Risk Management in the Banking Industry Based on New Basel Capital Accord - Assignment Example

Financial s - Control Assessment 2 The current Basel III(3) proposals will improve the quality of capital and liquidity (buffer) which  should reduce future problems we saw in the GFC,  but to the extent that banks, bankers, and politicians think they can be relaxed about systemic risk -- that could be a problem. Discuss critically. The current Basel 3 proposals are just an improvement on the Basel 2 proposals that were made in the light of ever increasing bank failures in the recent past. Risk management in banking industry as based on New Basel Capital Accord (Basel III) is intended to minimize risk associated with operational and financial procedures of banks. Basel III encompasses a set of practical recommendations issued in connection with banking regulations and laws by the Basel Committee on Banking Supervision (BCBS). Its three Pillars consist of a structured approach to risk reduction. Its primary purpose is to provide the essential protection against all probable risks that arise from banking activities so that the international financial system might be immune to the kind of failures that banks are often faced with nowadays. Thus its basic function is to set up some international standards so that all banking activities could be subject to a rigorous framework of overall supervision and regulation (Angelopoulos & Mourdoukoutas, 2001). Under Basel III common equity of banks has been redefined with emphasis on liquidity risk management. Thus the capital structure of the firm must be qualitative, consistent and transparent (Fabi, Laviola, & Reedtz, 2005). When banks raise capital the common equity component must be protected against all probable risks under the new rules for capital adequacy (Barrios & Blanco, 2003). Under this new regulation Basel III ensures that Tier 1 capital will basically consist of commonly held shares and retained earnings. On the other hand those capital instruments coming under Tier 2 would ne harmonized, so that risk factor would be minimized. Tier 3 would be removed. The current global financial crisis (GFC) has necessitated a systematic and consistent improvement process in the quality of capital irrespective of any other consideration such as, stiffer credit risk management (Mbuya, 2010). In other words BCBS is of the opinion that coupled with transparency and consistence, continuous improvement in the quality of capital would lead to minimizing the risk of bank failure. However, there is a different school of thought which places emphasis on systemic risk control measures. Banks, bankers and even political authorities place greater emphasis on the former while there is an ever increasing degree of pessimism among professional consultants that systemic risk is more responsible for the current spate of bank failures. Basel III essentially presupposes that banks’ derivative related credit exposure, repo rates and securities play a pivotal role in undermining the bank’s ability to control risk. However, those who support a systemic risk control process argue that such derivatives and associated risk are essentially part and parcel of the systemic risk factor and therefore what is so important is that banks ought to identify the system related shortcomings such as failure-prone interdependencies and system-centric inter-linkages (Blaško & Sinkey, 2006). These interdependencies and inter-linkages are more likely to produce a system wide ripple effect in the event something goes wrong with one bank’s risk control measures. Leverage ratios, counter-cyclical buffers, counter party credit risks and liquidity ratios are well integrated into Basel III which regulates banks in a manner that the latter’s freedom of action in such activities as lending and credit creation is limited through stringent requirements in managing risk and capital. Thus it’s obvious that these regulations are primarily and immediately aimed at the very constitution of the capital structure of banks and above all its nature (Kopecky & VanHoose, 2004). While banks’ lending and investment portfolios would be influenced by these regulations the most remarkable feature of them is the ability to control risk and its spread into diverse areas of the bank’s financial operations. Finally macroeconomic stability and smooth structural change are sought to be ensured by Basel III, though this outcome is not likely realized if the current level of underestimating the systemic risk factors continues. The first and foremost reason or requirement under Basel III for the introduction of new regulations could be found in the systematic development of rules and regulations. Basel III consists of the Capital Adequacy Accord and the Capital Requirements Directive. These two documents in turn encompass a series of rules and regulations on matters related to banks’ financial and investment activities. Though such activities are regulated by national laws and authorities as well the overall supervisory role of the Committee cannot be underestimated. Its influence in spheres of banking, risk management and risk insurance go a long way to reinforce the correlations among a number of causal factors. The first and foremost requirement of Basel III is basically intended to ensure banks’ conformity with some rules and regulations to enable the management of a bank to face unplanned for and unanticipated contingencies in their day-to-day operations, i.e. operational risk, credit risk and market risk (Crouhy & Galai, 1986). Secondly, Basel III has a set of rules on capital requirements that demand both compliance with and conformity to in accordance with international banking practices along with risk management techniques. These rules seek with concerted aim and objective to establish a certain international standard for effective risk management and insurance provision against would-be failures. In the first place there was no established standard on banking before this. Their professed objectives include such general rules as the minimum amount of financial capital and reserve ratios to meet contingency demands by customers. Apparently such requirements are intended to reduce the leveraging or debt raising capacity of banks. Organizations have a tendency to benefit from tax cuts through higher levels of leverage. Thus their equity capital as against debt capital tends to be marginal. Systemic risk factors like inter-dependencies and inter-linkages through monetary mechanisms and fiscal cleavages have been ignored for the simple reason that fiscal