Basel II Accord deals with all kinds of risk like credit risk, market risk and operational risk. Thus, the main difference between Basel I Accord and Basel II Accord is that the Basel II Accord also deals with operational risk
(Ahmed, 2008). The new set of international standards requires banks to maintain a minimum level of capital to meet their constraints, cover unexpected losses and improve public confidence. It also provides strong incentive to banks to upgrade their risk management standards (Balasubramaniam, 2011). So, the Basel II Accord stands upon three pillars (shown in Fig. 1):
Objectives of Basel II Accord
The objectives of the new Basel accord as enunciated by BIS are fivefold:
1. Promoting safety and soundness of the financial system.
2. Enhance competitive equality.
3. Greater sensitivity to the degree of risk involved in banking position, activities.
4. Constitute a more comprehensive approach to addressing risk and
5. Focus on internationally active banks, with the capability of being applicable to the banks with varying level of complexity and supervision (Balasubramaniam, 2011).
Pillars of Basel II Accord
1. ‘Minimum Capital Requirement’
2. ‘Supervisory Review Process’
3. ‘Market Discipline’
Figure 1:
Source: Chabanel, 2011
Minimum Capital Requirement: The capital adequacy ratio is set at 8% in the Basel II Accord. It is divided into different risk areas i.e. credit risk, operational risk and market risk. According to the BCBS (2004) banks can use three approaches to calculate the credit risk, i.e. the standardized approach, the internal ratings-based (IRB) approach or advanced IRB approach. Operational risk covers the risk of loss due to the system breakdown, employee fraud or misconduct, errors in models or natural or man-made upheavels among others (Ersel, 2011). Market risk covers the loss arising from changes in the value of a financial instrument as a result of changes in the market such as interest rates, exchange rates, credit spreads and other asset prices. Under Basel II total risk weighted capital is calculated in a different way from Basel I. The sum of the risk weighted assets from credit risk is summed up together with 12.5 percent of the capital requirements for operational risk and market risk (BCBS, 2004).
Capital Adequacy Ratio= Tier I + Tier II
Risk weighted Assets (Credit risk + Market risk+ Operational risk)
Definition of Tier 1 and Tier 2 Capital in Basel II Accord
TIER I is {paid-up share capital/common stock + disclosed reserves (legal reserves, surplus and/or retained profits)}. TIER II (undisclosed reserves (banks have made a profit but this has not appeared in normal retained profits or in general reserves of the banks) + asset revaluation Reserves (when a company has an asset revaluation and an increase in value is brought to account + general provisions(created when a company is aware that a loss may had occurred but is not sure of the exact nature of that loss)/general loan loss reserves + hybrid debt/equity instruments (such as preferred stock) +subordinated debt}.Risk weighted assets( RWA ) means assets with different risk profiles. It includes {Credit risk+ Market risk +Operational risk}.
2. Supervisory Review Process: In Basel II, the supervisory review process is the new Pillar which was not included in Basel I. It is concerned with reviewing bank’s internal procedures for capital determination with respect to risk profile. BCBS (2004) explained that this pillar obligates regulators to be able to see that a bank is properly capitalized regarding their risk exposures (Hasan, 2002). It promotes closer co-operation between supervisor and bank. Further, it allows to be more flexible with respect to bank’s prestige to set capital charges (Swamy,
3 .Market Discipline: The third pillar is also new in Basel II, which requires that the bank must unveil their soundness, risk, asset quality and capital adequacy to the market (Hasan, 2002). It is an indirect approach that assumes sufficient competition within the banking sector (Ersel, 2011). It encourages transparency of banks holding in the interest of all stakeholders, brings accountability and better corporate governance among the bank managements (Swamy,
Failure of Basel II Accord
Due to the financial crisis of 2007 and major debacles of the fall of Lehman Brothers, it became necessary to re-visit Basel II to plug the loopholes and make Basel norms more rigorous and wider in scope. Also, Basel II was seen as having some flaws, the IRB approach was one, and it was time for the Basel Committee to gather again and attend those flaws (BIS, 2010). Banks need high quality data for IRB approach, but the banks do not have the time series data for this purpose, which creates a big problem for evaluating the risk (Parrenas, 2002). The pro-cyclical process was the other reason for the failure due to which there was an economical boom in the country. In a downturn, when a bank’s capital base is likely being eroded by loan-losses, its existing (non- defaulted) borrowers were humbled by the relevant credit-risk models, forcing the bank to hold capital against its current loan portfolio. To the extent, it is difficult or costly for the bank to raise fresh external capital in bad times, it will be forced to cut back on its lending activity, there by contributing to a worsening of the initial downturn’ (Kashyap & Stein, 2004). Moreover, Banks totally depend upon the external credit rating provided institution. If any error occurs in the information provided by the external credit providers, then bank become exposed to risk (Teply, 2010). These flaws in Basel II led to the formation of a Basel III framework.
