Basel III Effecacy on Hedging Against Financial Risks - Essay Example

?Overview Basel II was launched in order to make the financial system more risk sensitive and to improve the capabilities of the financial s to actually improve their robustness and ability to cope with the extreme situations. However, the current economic crisis has put a big question mark over the ability of the Basel II framework to put an effective check over the behavior and practices of the financial institutions. The risk created due to the changes in the economic situation quickly eroded the capital of the banks thus making Basel II also a pro-cyclical accord. (Varotto)1 Basel-III is a new initiative by the Basel Committee on Banking Supervision to improve the liquidity as well as the capital adequacy of the banks amid the financial crisis. Though still in the consultative phase, Basel III is considered as an upgradation of the existing Basel –II framework and has placed new requirements on the economic capital of the banks. According to the new changes, the core capital of the banks will be increased as a percentage of the Tier 1 capital of the bank where the Tier 3 capital of the banks and financial institutions may be scrapped under the new rules. There will be many major changes under the new capital accord making banks more capable of facing the challenges of any future economic shocks. (Standard & Poors)2 This paper will discuss the notion of why Basel III will be effective on hedging against the financial risks and other potential financial crisis in the future. Prior Research Basel-III is still in a consultative phase and there is generally a dearth of the research on the topic and how it is going to affect the financial system. Basel II was launched in order to make banks’ capital more risk sensitive in the wake of the overall risks faced by the financial system as a whole. The current financial crisis has largely exposed the inability of the Basel II to actually safeguard the banks against the changes taking place at the global level due to the financial crisis. (The Economist)3 It’s being argued that the Basel-II failed to allow the banks to safeguard themselves against the extreme stress faced during the current economic crisis. Basel-III accord is therefore aimed at ensuring that balance sheets of the banks should be further strengthened to help them safeguard against the extreme situations. (Hauswald)4 It is also argued that Basel II was actually the underlying cause of the current financial crisis and Basel-III may not also result into better management of the banks in the wake of the potential financial crisis. This line of argument is however, based upon the notion of the pro-cyclical nature of the accord and how banks can actually circumvent the regulations in order to take benefit from them. (Lall)5 It is also argued that Basel-III may slow down the economic growth- a feature which was actually not present in the previous Basel accords. This is due to the higher liquidity requirements for the banks as well as the holding of large amount of Tier-1 capital thus restricting the ability of the banks to lend aggressively. (Corrigan)6 Understanding the Main Proposals of the Basel III Framework Basel-III is different from Basel II and Basel-I on different counts including the introduction of two new ratios which banks have to manage besides changing the ratios for the core capital and Tier 1 capital while at the same time eliminating the Tier 3 capital altogether. As such new Basel-III accord attempts to lay down new rules and regulations for capital, liquidity as well as the leverage of the banks to improve their risk management practices, supervision and internal governance mechanism. (Summerfield)7 The overall purpose of the accord is to strengthen the capital of the banks so that the extreme risks arising due to the financial crisis could be avoided. It is because of this reason that the new accord proposes to hold more buffer capital while at the same time advocating for higher cash holdings. As such, new accord proposes to introduce new 30 day liquidity coverage ratio as well as the new leverage ratio. The new leverage ratio is considered as a supplement for the Basel II risk based framework in order to introduce a floor for the leverage in the banking sector. Further, the new accord also aims to further streamline the counter credit party risks arising due to the derivative transactions by raising the capital buffer to support such transactions. (Standard & Poors)8 Probably the most important proposed change under the Basel-III is the reduction in the pro-cyclicality. One of the strongest criticisms on Basel II accord was its procylical nature and new accord aims to reduce the pro-cyclical nature of the new capital requirements. Another important proposal under the new accord is to shift the OTC derivative contracts to clearing houses thus washing their balance sheets from the potential toxic debt. This would therefore allow the banks to still take benefits of the power of derivatives while at the same time reduce their impacts on their balance sheets. (Kollewe and Wearden)9 Further, the new rules on the forward looking provisioning would allow the banks to accumulate capital during better times and subsequently using the same during the time of the stress. This new proposal may however, also result into the decline in the short term profitability of the banks due to higher provisioning for accumulation purposes. (KPMG) 10 Would it be an effective Hedge against Risks? While introducing the new capital accord, Bank of International Settlement outlined that the new capital accord is aimed to “improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, improve risk management and governance strengthen banks' transparency and disclosures.” (BIS). 