Financial Services: the Key Elements of the Basel III Framework - Report Example

?Financial Services Table of Contents Introduction 3 Background to Basel III 5 Overview of the Key Elements of the Basel III Framework 8 Capital Ratios 8 Constituents of Capital 9 9 Leverage Ratio and Liquidity Ratios 9 Shortcomings of the Basel II That Could Not Prevent the Financial Crisis 10 Implications of the Proposals of Basel III Framework 11 The Sufficiency of Basel III Standards to Prevent a Further Financial Crisis 13 Conclusion 15 References 16 Bibliography 19 Introduction In the year 1988, the Basel Committee on Banking Supervision established a capital quantifying arrangement in banks. This system was widely known as the Basel Capital Framework. It has been broadly utilised by almost all the financial authorities across the globe in addition to the entire set of banking entities that possess global operations. The Basel Framework’s establishment of the ‘capital measurement system’ in banks assisted in the execution of a credit risk structure with the help of set least capital adequacy standards. The Basel Framework has ever since acted as a compulsory discipline for the banks and has contributed to the monetary power of the banking federation as a whole (Bank for International Settlements, 2011; Blundell-Wignall & Atkinson, 2010). The capital adequacy limits set by the Basel Committee on Banking Supervision on the banks are anticipated to decrease the insolvency perils of the banks. The ‘capital adequacy obligations’ of the banks necessitate them to enhance the percentage of equity in their portfolio as compared to the percentage of debt. The equity value of a bank acts as a buffer and protects the depositors from the risk of bank’s default of assets. Since the ‘capital adequacy obligations’ imposed by the Basel Accords necessitate the elevation of the equity levels in the bank, it consequently enhances the depositor protection. By successfully restraining the debt-equity ratio of a bank, a capital adequacy obligation could lessen the propensity towards unwarranted risk-taking that is acknowledged to be related with debt finance (Dowd & Et. Al., 2011; Elliot, 2010). The ‘Basel Committee on Banking Supervision’ had introduced two sets of global regulatory principles so far, viz. the Basel I Accord in 1988 and the Basel II Accord in the year 2004. In December 2010, the Basel Committee had come up with a fresh version of its latest standards for bank capital as well as liquidity obligations. This latest set of worldwide regulatory standards for banks is referred to as the Basel III. The core facets of Basel III are planned to be realised as nationwide regulation by the first half of 2013. However, while certain portions of the new Basel principles are supposed to become effectual upon execution, the others would be implemented over a phase of numerous years. The main reason for the development of the Basel III was the deficits in the financial policies of the Basel Accord II that were exposed during the worldwide financial calamity in the year 2008 (Bank for International Settlements, 2011). This paper critically examines the general approach to measuring capital adequacy levels of banks as per the new standards implemented by the Basel III. The paper subsequently discusses the drawbacks of the Basel II standards that were exposed during the 2008 worldwide financial catastrophe and which consequently led to the development of the Basel III standards. Additionally, the paper also appraises whether the imposition of the Basel III standards for capital adequacy as well as liquidity obligations of bank will be sufficient to prevent a further financial calamity in future. Background to Basel III Various regulatory bodies have recognised that the prevalent strategies of capital regulations of the banks in the United States as well as the European Union, on the basis of the Basel I and the Basel II Accords as a major reason contributing to the 2008 financial disaster (Shearman & Sterling, 2011; Dowd & Et. Al., 2011). This can be substantiated from the fact that under the prevalent capital adequacy policies prior to the financial crisis, the least regulatory capital obligations of banks were inadequate. The low capital obligations imposed on the banks as per the Basel II in addition to certain standards linked to the Basel I were deficient in the context of the elevated exposures and real tangible losses endured by the banking entities during the economic downturn. It was also stated that the quality of the capital maintained by the banks as per regulations were time and again found to be inadequate in absorbing the losses sustained by the banks during the economic crisis successfully (Shearman & Sterling, 2011). The capital adequacy policies set as per the standards of the Basel II along with that of the Basel I, did not sufficiently detain the risks that were caused by bank exposures to certain dealings. The transactions or dealings that increased the exposures of the banks that the regulatory standards failed to capture were securitisations, repurchase agreements and derivatives. The regulatory policies of Basel I and Basel II also failed to effectively take into account the systemic risks related to the upsurge of leverage in the fiscal and monetary system. Furthermore, the standards imposed by the Basel I and Basel II Frameworks concentrated merely on capital and ignored the liquidity issue. There were no globally approved quantitative principles for liquidity guidelines of banks (Dowd & Et. Al., 2011). This non-consideration