Basel III Accord
According to the Basel Committee on Banking Supervision (BCBS) it is important for a banking industry to recover from the financial stress (BCBS, 2010a). The BCBS has revised the framework to alter the market failure, which becomes manifest in the financial crisis of 2007. On 16 December 2010, the Basel Committee on Banking Supervision (Basel Committee) published many of the Basel III rules with the objective of reducing the probability and severity of future crisis. The guidelines aimed to promote a more resilient banking system by focusing on four vital banking parameters, namely: capital, leverage, funding and liquidity.
It is an evolution rather than revolution in many banks. It was developed from the existing Basel II framework. The most critical differences for banks are the introduction of liquidity and leverage ratios, and enhanced minimum capital requirements. An effective implementation of Basel III will proclaim to regulators, customers and shareholders that the bank is recovering well from the global banking crisis of 2007 (Chabanel, 2011). Summary of Basel III is shown as follows :
Figure 2: SUMMARY OF BASEL III
Source: (BCBS, 2010b)
Basel III Elements &Aspects
1. Raised regulatory Capital :. Under Basel III, it is required that banks must maintain a minimum ratio of total capital to risk-weighted assets of 9% with minimum Tier I capital adequacy ratio of 6%. Therefore, to raise quality, consistency and transparency of the capital base It also provides harmonized deductions (Tier II capital instruments) and elimination of Tier III instruments (BIS, 2010).
2. Strengthening of Risk coverage: Basel III raises capital requirements for the trading book and complex securitization. It provides credit risk based on stressed inputs. CCR standards and strengthening standards are introduced for collateral management and initial margining (www.businessline.com).
3. Leverage Ratios: Leverage ratios are introduced as a complementary measure to avoid the overuse of on-and off- balance sheet leverage in the banking sector, inspite of portraying healthy risk based capital ratios. During financial crisis of 2007, banks those had high leverage were forced to decrease this which caused an elaboration of downward trends in the economic market. Leverage ratio calculations should be based on banks, accounting Balance-sheet and since off-Balance-sheet items (BIS, 2010).
4. Pro-cyclicality (Counter cyclical buffer): It deals with dampening cycli-cality of the minimum requirements and promoting stronger forward looking furnishing.. This buffer can be rendered by national authorities when they believe that the excess credit growth potentially implies a threat of financial distress (BIS, 2010).
5. Liquidity standards: Basel I and II were concentrated upon bank capital, but in Basel III there is an added requirement of liquidity on the outside of capital requirements. The liquidity standards are set, as with the capital requirement with minimum requirement of liquidity. The various liquidity standards are LCR, NSFR and common set of monitoring tools. It is as follows :
5(a). Liquidity coverage ratio: It is the short-term standard, which has the objective to safeguard banks against persistent financial distress for a period of 30 days. It works in such a way that the bank should make sure that they have enough liquid assets to cover for a specific situation under stress (BCBS, 2010a). The scenario as explained by BCBS (2010a) is that the bank should be able to cover for a downgrade in credit rating, partial loss of deposits, loss of unsecured wholesale funding, substantial increase in secured funding haircuts and increases in imitaive calls on OBS exposures (BCBS, 2010c). LCR can be calculated as :
Stock of high-quality liquid asset/Total net cash outflows over the next 30 days>=100
The LCR was emened by the Committee in January 2013 and came into effect on 1 January 2015. The minimum requirement was initially set at 60% in 2015 and will then rise in equal annual steps of 10 percentage points to reach 100% in 2019 (BIS, 2015).
