The Basel Accords and the Economic Impact on Banks - Term Paper Example

?Basel III Introduction The banking crisis of 2008 has caused regulatory agencies to analyze the possible root causes of the financial meltdown. Banking crises have been affiliated with major economic disturbances and recessions. The root cause of the 2008 Great Recession may be due, in part, to the implementation of the Basel Accords to level the playing field in the international banking community. Basel I was criticized for being inadequate in its assessment of assets to risk categories because assets with different risk composition would be categorized into the same risk groups. A primary issue of the Basel II accords was the practice of securitization were banks combined risky loan assets into asset-backed securities and sold the securities to investors. When the housing bubble collapsed before the financial crisis, the asset-backed securities loss value and many banking firms faced insolvency and required federal bailouts. This paper will review the Basel Accords and the economic impact on banks because of the Basel Accords. Basel I and II background Basel I, which centered mainly on credit risk, came into existence in 1988 and became legally enforceable in the G10 nations in 1992 (Barron, J 2011). The goals of Basel I was to mandate that banks preserve enough capital to absorb losses without creating universal difficulties. Basel I was criticized for being inadequate in its assessment of assets to risk categories because assets with different risk composition would be categorized into the same risk groups. The Basel III established the amount of reserves required by banks to avert losses and cushion the financial industry against possible future financial catastrophes. Basel II was created in June 2004 after concerns arose with Basel I because of the regulatory arbitrage. Basel II was seen as a more risk-sensitive standard that applied bank’s own approximates of risk in deciding minimum capital demands. Basel II placed measures on the amount and usage of a bank’s capital to cover the risks they experienced. One of the fundamental modifications suggested by Basel II is the heightened sensitivity of a bank’s capital obligations to the risk of its assets: the quantity of capital that a bank has to capture is to be directly associated to the riskiness of its underlying assets (Drumond, I 2009). Because Basel II connected the riskiness of banking institution lending with the funds it held, basically making higher risk transactions have elevated reserve requirements than lower risk ones (Barron, J 2011). A chief concern of the Basel II imitative was the practice of securitization. Banks grouped risky loans into asset-backed securities and sold the securities to investors. This practice allowed the banks to move the risky assets off their balance sheets. This process allowed financial institutions to decrease their capital obligations, take on increasing risks and augment their leverage ('FOCUS: The Business Impact of Basel III' 2010). The early Basel accords permitted banks to engage is the process of securitization. The 2008 banking crisis was not mainly the consequence of negligent regulations but was caused by abuse of the United States financial system by financial entities. The affordable housing projects beginning in the 1990s, when Basel I was established, permitted banks to make risky mortgage loans. The risky loans were packaged into mortgage-backed securities and investors purchased the risky assets hoping for a high return on their investment. When the housing bubble began to diminish, the risky loans in mortgage-backed securities lost value and financial establishments holding the assets faced financial hardships. Lehman Brothers faced insolvency and regulators agreed to a sequence of standards directed at avoiding a repeat of the 2008 banking crisis (Preston, A 2010). The banking crisis magnified the necessity for federal officials and central banks to reorganize banking industry regulations ('FOCUS: The Business Impact of Basel III' 2010). Following the financial bailouts consisting of trillions of dollars added to the federal budget, legislators began to address the concerns Basel II (Dammers, C 2010). Basel III The Basel Committee arrived at an agreement on the amount of reserves are needed by banks to absorb losses and cushion the financial industry against possible future financial catastrophes. The committee's proposal, known as Basel III, increased the minimum common equity that financial institutions will hold to 7% and it also added a counter-cyclical safeguard of up to 2.5% of risk-weighted assets, which regulators can enforce when they perceive credit is flowing freely ( 'Basel III - The Whimper). Basel III limits the types of assets that can be included in Tier 1(Monroe, M 2010). The minimum common equity capital ratio of 4.5% of risk-weighted assets must be adhered to by Jan. 1, 2015 and the capital conservation buffer of an additional 2.5% of risk-weighted assets by Jan. 1, 2019 (Monroe, M 2010). Basel III allows for a phase-in of the minimum common