Executive Summery
This report discusses Basel III regulation that was recently released by the Basel committee. The scope of the report covers various aspects of the regulation framework. These incorporate issues that were found in Basel II regulation, which compelled drafting of Basel III. Features of the Basel III regulation (compared to Basel II) are important when considered critically. Nonetheless, there are various implications of Basel III on the banking sector. According to the research conducted, Basel II caused a lot of financial crisis. Regulators believe that Basel III will help in the management of financial risks thus eliminating financial crisis. However, Basel III regulation requires a lot of capital from banks and other financial institutions. This might hinder its implementation.
Introduction
Basel III regulations include new forms liquidity standards. These are bank regulations recently set by the Basel committee (Wittenbrink 2011, p. 14). The guidance procedures regarding the minimum capital instruments were released in January 2011. These regulations were formulated by the regulators to solve financial crisis experienced in the past. During these times, Basel II regulation was functional. Regulators believe that this regulation framework will help in proper management of unexpected financial risks by the banking institutions. In this report, the main factors that made regulators to consider shifting from Basel II to Basel III are discussed. Also, the key features as well as the implications of the Basel III regulation on the banking sector are discussed.
Main factors that made regulators to consider shifting from Basel II to Basel III
Initially, there were some limitations with the Base lI regulations. Even though these limitations were perceived early enough, no changes were made till the implementation of Basel II (Hull 2012, p. 23).This implies that the flaws of Basel I were carried forward to Basel II. The first weakness of Basel I is that it only focused on one major kind of risk, which is credit risk. Again, with Basel I, it was difficult to make a distinction between various kinds of assets that were risky. There was a delay in the implementation of the Basel II up to January 2009 by the U.S. though it was already adopted fully in January 2008 under the directives of the EU Capital requirements. Thus, it was unable to affect the existing financial predicaments.
Under the Basel II capital accord, three ideologies (pillars) were created to help in dealing with the regulation of finances. These 3 pillars included requirements for minimum capital, tools used by regulators for management, and transparency in the markets (Eubanks 2011, p. 45). According to the first pillar (requirements for minimum capital) various types of risks were classified into three categories. The concerned risks promoted the need for Basel III, which is more advanced. The three categories included the market, credit, and operational risks. Obviously, risks were more included here as compared to Basel I accord. The major role of financial institutions under the Basel II accord was the management of risks. Therefore, the financial institutions had the mandate of performing their private internal ratings based on numerous different kinds of assets. However, ratings agency could still categorize some other assets. The major responsibility of this pillar was to give creditors an opportunity of using their own risk models and evade the approach standardized in regard to Basel I Accord. However, this approach created two main problems. These factors made regulators to consider shifting from Basel II to Basel III.
The first problem is on the Credit Rating Agencies (CRA). The CRAs have received a lot of disapprovals in the recent past due to their role in creating financial crisis, especially in line with how they awarded credit ratings to subprime mortgages. They awarded credit ratings that were too good to be true (Eubanks 2011, p. 47). In addition, they acquired money from the financial institutions that they offered a good credit rating for. In this regard, their main interest was giving satisfactory credit ratings so that they could increase the returns they received from these institutions. This was a clear indication of interest conflict.
Another problem that was created by the first pillar of the Basel II accord was with the Internal Ratings Based Approach (IRB). In most cases, the IRB institutions would simply decide to create their private models for risk management as long as their institutions were big enough to have all the capability of affording it (Cox 2007, p. 54). Every so often, Lower capital ratios were created while using these modified risk models as compared to situations where the standardized methodology was adopted. Essentially, it is only worthwhile to get a low requirement for capital if that particular institution would be able to get back the costs incurred to develop the risk model. This created a chance for the banking systems to hold lower capital levels though it was not in the plan of the Basel II accord.
The second pillar of Basel II (regulation) also had its own limitations. First, it internationalized the concerned regulation (Chorafas 2004, p. 63). However, most countries were reluctant to adopt this regulation. There was no need to impose additional regulations on the sector that, according to them, was already doing well. More management tools were offered to the state regulators to perform their own investigations. But since different countries have different jurisdictions, this regulation was applied in many varying ways which demonstrated to cause a lot of problems practically. Consequently, different kinds of results would be obtained from same banks that operated in different nations. Apparently, these differences were caused by the fact that different nations interpreted the regulations differently. This was delicate issue that required an agreement to be arrived at, but it was difficult. The European Banking Authority, which was formerly known as the Committee of European Banking Supervisors, came up with some guidelines to be used by the national supervisors. However, these guidelines proved fruitless in helping to solve the frustrations that were being experienced by the banks (Chorafas 2004, p. 65). Therefore, the regulations continued to cause lots of complications.
In the third pillar of Basel II (market transparency), banks were forced to be more transparent. They were required to issue information with regard to the kind of approaches they used in managing risks. The underlying concept was to subject the risk models used by different creditors for examination and market discipline. This would tentatively depress the precarious behavior of different banks (Grier 2007, p. 74).
Precisely, all the major forms of regulation needed were provided by the three pillars of the Basel II regulation. However, these regulations were never effective and resulted in lots of crisis because of the late adoption of the accord. The approaches that were used to manage risks were feeble and this was one of the factors that contributed to decline in market confidence. The major consequence was a reduction in the cost of insecurities. In addition, the hazard that was related to securities that were supported with mortgages was totally unjustified and contributed much to the subprime crisis.