of the liquidity of the banks in addition to their failure to control the risks caused by bank exposures is often alleged to have been a severe limitation when the economic downturn stretched out in the year 2007. These drawbacks of the Basel I and Basel II became more apparent when there were rapid decline in liquidity in the major financial support markets utilised by numerous banks as well as bank-sponsored entities as a result of the financial downturn (Dowd & Et. Al., 2011; Elliot, 2010). The ‘Basel Committee on Banking Supervision’ acted in response to the economic as well as the financial depression, and started to build up standards to complement and in certain cases, alter, the prevailing standards of Basel I as well as Basel II. As a result the Basel committee released projected amendments in July 2009, which chiefly dealt with banks’ risk-based capital obligations as well as their disclosure prerequisites. In December 2009, the Basel Committee published suggestions concerning amended requirements for risk-based capital of banks and fresh liquidity standards in addition to the introduction of a predetermined requirement of leverage ratio. Subsequently, the Basel Committee formed the Basel III framework and released the confirmed document containing the core elements of Basel III in December 2010 (Byres, 2011; Bank for International Settlements, 2011; Shearman & Sterling, 2011). The Basel III comprises of the fundamental constituents of the ‘Basel II framework’. However, there are numerous significant new constituents associated chiefly to the least capital obligation ratios, policies defining the eligibility of capital as per the regulations in addition to liquidity and leverage obligations for banks (Ennis & Price, 2011). Overview of the Key Elements of the Basel III Framework Capital Ratios The regulatory standards of Basel III would necessitate the banks to hold at least 4.5% common equity constituent by the year 2015. Presently, the banks are required to hold a value of 2% common equity as regulatory capital. The ‘Basel III framework’ had sustained the ‘core solvency ratio’ to be maintained by the banks at 8% of the banks’ risk-weighted assets. As per the new framework, by the year 2015, the banks would have to hold 6% of Tier 1 capital which is inclusive of the common equity value of the banks. Presently, the banks have to maintain minimum of 4% of Tier 1 capital base. Additionally, the banks would have to maintain a ‘capital conservation buffer’ equivalent to 2.5% of their risk-weighted assets by the year 2019. This implies that after 2019, the banks would be required to retain a value of 7% of their risk-weighted assets in common equity, which includes 4.5% minimum and 2.5% ‘capital conservation buffer’. Consequently, the banks whose common equity value lie in between 4.5% to 7%, would be subjected to restrictions in terms of share buybacks and dividend payouts among others. Furthermore, during the periods of extreme credit expansion, the Basel III framework is expected to impose an additional ‘countercyclical capital buffer’ of 2.5% of risk weighted assets. The banks would be permitted to release this buffer amount of capital during periods of credit reduction (White & Case, 2011; Shearman & Sterling, 2011). Constituents of Capital According to the ‘Basel III framework’, the Tier 1 common equity element of banks would be composed of ‘ordinary share capital’ as well as retained earnings. The ‘additional Tier 1’ also referred to as the ‘non-common equity Tier 1’ would chiefly consist of preference shares that are continuously non-cumulative in nature in addition to other instruments that meet the criteria. The new Basel III standards would not require the division of ‘Tier 2 capital’ into lower Tier 2 and upper Tier 2, and instead a sole group of criteria would be applicable to the Tier 2 capital. The instruments falling under the category of Tier 2 and the additional Tier 1 would be either transformed to common equity or written down in the occasion of the bank becoming non-workable without assistance. Furthermore, the Basel III framework does not necessitate the banks to maintain a ‘Tier 3 capital’. Additionally, the regulatory alterations if any would be applicable to the common equity element of Tier 1, instead of the overall capital (Shearman & Sterling, 2011). Leverage Ratio and Liquidity Ratios Banks would have to maintain a ratio of ‘Tier 1 capital’ and the bank’s asset equivalent to 3%, after the complete implementation of the Basel III. Consequently, the banks would be required to maintain a leverage ratio of 33:1, implying that the leverage of the banks would be limited at 33 times their ‘Tier 1 capital’. For the maintenance of short-term liquidity, from the year 2015, it would be necessary for the banks to uphold a buffer of liquid assets standardized pertaining to the ‘net cash outflow’ over a stressed phase of 30 days. On the other hand, for the preservation of the long-term liquidity, it would be essential for the banks to possess secure funding ready to meet the financial support necessities over a stressed phase of one year. The execution of the long-term liquidity obligations as per the Basel III is supposed to be imposed from the year 2018 (Shearman & Sterling, 2011; Bank for International Settlements, 2011). Shortcomings of the Basel II That Could Not Prevent the Financial Crisis One of the major causes for the severity of the economic and financial disaster of 2007/2008 was that the banking entities of several countries across the world had developed disproportionate