Capital Ratios of Banks by Basel III - Book Report/Review Example

Capital Ratios of Banks by Basel III The proposals made about capital ratios of banks by Basel III committee have increased a minimum capital requirement for banks from 2% to 4.5% of risk-waited assets. These changes are meant to assist a bank to have a higher liquidity levels which will help to compact financial like the one experienced in 2007/2008 where the banks collapsed leaving the whole world with a crisis that has never been witnessed before. The leverage ratio for minimum risk based capital requirement was initially 2% and the increased to 4.5% meant to help the situation. However in measuring total risk based capital the committee has retained the framework that was adapted initially in determining risk based capital. This new regulatory standards about capital adequacy of banks has been hailed as requirements that are likely to strengthen bank capital and liquidity thus helping banks to have leverage. However the GDP needs to be considered as an agent and necessary consideration when setting the banks liquidity levels. Basel III has given three tiers which are to be considered by the bank before being accepted as fulfilled the requirement. According to the committee , in order to have a consistent ,transparent and quality capital there is need to have tier one consisting of shareholders equity, tier two consisting of instruments like derivatives and bonds. The committee also introduced risk coverage framework where they required a proper credit and market risk management. It required that credit should be valued adjusting for risk. It also required that banks should strengthen credit exposure risks by raising capital buffers. The committee has given dates when these requirements should be implemented by banks. In 2011 banks are required to come up with strategies of monitoring liquidity ratios of the banks as well as develop a supervisory framework which will ensure that leverage is maintained. In 2013 banks should start running parallel leverage ratios in order to reduce risks for a financial crisis. They are also required to start increasing capital requirement to the higher minimum requirement that have been set. In 2015 banks are required to attain the highest minimum capital requirement as well as attain the required leverage ratio. The liquidity coverage ration will be introduced in 2015 according to the committee, and 2016 the bank should start the process of increasing conservative buffer level. In 2017 the bank is required to make final adjustment to the leverage ratio which will be completed in 2018, still introduction of net funding ratio which ensure that banks maintain a certain funding to keep their stability. Large scale de-leveraging had been forced upon banks due to heavy losses along with the huge reduction in counter parity risk exposure. Analysts believe that the post crisis period will be characteristic of a financial set up that will have low levels of leverage, lesser number of mismatches in funding in terms of both currency and maturity, lesser exposures to counter parity risks and higher transparencies in the context of financial instruments that will be used. During the 1990s the banking business model was moving towards an equity culture and focusing upon fast growth in share prices and earnings. Previously banks worked on a model that was based on balance sheets and other old fashioned spreads related to loans, which were not allowing banks to expand speedily. As a result, they had shifted to strategies that focused upon activities based on trading incomes and fee through the process of securitization that allowed banks to enhance profits while economizing on capital expenses at the same time. Viewed from this perspective the model related to originate to distribute along with the process of securitization, is not necessarily about spreading risks; instead it is a major part of the procedure that drives revenues, returns on capital and share prices towards higher levels (The Economist, 2010). The model is more in the nature of increasing the risk taking abilities and recognition of up front revenues. From another perspective the banking systems had started to club its conventional credit practices with an equity culture. To motivate sales staff and executives in this regard, banks and financial institutions had to give them opportunities to benefit from this business model; thus making a case for the increase in their compensation, which had to evolve eventually. As a consequence there was a marked increase in bonuses generated on the extent of up front revenues relative to salaries. There were large number of options given in this regard and schemes of employee participation in share schemes became a norm in most banks and financial institutions. It was argued that such incentives were to eventually benefit share holders, in citing the philosophy that by investing a little in employee benefits the owners of the company will benefit multiple times (Stern & Feldman, 2004). Banking business models had begun to be increasingly based on securitization and capital market sales. A number of banks in Europe such as Deutsche Bank and UBS had been taking advantages of such practices earlier also and for these reasons, many US banks had lobbied for and supported with US regulators in moving towards the new rules and to adopt the Basel III rules at the earliest. A major assumption in this regard was about regulating capital under the Basel system which was also called portfolio invariance. In normal parlance the risk related to an asset such as a mortgage depends on the extent to which the asset is made a part of the portfolio. Banks had taken account of this and made judgment in having responded towards the arbitrage opportunities that had arisen during the transition phase from Basel I to Basel III. Had securitization of mortgages been accelerated and shifted to vehicles other than balance sheets, financial institutions could have raised the returns on capital straight away without the need to wait until the implementation of the new regime. It would not have