11The overall aim therefore is to ensure that the stability in the financial sector could be maintained and the risk and governance mechanisms are improved. Whether Basel-III would be able to achieve these objectives and can prove an effective hedge against the risks and potential new financial crisis could only be assessed when the new accord is fully implemented. However, some measures such as the introduction of the 4.5% of the core capital as the percentage of total risk weighted assets will create an additional buffer for the banks to safeguard themselves against the changes. The proposal that the leverage ratio to be introduced as a regulatory ratio will also further strengthen the ability of the banks to have better safeguard against the large scale changes in the overall risk profile of the whole financial system. One of the key weaknesses of the Basel II was its inability to help the banks to withstand the risks arising due to their investments in riskier assets. The models developed based on the Basel II requirements were considered as inadequate to forecasts the risks which could be arising from the banks’ investments into the riskier assets. Basel-III however, has further narrowed down and improved the criteria for better model building by the Banks to increase their robustness and ability to forecast the losses which may incur as a result of these investments. It is argued that one of the key reasons for the current financial crisis is the contagion effect and the counterparty credit risk. The contagion effect is due to the integrated nature of the economy and may largely remain outside the control of the banks. (Blundell-Wignall and Atkinson). 12However, the management of counterparty credit risk was considered as something which could be controlled by the banks through better risk management. The new rules set out in the Basel III are set to improve the counterparty credit risk management thus further strengthening the grip of the banks on managing riskier assets. This feature of the new accord therefore is going to help the banks to have better hedge against the financial risks and would allow banks to have buffer capital to manage such assets. (BIS)13 One of the key issues which could be a potential problem is the differences between the internal risk models of the banks and the rules outlined by the Basel-III. Though it’s believed that Basel-III has attempted to narrow this gap down however, this still remains and could therefore prevent banks from having an effective control over their risk profile under the new regime of Basel-III. What are its potential effects on trade and investment finance? It is argued that the new capital accord may result into the slow down in the growth rates of the economy. According to one study conducted by OECD, the medium and short term impact of the new accord on the economy would be in the range of -0.05% to -0.15%. This could be due to the increase in the overall banking spreads thus making the credit more expensive for the borrowers and thus reducing the overall flow of credit to the private sector. (Slovik and Cournede)14 Higher borrowing costs therefore could also result into the decline in the investment due to high cost of investment. However, this still has to be proved as the accord is fully implemented in the G-20 countries. From the perspective of UK, this can be important owing to the fact that UK economy is facing inflationary pressures and considering the 2%15 target requirements for the inflation, higher banking spreads may help the Bank of England to control inflation on long term basis. Another important issue which has been raised regarding the impact of the new accord will be the increased difficulty to be faced by the new and smaller borrowers. Since the overall cost of borrowing will increase besides the capital requirements for small borrowers will be higher, banks will have to ration higher capital. This would implicitly reduce the flow of credit to the smaller borrowers and further slowing down the economy. (Chandan)16 This feature will also be more detrimental for the economies and banks of the developing countries because of the overall characteristics of such economies. Borrowers in smaller and developing countries will therefore find it difficult to have access to the credit and therefore reducing the capital formation in such countries. Methodology Methodology is considered as the systematic use of different statistical methods to probe the underlying research questions. (Saunders, Lewis and Thornhill).17 This thesis attempted to understand and explore the potential impacts of the new Basel accord on the risk management and governance capabilities of the banks besides understanding whether the new accord will result into an effective hedge against the financial crisis. In order to achieve the above research objective, secondary research approach was adapted to survey the existing literature and studies on the topic. Secondary research focuses on the collection of data and literature from the existing body of knowledge and helps the researcher