The main features of Basel III and how they differ from Basel II
There are several features of the Basel III accord that differ from Basel II. Firstly, the Basel III accord offers better quality capital as compared to the Basel II accord (Gregoriou 2009, p. 53). In Basel III, capital has been given a much more stringent definition. The fact that better quality of capital is offered implies that there will be a higher ability to absorb losses that are incurred by the banks. Thus, banks will be more resilient and will be able to endure the times when they are under financial stress.
As opposed to Basel II, where banks had no capital conservation buffers, it is obligatory for banks to have a capital conservation buffer of 2.5 percent in the Basel III accord. The major purpose of this requirement is to make sure that banks always have some capital, which can help them in absorbing losses that can be experienced during times of financial strain.
Another important feature of Basel III accord is the introduction of counter-cyclical buffer. The main aim of introducing this feature is to help in boosting and reducing the requirements for capital during favourable periods and worst periods respectively. The countercyclical buffer will help to reduce the activities in the bank during good times and will raise the lending rates during times of financial stress. The amount of this buffer varies from 0% to 2.5% (Ral & Gorak 2011, p. 26).
Under the Basel III accord, there is an increase in the least common equity obligation to 4.5% as compared to Basel II where it was 2%. This is maximum capital for absorbing losses. Additionally, the necessities for Tier 1 capital have also been increased to 6% over the previous 4% in the Basel II regulation. This consists of both common equity as well as other financial instruments to make it eligible. With the inclusion of a conservation buffer, there will be a rise in the total amount of capital required to 10.5%. However, the least requirement for total capital will still be 8% as it is presently.
According to the assessment that was conducted on the 2008 financial crisis, the worth of most assets reduced drastically than it was originally assumed. The Basel III accord introduced the concept of the leverage ratio, which is the comparative capital sum to the total amount of assets. The major purpose of this is to act as a safety measure (Hull 2012, p.102). Another feature that is introduced under the Basel III accord is the liquidity ratios. This accord creates a structure for controlling liquidity risks, though new liquidity ratio will be implemented in 2015. Net stable ratio, which is also another feature for controlling liquidity risks, will be implemented in 2018.
The final feature of the Basel III accord is the Systemically Important Financial Institutions (SIFI). It is anticipated that banks that are considered to be systemically important should have their own abilities to absorb losses further than the obligations provided by the Basel III accord. Some of the operation alternatives include additional capital charges, bail-in-debt and contingent capital.
Implications for the new regulation for banks
Basel III accord regulations introduce very stringent measures to deal with financial crisis (Gregoriou 2009, p. 71). However, these regulations may not be adopted equally in different nations. Again, these regulations may not be adopted at the same time. Consequently, banks operating in several nations will have to conform to the stern national timelines as required. Besides, minor facts of the rules applicable to the national capital adequacy will be different when this accord is completely adopted. These banks will again be forced to observe the jurisdictions of their host nation, even if these nations have the strictest capital adequacy obligations.
Intercontinental banks can also experience strain due to the obligations of the counter-cyclical buffers evident in Base III regulations. According to the Basel III regulations, each nation can decide to upsurge its own capital requirements as long as they feel that there is a risky credit build-up. The countercyclical buffer to be upheld by an international bank will be a weighted average of the several countercyclical buffers that operate in the nations in which it has coverage for credit (Wittenbrink 2011, p. 43).
According to the report that was released in December 2010 by the Basel committee, banks must acquire an extra Tier 1 equity capital amounting to 602 billion euros. This amount should be acquired by the close of the year 2009 if they have to comply with the new regulations for common equity. Most banks will not be able to meet this requirement.
Conclusion
In conclusion, the Basel III accord was drafted to deal with issues in Basel II including the financial crisis. Actually, the Basel III regulation is very effective in dealing with the expected risks, but not unexpected risks. However, banks will be forced to acquire considerable capital for securities. This might result in the failure of the accord if not reviewed properly. If accurately addressed, Basel III can be the best regulatory framework.
References
Chorafas D 2004, Economic Capital Allocation with Basel II: Cost, Benefit and Implementation Procedures, Butterworth-Heinemann, Jordan Hill.
Cox D 2007, Frontiers of Risk Management: Key Issues and Solutions, Euromoney Books, London.
Eubanks, W 2011, Status of the Basel III Capital Adequacy Accord, DIANE Publishing, Pennsylvania, PA.
Gregoriou, G 2009, Operational Risk Toward Basel III: Best Practices and Issues in Modeling, Management, and Regulation, John Wiley & Sons, New York, NY.
Grier, W 2007, Credit Analysis of Financial Institutions, Euromoney Books, London.
Hull, J 2012, Risk Management and Financial Institutions, John Wiley & Sons, New York,NY.
Ral, J & Gorak, J 2011, The Effects of Basel III on Private Equity Financing, VDM Verlag, Saarbrucken.
Wittenbrink, A 2011, Financial regulation through new liquidity standards and implications for institutional banks: Basel III, GRIN Verlag, Munich.