been irrational to take this step to the extent that the proportion of the balance sheet mortgages and off balance sheet mortgages were equated with higher returns that were expected by clubbing with the Basel III mortgages (Financial Services Authority of the United Kingdom, 2009). Banks had to face severe liquidity problems which resulted in mismatch of their liabilities with the length of their assets as mortgages increased with the introduction of Basel III. The corporate governance and functions of risk control in many organizations is often adjusted in accommodating strategies when equity culture is clubbed with banking credit cultures. For instance, in a bank such as UBS, top risk managers that left were replaced by sales people that did not have any background of risk management. It is thus clear that corporate companies had also played a major role in creating the financial crisis. Banks that did not involve too much in mortgages were performing comparatively better. A number of lessons are learnt from such practices (Stephen, 2008). Firstly, it is difficult to check a culture of investment banking by the governing board of any organization and risk control practices also become more difficult because banking products are more complicated. The extent of risk ownership as related to banking strategies in the long run is linked to the structure of the board and independence of directors. The change of strategies in adopting Basel III implied that banks had to bear additional risks and banking board rooms were unable to cope with the rising complexities and financial burden. With the unfolding of the crisis, governments had no options but to become the owners of troubled financial institutions and to give guarantee to the large number of loans. Governments had to also assume the risk related to poor collaterals and to make regulations to adjust the increasing disparities in the economy (Bookstaber, 2009). Large scale de-leveraging had been forced upon banks due to heavy losses along with the huge reduction in counter parity risk exposure. Analysts believe that the post crisis period will be characteristic of a financial set up that will have low levels of leverage, lesser number of mismatches in funding in terms of both currency and maturity, lesser exposures to counter parity risks and higher transparencies in the context of financial instruments that will be used. Markets had failed because of financial innovations that further undermined the benefits of regulation that was dependent largely upon transparent methods, disclosures, and discipline of markets to reduce the excessive risks that were being taken. There is strong need for reforming the supervisory and regulatory structures as also for increasing innovations and restructuring banking institutions and markets so that they are consistent and have the strength of being systemically stable. b). the regulations that have been introduced by Basel III may not be effective because the main aim of banks is to make profits. Bank management may play around with the financial records affecting the performance of banks. Holding high liquidity levels will not stop a bank from engaging in activities, which are likely to jeopardize the ultimate financial performance of the bank. Maintaining high liquidity levels will not in any way reduce a financial crisis because the crisis was not entirely based on liquidity, leverage and coverage ratios. The financial crises was due to the inability of debtors to pay-off their loans plus interest. This is a management issue. Proper credit evaluation was not carried out by the banks before giving credit to individuals . according to one mortgage holder who was interviewed by a radio in Chicago, he stated that only ,a criminal will give you money as banks debt before the financial crisis. this means strengthening the liquidity and leverage ratios without checking the management activity will lead to the same crisis. The same was said after 1939 depression where strict management of finances was introduced but since then various crisis has affected the world. The crisis also affected the capital market, which is not affected by Basel III. Financial crisis is caused by many factors, for instance the current crisis has been escacaleted by political stability in oil producing countries and Greece failure to honor debts which they were holding. European union intervened causing the current crisis that is being experienced in the world. Standard variables such as the mortgage rates, the extent of mortgage spreads to federal funds, twelve month house price inflation, aggregate excess of banking capital under Basel. The allowances relating to the effect of the S&L crisis during the later part of the 1980s, allowed the model to work quite efficiently during 2004 but was not consistent in the regulatory and structural shifts that occurred later. Hence it can be concluded that such a model did not provide for a logical reasoning into the parabolic jumps following 2004, which is evident from the freeing up of the capital resources under the fully implemented Basel III systems (Tarullo, 2008). Banks were provided with sophisticated parameters by way of the QIS4 simulation in making them recognize the fact that additional capital saving of over US$ 220 billion would occur by the end of 2007 if they followed the model. The model was suggestive of the fact that the entire period, during which the new models would be implemented, banks could accelerate profits by using lower quality mortgages as supported by the American Dreams projects in America. It is very true that most of the complexities associated with the sub-prime crisis can be related to such securities. A major issue raised in banking circles pertains to the question that if Basel international banking regulations were implemented, why such activities and adversities were much strong in the USA as compared to other regions (Ben, 2009). A number of reasons account for such results, major amongst them being the American Dream policy of President George Bush, which sent the message that house ownership could be achieved through