to find out meaningful patterns to form conclusion. It is also important to note that the survey methodology was used to collect the data for this thesis. However, this study is essentially a qualitative review of the existing literature since the accord is not fully implemented and the existing literature only discusses as to what could be the potential impacts of the new accord on the financial risk management and protection against the financial crisis. Findings The above qualitative review of the existing literature and other sources suggest that the new Basel accord will be helpful in providing the banks additional buffer capital to safeguard themselves against the extreme changes. The introduction of new leverage and liquidity measures therefore would allow banks to better prepare themselves against the changes in the risks arising due to extreme events. The new rules for the leverage, better counterparty credit risk management, more robust credit models as well as the better liquidity will provide banks in G-20 countries to have an effective control over controlling their risk appetite and have buffer capital to support. (Wearden)18 It is also however, important to note that new Basel accord may result into the slow down of the economy due to the wider credit spreads and the lack of credit extension to the smaller borrowers. Higher banking spreads and lack of credit extension to riskier borrowers may therefore result into the slow down of the economic activity and impact the short term profitability of the banks. (Onaran, Clark and Heaven)19 The higher core capital ratio may further result into the mergers and acquisitions where the smaller banks may be merged with the larger banks in order to fulfill the new capital requirements. (DOHERTY)20. This may further result into the higher concentration in the banking industry thus making financial system more vulnerable to the changes in the economic environment. Though banking sector of UK is dominated by big banks however, smaller banks may find it difficult to cope with the increased requirements for the core capital and subsequently merge with larger banks. Conclusion The above discussion suggest that the new capital accord may result into the better financial risk management and allow global banks to have better infrastructure in place to sustain the extreme risks arising out of the financial crisis. It is however, unclear as to whether new accord will help to provide a hedge against the financial crisis because of the integrated nature of the economy. The current economic crisis emerged due to the contagion effect and interconnectedness of different sectors of the economy with each other. This dependence of different sectors therefore may always keep the economy and the financial system vulnerable to the changes. The new accord therefore can only provide a better hedge against the financial risks arising purely due to the behavior and practices of the banks in financial services sector. By equipping banks with higher capital and more liquidity, new capital accord will help banks to have an effective hedge against the financial risks. Bibliography 1. BIS. "International regulatory framework for banks (Basel III)." 2011. BIS. 17 March 2011 . 2. BIS "Strengthening the resilience of the banking sector - consultative document." December 2009. BIS. 17 March 2011 . 3. Blundell-Wignall, Adrian and Paul Atkinson. "THINKING BEYOND BASEL III: NECESSARY SOLUTIONS FOR CAPITAL AND LIQUIDITY." 2010. OECD. 17 March 2011 . 4. Chandan, Sam. "What You Need to Know About Basel III." 30 September 2010. The New York Observer. 17 March 2011 . 5. Corrigan, Tracy. "Basel III will put brakes on growth but slow and sensible is the way to go." 30 September 2010. Telegraph. 17 March 2011 . 6. DOHERTY, JACQUELINE. "Rekindling the Urge to Merge." 25 Septemeber 2010. The Wall Street Journal. 17 March 2011 . 7. Hauswald, Robert. The Procyclical Effects of Basel II. 13 November 2008. 17 March 2011 . 8. Kollewe, Julia and Graeme Wearden. "Basel III- Main Points." 13 September 2010. Guardian. 17 March 2011 . 9. KPMG. Basel 3- Pressure is building. December 2010. 17 March 2011 . 10. Lall, Ranjit. "Why Basel II failed and Why any Basel III is doomed." 2009. Global Economic Governance. 17 March 2011 . 11. Onaran, Yalman, Simon Clark and Joseph Heaven. "The Battle Over Bank Rules at Basel III." March 2010. Business Week. 17 March 2011 . 12. Saunders, Mark N.K., Philip Lewis and Adrian Thornhill. Research Methods for Business Students. London: Financial Times/ Prentice Hall, 2002. 13. Slovik, Patrick and Boris Cournede. "Macroeconomic Impact of Basel III." 14 Feburary 2011. OECD. 17 March 2011 . 14. Standard & Poors. "Basel III For Global Banks: Third Time's The Charm?" 4 March 2010. Standard & Poors. 17 March 2011 . 15. Standard & Poors, "The Basel III Leverage Ratio Is A Raw Measure, But Could Supplement Risk-Based Capital Metrics." 15 April 2010. Standard & Poors. 17 March 2011 . 16. Summerfield, Alexander. "From Basel II to Basel III: history and issues." 28 June 2010. Societe Generale. 17 March 2011 . 17. The Economist. "The banks battle back." 27 May 2010. The Economist. 17 March 2011 . 18. Varotto, Dr. Simone. "Liquidity, Credit Risk, Market Risk and Bank Capital." International Journal of Managerial Finance 7.2 (2011): 157-162. 19. Wearden, Graeme. "Basel III rules will force banks to hold more capital." 12 September 2010. Guardian. 17 March 2011 . Read More