equity capital ratio, the capital conservation buffer, and the Tier 1 capital requirement (Monroe, M 2010). Basel III restricts the types of assets that can be allowed in Tier 1 capital to common shareholders' equity plus limited risk assets that is capped off at 15% of common equity in the aggregate and 10% of common equity for any one asset type (Monroe, M 2010). The risky category of assets included mortgage servicing rights and deferred tax assets (Monroe, M 2010). The needed ratio of Tier 1 capital that included equity and retained earnings over risk-weighted assets will change from 4.0% to 6.0%; and the compulsory ratio of equity to risk-weighted assets will rise from 2.0% to 4.5% ('FOCUS: The Business Impact of Basel III' 2010). Two capital buffers will be established, both buffers will necessitate banks to maintain extra common equity. The buffers are significant because it will compel institutions to act rapidly to fortify their balance sheets as the risk of possible losses intensifies (Barron, J 2011). When the firm’s capital ratio falls below 7.0% during periods of financial turbulence, the capital conservation buffer is required to be above 2.5% with common equity ('FOCUS: The Business Impact of Basel III' 2010). The capital conservation buffer will be started in 2016 at a level of 0.625% of risk-weighted assets, progressively rising annually to arrive at 2.5% by 2019 (Perspectives on Basel III' 2010). Banks are not required to maintain the capital conservation buffer during intervals of difficulty but they will face restraints on the distribution of earnings if the buffer is not maintained ('Perspectives on Basel III' 2010). Basel III also proposed to establish a countercyclical capital buffer from 0% and 2.5% to kick-in only during intervals of extreme credit growth. The objective of the countercyclical buffer is to reverse the pro-cyclicality of the Basel II accords. The countercyclical buffer is added to the capital conservation cushion when the economic environment in a nation creates excessiveness in the growth of credit that may affect the quality of the assets ('FOCUS: The Business Impact of Basel III' 2010). Economic impact of Basel III During a recession asset prices, such as home values, decrease and the risks affiliated with a homeowner tend to increase that in turn would require the capital obligation for financial institutions to increase and this increase would limit further lending. The countercyclical buffer will have an inverse effect on a bank’s capital obligations. A financial institution’s capital base will increase when the macroeconomic conditions in a country are favorable and will be decreased when the macroeconomic conditions in a country is unfavorable. The increased capital and decreased risk by banks may lead to repressed credit availability. In an attempt to avert a reoccurrence of the 2008 banking crisis, Basel III could have adverse effects on the business cycle. This feature of Basel III has created some concerns, in academic and policy-making circles because it may emphasize the cyclical propensity of banking. If there is stress in the market for bank funds during a recession, borrowers are downgraded by the lending risk models that bank utilize and, as a result, the minimum capital requirements for banks will rise. During the downward phase of the business cycle it is difficult or costly for institutions to raise funds. The required increase in bank capital buffers and the economic conditions may encourage banks to further decrease lending, thereby intensifying the economic downturn (Drumond, I 2009). Because Basel III will progressively require institutions to maintain larger capital buffers to absorb possible losses, this may have an adverse affect in the credit system because banks may impose stricter guidelines on credit cards, mortgages and other types of loans (Frank Jordans & Greg, K n.d.). Banks that will be required to maintain additional capital buffers will restrict lending. Consumers could witness institutions implementing stricter rules on credit availability and the banks may increase consumer banking charges to build reserves to meet the buffer standards of Basel III (Frank Jordans & Greg, K n.d.). When the economic environment is adverse financial institutions boost their capital ratios by cutting down on lending. Access to loans will become difficult and expenses associated with lending will increase for the borrower ('FOCUS: The Business Impact of Basel III' 2010). The larger corporations may consider alternative ways of obtaining financing. Big corporations have the capabilities of raising capital through the issuance of corporate shares or issuing debt. Smaller organizations may experience difficult borrowing conditions, because the Basel III indicatives have an effect on mostly small financial institutions and increasing equity or issuing debt is an expensive alternative for small and medium-sized entities than for major corporations ('FOCUS: The Business Impact of Basel III' 2010). Interest rates on credit provided by banks to small firms will increase because the small business is