zero equity lending. The policy had greatly generated mortgages and the policy of deducting mortgage interest added to the crisis. The Tax Reform Act of 1986 had provided for the inclusion of the Real Estate Mortgage Investment Conduit (REMIC) rules that allowed for issuing multiple class passes through securities with no need for entity level taxes. Such measures significantly increased the attractiveness of mortgages. Tax changes made in 1997 greatly exempted homeowners from capital gains tax that did not hold applicable in the case of financial assets such as stocks and shares. The capital restrictions imposed on private financial institutions such as Fannie and Freddie from 2004 onwards permitted banks to freely enter the vacuum that was created by such policy measures. The increasing dominance and influence of the investment banking practices, mainly in the US, became a major feature of the revised business models. The investment banks in other nations such as Germany, UK and Switzerland could take up only smaller activities in order to retain their market shares. They were also influenced by incentives that offered improvement in return by adopting the Basel processes. Many of the countries became drawn into the crisis due to other factors also. Banks of other countries expanded their off balance sheet activities and speedily began using facilities of wholesale financing in anticipation of availing of more profitable opportunities in mortgages under Basel III. They began investing in products that were created with the new policies, kept up with the strategies in attempts to retain their market shares and started becoming engaged in partnerships with other banks that were at risk (Daniel, 2009). The financial systems had in fact accommodated new models of banking business in order to extract benefits from the leverage that had been created in the last few years. This was exploited by time specific catalysts in terms of, for example, assisting low income families with zero equity mortgage proposals through the American Dream Project. During this time the Office of the Federal Housing Enterprise Oversight had introduced higher capital requirement and control over balance sheets of some private financial institutions thus paving the way for banks to continue with the practice of low income mortgages. With the publishing of the Basel III accord on regulation in international banking, arbitrage opportunities were opened for banks in enabling them to speed up their off balance sheet activities. Investment banks were permitted to voluntarily take advantage of changes in regulation so as to manage their risks by using capital calculations. After US financial regulators provided for higher levels of capital requirement and balance sheet control on private financial institutions, some banks that had so far been engaged in selling private mortgages to such private financial institutions, started to face revenue gaps and considerable downfall in their earnings. The idea was to create their own collateralized debt obligations and structured investment vehicles. The impact of such controls was to influence Federal Mortgage Pools and the relating response of regulation on private financial institutions was acted upon a little late by banking regulators (Markus, 19). Investors and financial institutions had become extra optimistic about risks and prices of assets and were further encouraged by low interest rates that drastically changed the financial landscape. In the process there was a masking of the extent of leverage that could be given, thus making the risks more inter connected and opaque. There was no prudential watch kept nor was there any market oversight in stemming the excessive risk taking that was being resorted to. The interconnectedness of the different activities relating to regulated and unregulated markets and institutions were not taken into account. This was partly because of the fragmentation in regulatory structures as also because of the legal constraints that were placed on sharing of information by financial institutions. Immediately after the crisis had become a reality, a number of differences surfaced in national and international methods of dealing with international bank resolutions and bankruptcy issues. The crisis had driven home the fact that the central bank had limitations in its existing mechanisms because of the liquidity support required from the banks and the needs of bringing in changes in the banking practices in this regard. Large scale de-leveraging had been forced upon banks due to heavy losses along with the huge reduction in counterparty risk exposure. Analysts believe that the post crisis period will be characteristic of a financial set up that will have low levels of leverage, lesser number of mismatches in funding in terms of both currency and maturity, lesser exposures to counter parity risks and higher transparencies in the context of financial instruments that will be used. During the 1990s the banking business model was moving towards an equity culture and focusing upon fast growth in share prices and earnings. Previously banks worked on a model that was based on balance sheets and other old fashioned spreads related to loans, which were not allowing banks to expand speedily. As a result, they had shifted to strategies that focused upon activities based on trading incomes and fee through the process of securitization that allowed banks to enhance profits while economizing on capital expenses at the same time. Viewed from this perspective the model related to originate to distribute along with the process of securitization, is not necessarily about spreading risks; instead it is a major part of the procedure that drives revenues, returns on capital and share prices towards higher levels (The Economist, 10). The model is more in the nature of increasing the risk taking abilities and recognition of up front revenues. From another perspective the banking systems had started to club its conventional credit practices with an equity culture. To motivate sales staff and executives in this regard, banks and financial