on? as well as off?balance sheet leverage. This excessive rise in the leverage was escorted by continuing wearing away of the level as well as quality of the banks’ capital base. Additionally, during the same period, numerous banks possessed inadequate liquidity buffers. As a result, the banking system could not soak up the consequent universal trading in addition to the overall credit losses. Moreover, the banking entities across the world could not handle the re-intermediation of huge ‘off?balance sheet exposures’ that had developed in the shadow banking classification. The financial depression was additionally augmented by a pro-cyclical deleveraging procedure and by the interdependency of general financial institutions through a range of multifaceted transactions (Dowd & Et. Al., 2011; Blundell-Wignall & Atkinson, 2010). Implications of the Proposals of Basel III Framework The major alterations that are supposed to be brought about in the banking capital requirements as a result of the implementation of the Basel III are enhanced quality and quantity of capital, diminished leverage in banks by means of backstop leverage ratio, augmented liquidity coverage, and reinforced risk capture (KPMG, 2011; Moody’s Analytics, 2011). The ‘Basel III framework’ comprises of several measures that are targeted to enhance the quality of the banks’ regulatory capital. The final objectives of these measures are to augment the loss-absorption ability of the capital in all circumstances, such as going concern or liquidation. As a result of the new measures of the Basel Committee, it is likely that there would be considerable rise in the capital level of the banks in addition to withholding of earnings and hence decline in dividend payouts. Another possible implication of the Basel III measures is that the nationalised regulators would possess a lesser amount of flexibility to permit financial instruments to be integrated in the Tier 1 or Tier 2 capital of banks. Furthermore, in order to meet the supplementary capital requirements as prescribed by the standards of Basel III, it is likely that all the banking entities would be permitted to release contingent convertibles (KPMG, 2011). The Basel III regulations comprises of diverse actions aimed at enhancing the capital level detained by the banks in addition to offering counter-cyclical methods to deal with financial instabilities. In order to abide by these regulations the banks would require further capital and the amount of this deficit could be met by the banks by raising common equity or by not paying out dividends. According to the Basel III, during the times of distress the banks would be permitted to utilise their ‘capital conservation buffers’. However, it is improbable that the banks would select to do so because of the related restrictions on the distribution of their profits. Instead the banks might possibly target a superior Tier 1 common equity ratio of around 9% as per the market anticipation (KPMG, 2011). Additionally the banks would have to take into concern the Pillar 2 risks as well as the amount to be held as ‘countercyclical capital buffer’. Hence, it is likely that the banks would intend to hold a capital ratio between the ranges of 13% to 15% (KPMG, 2011). The inclusion of the leverage ratio in the regulation of Basel III could result in decreased level of lending by banks, which would surely reinforce the capital position of the banks. The enclosure of the leverage ratio would possibly lessen the risk of an upsurge of unnecessary leverage in the banking entities and the overall financial system. This would also induce the banks to concentrate on lending that would generate superior return. Since the leverage ratio prescribed by the Basel III does not take into concern the risks associated with the bank’s assets, there is a possibility that the banks would be obligated by the market as well as the rating bureaus to uphold an elevated leverage ratio than mandatory by the Basel Committee (KPMG, 2011). The emphasis of the Basel III on enhanced liquidity coverage of banks would result in the augmentation of the steadiness of the financial sector in general. However, the inclusion of the liquidity coverage ratios would have a depressing influence on the profitability of the banks. This is because the banks would be obligated to hold considerably more amount of liquid assets bearing low yield in order to reach the ‘liquidity coverage ratio’. Moreover, as a result of the banks’ requirement to maintain the liquidity coverage as per the Basel III Framework, the banks are likely to alter their funding outline. This would result in amplified demand for relatively long-term funding (KPMG, 2011). All the measures implemented by the Basel III framework and their possible implications would result in a prototype change in the liquidity and the capital requirements of the banking entities. In order to place themselves competitively in the latest regulatory framework, banks should make sure that they engage in the implementation of the Basel III requirements as soon as possible (Moody’s Analytics, 2011). The Sufficiency of Basel III Standards to Prevent a Further Financial Crisis The Basel III principles for capital adequacy and liquidity requirements can be considered to be an opportunity as well as a test for the banks. The Basel III framework can endow the banking entities with a solid base for the subsequent progress and expansion in the banking sector. The appropriate compliance of the Basel III standards can make sure that past excesses in leverage are avoided. The Basel