5 (b). Net stable funding ratio: It is the second standard which sets a minimum amount of stable funds of a bank for a period of one year. It addresses liquidity mismatches and provide incentives for banks to use stable sources to fund their activities (BIS, 2015). Long term assets should be funded with a minimum amount of assets that is decided based on the long-term asset liquidity risk (BCBS, 2010c). NSFR can be calculated:
Available amount of stable funding/required amount of stable funding>100
5 (c). Monitoring tools: In liquidity standards, supervisors assign monitoring tools which help supervisors to decide the amount of liquidity that a bank is exposed to. The reason for these measures is that during the crisis, it was found that supervisors globally had very different ways of calculating liquidity risk. This involves measures such as concentration of funding and LCR by significant currency (BCBS, 2010b).
6. Capital conservation buffer: It is designed to ensure that banks build up a capital buffer during normal times (i.e. outsides periods of stress) which can be drawn down as losses are provoked during a stressed period. This buffer is the extra capital that banks must maintain above the minimum capital requirements (BCBS, 2010a). Therefrom, in addition to the minimum total of 8%, banks will be required to hold a CCB about 2.5% of RWA’s in the form of common equity. The CCB will be phased-in over a period of four years in a uniform manner of 0.625% p.a., commencing from January1, 2016 (Singhal, 2011).
7. Systematically important financial institutions: For certain banks that are in a group of systematically important financial institutions, it is a special requisite. The Basel III prescribes additional norms of SIFI’s. Large important institutions are interconnected and can transfuse shocks between each other. The capacity should be between 1-2.5% depending on how important the banks are in systematic point of view (BCBS, 2010b).
Table 1: Summarizes the new elements in Basel III
Challenges of Basel III
1. A new risk and financial management culture:Basel III is the new regime that seeks much greater integration of the finance and risk management functions. However, the adoption of a more stringent regulatory perspective might be hampered by dependence on multiple data silos and by a separation of powers between those who are responsible for finance and those who manage risk. As well as being a regulatory rule, Basel III in many ways provides a framework for true enterprise risk management, which involves covering all risks to the business (Labhart, 2012).
2. Managing Basel III (different geographies, different issues: Different regions and countries face different challenges in applying Basel III. The EU plans to deliver a combined set of rules across Europe, to discourage ‘gold plating’, and ensure that there is a level playing field, removing the scope for regulatory arbitrage. The US efficiently omitted Basel II, so that it will be making a fresh start, building on the foundations of Basel I. Some countries choose to start with a clean sheet and implement the full set of rules and others opt to use Basel III solely as a direction of travel, without adopting the full package. Further, the global complexity adds complication since banks might need to manage different regulations in different jurisdictions; and a bank, possibly will be obliged to report under Basel I in one country and Basel III in another, depending on where the bank is domiciled (Michael, 2011).
3. Managing the data:To deliver conformity against Basel III, all banks must now ensure that risk and finance teams have quick and easy access to centralized, clean, and accurate data. This data must reflect their bank’s credit, market, concentration, operational, impairment, and liquidity risk. All banks will also need to calculate the enhanced capital, new liquidity ratios, and new leverage ratios. Furthermore, the data must be carefully defined and managed to ensure that the correct ratio calculations for capital adequacy, leverage, and liquidity must be delivered every time ( Harle & Luders, 2010).
4. Auditing the data: When a regulatory report has been submitted, it is necessary that regulators follow up with the bank to clarify critical issues about how the results were calculated and the rules were applied. This will require the bank to identify, check, approve and submit the data, quickly and accurately (Michael, 2011).
5. Stress testing: It is the ability to understand the influence of significant market events on the key ratios to receive greater significance under Basel III. It provides an insight on the plausible scenarios on banks’ risk profile & capital position. The bank periodically determine and refines its stress tests in an effort to ensure that the stress scenarios capture material risks as well as reflected possible extreme market moves.(Jain, 2013).
6. Taking an integrated approach: The Basel III regulations reflect the cohensive nature of banks and banking. This approach allows risk managers to focus their attention towards primary risk management activities rather than the time-consuming data extraction, quality and reporting issues. Fast calculation engines would assist weekly and even daily calculations and would feed unified and widespread regulatory reporting that is mapped to the local supervisors’ exact requirements, and provide additional business insight for the bank (Chabanel, 2011).