riskier and necessitates an increase in regulatory capital as lending to larger firms (Tolley, S 2010). For the top 30 or so U.S. and European banks, these capital and liquidity requirements will be a nonevent. However, for the smaller and midsize banks, the increased competition for capital and liquidity may produce very strong pressure for consolidation both in the United States and Europe. Banks have argued against Basel III because the standards could reduce bank earnings and increase the cost of borrowing for businesses and consumers and banks have also indicated that the measures may cause a decrease in lending, which may limit economic growth. (Eric, J 2010) Denmark's mortgage institutions, central bank and financial regulatory authority stated that Basel III measures could present a severe danger to the Danish mortgage lending system and wipe out the nation's adjustable rate mortgage lending( 'Basel III 'to destroy' Denmark's ARM loans' 2010). Basel III capital requirements will cause banks to search for new sources of funding because the prepackaging of mortgage-backed securities may not be a viable investment. Before the 2008 banking crisis, banks made up a very large percentage of the investors in asset backed securities and the low funding and capital expenditures meant that securitization was an enormously low cost funding source for banks (Dammers, C 2010). Basel III rules may result in a decrease of investments in the securitization markets because the measures for securitization risk weights means that securitization may be less tempting to banks because it will be more of a burden on capital levels and returns may be lower (Thomas, P 2010). The decrease in the securitization and the need for banks to search for alternative sources of funding is due to Basel III’s introduction of a countercyclical capital buffer. When the banking system is facing a period of overabundance of lending growth, the countercyclical buffer will be positioned as a protection against the build-up of risk (Thompson, M 2010). With rigid underwriting metrics, business insecurity and the economic business cycle, banking profits will be squeezed, especially the banks with huge commercial or residential real estate representation. These banks may experience difficulty raising funds under the Basel III structure and may encounter more stress on their business structure than the bigger institutions (Sharma, J, & Greenlee, J 2011). Investors analyzed banks as an investment by their return on equity. Because of Basel III, banks wanting to maintain their investment grade and bond rating, banks will maintain better quality equity that will be required to be held against risk weighted assets. Bankers will need to find methods of decreasing the apparent riskiness of their asset base. In the past, financial firms utilized high risk sub-prime loans and packaged them into AAA-rated collateralized debt obligations marketed as risk-free investments (Preston, A 2010). With the new measures banks will be required to analyze the expectations for how the underlying assets are to perform, including default probability, rates of loss severity, and prepayment speed (Thompson, M 2010). A concern of the Basel structure is the risk-weighted assets and how that risk is calculated. The Basel III regulation is permitting banks and independent rating agencies to determine the riskiness of the assets (Preston, A 2010). Financial institutions should be cognizant that dividends and bonuses may be placed on hold if the institution has to draw down on its required capital conservation buffer of 2.5% above the Basel III minimums (Sharma, J, & Greenlee, J 2011). Shareholder distributions and bank management bonuses would remain interrupted until the bank builds up its required capital conservation buffer. This provision of Basel III could jeopardize the bank’s market capitalization and access to funds (Sharma, J, & Greenlee, J 2011). The danger to a bank’s equity position could cause the bank to suffer in the financial markets and, as a result, the bank may become insolvent. If a bank endures losses that compels it to draw down the capital conservation buffer, the bank will need to put into action corrective measures, such as cutting down dividends or lessening share repurchases to reestablish the buffer (Barron, J 2011). Conclusion Regulatory agencies reviewed the banking crisis of 2008 to examine the possible causes of the financial meltdown. The Basel Accords were implanted and the effects of the measures may have led to 2008 Great Recession. Basel I permitted banks to lower their credit standards for risky mortgage loans. Basel II allowed the banks to package the risky loans as security assets and those assets were sold to investors. This off-balance sheet financing provided a cheap source of funds to the banks. When the sub-prime loans loss value, many banks faced insolvency and federal bailout funds was required to keep the banks in operation. Basel III was established to require banks to provide a capital buffer against their risky assets. 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