III standards require the banks to maintain an elevated level of enhanced quality capital as well as more liquidity in addition to maintenance of more secure funding profile. Thus, the proper implementation of the Basel III framework is intended to make the banking system tougher and also more flexible than it demonstrated in the middle of the most recent financial and economic depression (Ennis & Price, 2011; Bank for International Settlements, 2011). The choice of the technology architecture utilised to execute the Basel III framework would play a decisive role in making sure that the latest regulatory framework is an opportunity for the banking entities. The technology architecture chosen by a bank is required to consider the structure of the bank and the processes employed in it in addition to its scale and geographic spread. Additionally, it is necessary that the technology architecture impeccably merges all these into the magnitude and reach of the Basel III regulations. The solution should be adequately resilient to fit the requirements of the bank and accommodate alterations in the businesses as well as the policies (Blundell-Wignall & Atkinson, 2010). The imposition of enhanced capital adequacy and liquidity obligations would not definitely guarantee the prevention of any further financial turmoil. However, the compliance of the Basel III obligations would strengthen the banking sector’s position to meet up with the challenges of financial depression. This is because the Basel III framework would make the banking entities more flexible by ascertaining that they hold much advanced levels of financial sufficiency in future (Amediku, 2011). Conclusion It has been illustrated from the study that the implementation of Basel III would be an evolutionistic approach for the entire banking industry. Hence, the influence of Basel III on the banking entities and the banking industry as a whole would be tremendous as it would develop considerable challenges for the banks in the context of higher capital and liquidity requirements (Bank for International Settlements, 2011). The intricacies and tough requirements of Basel III and the business hassles of the banking system would necessitate that the banks employ a resilient Basel III administration solution that brings rapidity, precision, and performance to develop a competitive lead. The banks that are successful in employing the most favourable solution would not only develop a perfect platform for implementing the Basel III requirements, they would also build a firm base for their upcoming business development (White & Case, 2011). Furthermore, the successful execution of Basel III by a bank would also exhibit to the financial and banking regulators, in addition to the bank’s shareholders and clients that the bank is recuperating well from the worldwide banking calamity of 2008 (Byres, 2011). Conclusively, it can be stated that a prompt implementation and compliance of the Basel III requirements would contribute to the banking entities’ competitiveness by providing superior management outlook into the business. This would also permit the banks to gain advantage of potential opportunities and also be better prepared to encounter phases of financial depressions. References Amediku, S., 2011. Was Basel III Necessary And Will It Bring About Prudent Risk Management In Banking? Working Paper, Bank of Ghana. Byres, W., 2011. Basel III: The Journey and the Destination. LaTrobe Finance and Corporate Governance Conference. Bank for International Settlements, 2011. Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems - Revised Version June 2011. Basel Committee on Banking Supervision. [Online] Available at: http://www.bis.org/publ/bcbs189.htm [Accessed November 03, 2011]. Blundell-Wignall, A. & Atkinson, P., 2010. Thinking Beyond Basel III: Necessary Solutions For Capital And Liquidity. OECD Journal: Financial Market Trends, Vol. 2010 (1). Dowd, K. & Et. Al., 2011. Capital Inadequacies: The Dismal Failure of the Basel Regime Of Bank Capital Regulation. Policy Analysis, Vol. 681. Elliot, D. J., 2010. A Primer on Bank Capital. The Brookings Institution. [Online] Available at: http://www.brookings.edu/~/media/Files/rc/papers/2010/0129_capital_elliott/0129_capital_primer_elliott.pdf [Accessed November 03, 2011]. Elliot, D. J., 2010. Basel III, the Banks, And the Economy. The Brookings Institution. [Online] Available at: http://www.brookings.edu/~/media/Files/rc/papers/2010/0726_basel_elliott/0726_basel_elliott.pdf [Accessed November 03, 2011]. Ennis, H. M. & Price, D. A., 2011. Basel III and the Continuing Evolution Of Bank Capital Regulation. The Federal Reserve Bank of Richmond. KPMG, 2011. Basel III: Issues and Implications. Issues and Insights. [Online] Available at: http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/basell-III-issues-implications.pdf [Accessed November 03, 2011]. Moody’s Analytics, 2011. Implementing Basel III: Challenges, Options & Opportunities. White Paper, Enterprise Risk Solutions. Shearman & Sterling, 2011. The New Basel III Framework: Implications for Banking Organizations. Client Publication. White & Case, 2011. Basel III Rules Published. Publication. [Online] Available at: http://www.whitecase.com/files/Publication/2bb064cc-f908-45d9-add5-bb8315fbd3ee/Presentation/PublicationAttachment/a3061fa3-9c1a-4d57-a07e-cb955b39c8a1/alert_Basel_III_Rules_Published.pdf [Accessed November 03, 2011]. Bibliography Turner, A., 2011. Leverage, Maturity Transformation and Financial Stability: Challenges Beyond Basel III. Class Business School. Read More