institutions had to give them opportunities to benefit from this business model; thus making a case for the increase in their compensation, which had to evolve eventually. As a consequence there was a marked increase in bonuses generated on the extent of up front revenues relative to salaries. There were large number of options given in this regard and schemes of employee participation in share schemes became a norm in most banks and financial institutions. It was argued that such incentives were to eventually benefit share holders, in citing the philosophy that by investing a little in employee benefits the owners of the company will benefit multiple times (Stern & Feldman, 64). Banking business models had begun to be increasingly based on securitization and capital market sales. A number of banks in Europe such as Deutsche Bank and UBS had been taking advantages of such practices earlier also and for these reasons many US banks had lobbied for and supported with US regulators in moving towards the new rules and to adopt the Basel III rules at the earliest. A major assumption in this regard was about regulating capital under the Basel system which was also called portfolio invariance. In normal parlance the risk related to an asset such as a mortgage depends on the extent to which the asset is made a part of the portfolio. Banks had taken account of this and made judgment in having responded towards the arbitrage opportunities that had arisen during the transition phase from Basel I to Basel III. Had securitization of mortgages been accelerated and shifted to vehicles other than balance sheets, financial institutions could have raised the returns on capital straight away without the need to wait until the implementation of the new regime. It would not have been irrational to take this step to the extent that the proportion of the balance sheet mortgages and off balance sheet mortgages were equated with higher returns that were expected by clubbing with the Basel II mortgages (Financial Services Authority of the United Kingdom,19). Conclusion The adoption of Basel III will help to reduce financial crisis in world but not eliminate. It is a fact that now everyone acknowledges the Basel is introducing strict rules. The model of proposed model now under study and many would like it to be adopted. Strict financial discipline will was a reason for the good performance of banks. Good judgment on the potential of the business, avoiding high leverage will help the banks to perform well in the recession period. The world community will monitor the performance of the banks in the coming days. Considering the growth history and the potential of growth, banks have a long way to go and world can think about an alternative to the conventional banking system. Reference List Basel Committee on Banking Supervision ‘Basel III: A global regulatory framework for banks that are more resilient and banking systems’, revised version June 2011 BIS website: http://www.bis.org/publ/bcbs189.htm Bebczuk, R. (2006). “An evaluation of the contractionary devaluation Hypothesis” Inter-American development bank working Bekaert, G. (2005). “Does financial liberalization spur growth?,” Journal of Financial Economics vol 7 New York:MacGraw-Hill. Ben S Bernanke (2009), Lessons of the Financial Crisis for Banking Supervision, speech delivered at the Federal Reserve Bank of Chicago Conference on Bank Structure and Competition, Chicago, http://www.federalreserve.gov/newsevents/speech/bernanke20090507a.htm, Accessed on 26 March 2010. Blundell-Wignall, A and Atkinson, P ‘Thinking beyond Basel iii: Necessary Solutions for capital and liquidity’, OECD Journal: Financial Market Trends, Vol 2010, Issue 1 http://www.oecd.org/dataoecd/42/58/45314422.pdf Bookstaber Richard, (2007), Demon of Our Own Design, Wiley. Daniel K Tarullo, (2009). Modernizing Bank Supervision and Regulation, before the Committee on Banking, Housing, and Urban Affairs, US Senate, Washington, DC, Washington, http://www.federalreserve.gov/newsevents/testimony/tarullo20090319a.htm, Accessed on 26 March 2010. Dowd, K et al ‘Capital Inadequacies: The Dismal Failure of the Basel Regime of Bank Capital Regulation’, Policy Analysis, The Cato Institute,, July 2011 http://www.cato.org/pub_display.php?pub_id=13490 Elliot, D ‘A primer on Bank Capital’, Brookings Institute, January 2010 http://www.brookings.edu/~/media/Files/rc/papers/2010/0129_capital_elliott/0129_capital_primer_elliott.pdf Elliot, D ‘Basel III, the Banks, and the Economy’, Brookings Institute, July 2010 http://www.brookings.edu/~/media/Files/rc/papers/2010/0726_basel_elliott/0726_basel_elliott.pdf Ennis, H and Price, D ‘Basel III and the Continuing Evolution of Bank Capital Regulation’ Federal Reserve Bank of Richmond Economic Brief, June 2011 http://www.richmondfed.org/publications/research/economic_brief/2011/pdf/eb_11-06.pdf Financial Services Authority of the United Kingdom (2009), The Turner Review: A Regulatory Response to the Global Banking Crisis, http://www.fsa.gov.uk/pubs/other/turner_review.pdf Accessed on 26 March 2010. Markus Brunnermeir et al. (2009), The Fundamental Principles of Financial Regulation. Murphy, A. 2003. Practical Financial Economics: A New Science. New York: Greenwood Publishing Group. Robbe , J. & Paul A. 2005. Securitization of derivatives and alternative classes. Kluwer Law International. Stephen Morris and Hyun Song Shin (2008), Financial Regulation in a System Context, Brookings Papers on Economy Activity. Stern & Feldman, (2004), Too Big to Fail, Brookings Institution Press. Turner, A ‘Leverage, maturity transformation and financial stability: challenges beyond Basel iii’ Speech at Cass University, March 2011 http://www.fsa.gov.uk/pubs/speeches/031611_at.pdf Tarullo Daniel, (Sept, 2008). Banking on Basel, http://bookstore.piie.com/book-store/4235.html, Accessed on 18 November 2011. The Economist, (2010). Blame game, http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/art. Accessed on 18 November 2011. Wignall, Atkinson and Lee, (2008).The Current Financial Crisis: Causes and Policy Issues, FINANCIAL MARKET TRENDS – ISSN 1995-2864. Read More