prudence and excessive emphasis on monetary aggregates like M0, M1 and M2 have been have led EU central banks and governments nowhere but down the economic precipice. As a corollary what’s expected of the bank’s management is prudential oversight and management of sound financial ratios. It’s the degree of liability on the part of the bank in times of impending insolvency that is taken into consideration by the Committee. Such oversight ignores qualitative changes to the system. In other words the system is both replete with inadequacies and diverse divergences. The primacy and immediacy of a new capital requirements framework in place of the older one was recognized as expediency by the Committee. The logicality behind this move is to be found in the pressing need for a comprehensive and risk-sensitive framework that would meet demand for day-to-day operational exigencies (Yilmaz, 2009). However the compulsion for a thorough risk management mechanism isn’t understandable given the spate of bank failures and degree of their exposure to risk at a given time, in the total absence of a systemic restructuring process. In conclusion Basel III agreement’s innovative features need to be recapitulated in succinct form in order to drive the point home that despite a number of good reasons for the establishment of Basel III Accord on good international banking practices, strategic bottlenecks in the banking industry have forced managers to abandon prudential financial management principles in preference for risk-prone investment strategies that basically have a negative impact on operations and credit management. 2. If firms ( banks) , who are perceived as ‘ too big to fail’, have their debt backed by the government, as they have in the present GFC, would it make it easier and cheaper for them to borrow more, grow bigger and to take bigger risks? Does this then mean that bailouts are now becoming institutionalized and may become more frequent? Discuss It has been said that banks in Europe and North America have been growing bigger and as a result bank failures might be minimized. However, the opposite has been proved to be right. For example, the biggest bank failures in the history occurred in the current decade in the USA like the Federal Deposit Insurance Corporation (FDIC) and Colonial Bank (CB) and in total number there have been little over 25 such failures. In Europe Northern Rock and Bank of New England in the UK and Sachsen LB in Germany all reminded that even the biggest of banks could fail when risk management measures failed due to the cumulative impact of continuous errors (Weiner, 2002). Institutionalization of government sponsored bailouts and a plan has become the norm of the day though governments have been questioning the credibility of such bailouts in the face of bigger failures. When banks have their debt repayment guaranteed under numerous bailout schemes as in the case of US Emergency Economic Stabilization Act of 2008. Under this bailout plan $700 billion US$ were to be spent on rescuing filing firms, including banks. These bailout plans have cost the tax payer billions of dollars. Despite this mammoth size of the US government’s federal spending on recovery plans, asset bubbles still do persist in the American economy. In Europe the picture is not much different. European Union (EU) has been more worried about the structural imbalances in banks. However, with Northern Rock failure the jolt created panic among the general public. The response was both primary and immediate. Depositors hurriedly withdrew their money, thus exacerbating the disaster. The British government and the Bank of England did not have a rescue plan proper, except to cajole other banks to bring about an asset transfer based bailout. Subsequently the EU governments became more concerned about bigger EU coordinated bailouts. Thus billions of Euros were allocated for these plans. Despite all these efforts bank failures continue and recently some economic experts have delineated the phases of big failures with reference to a variety of bubbles. Asset bubbles occur when assets like financial instruments are overrated in value so that, a continuous chase after assets by the investor public leads to the creation of bubbles. When bubbles burst values or prices hit rock bottom (Marks et al, 2009). In the same vein property bubbles and housing bubbles created similar problems. According to economists when assets are overpriced bubbles get bigger and when they burst the fallout effect is worse. In the case of bank failures in Europe similar bubbles had their impact on the continuous run on bank deposits. The net result was one bank failure after the other and government coordinated efforts were needed to prevent a holistic impact on the whole economy. Government sponsored bailout operations were further needed since these bad failures were not simply due to asset bubbles. For example, poor monitory policy measures of governments and loose credit policies of banks were all responsible for these failures. During the last half a decade billions of worth bailouts were carried out both in Europe and North America. The net result of these bailouts can be seen in inflationary pressures in the economy. Immediately after the bailout the first wave of spending by depositors is felt and it continues till the economy gets heated. From the view point of the fiscal debate on the subject of bailouts subsequent government taxes should reduce the power of expenditure by corporate sector and individual citizens (Hellmann, Murdock & Stiglitz, 2000). However, there is no clear cut theoretical postulate to prove that such taxation would inevitably absorb excess spending by individual citizens and firms. Despite EU supervised monetary policy measures there is very little by way of a safety net to ensure that spending by individual citizens and corporate bodies would be curtailed by such policies. Therefore both monetary and non-monetary institutions become absorbed in to a system of bailouts. This in turn creates an institutional process leading to a series of requests for bailouts by failing banks. Institutionalization can be described as an unconscious process in which the government creates especial authorities and institution to exercise oversight over bank failures (Bhattacharya, Boot & Thakor, 1998). The most fundamental problem of institutionalization can be seen in respect of EU wide system of rescue plans being carried out by individual central banks of member countries. In addition to this the European Central Bank (ECB) is involved in putting in place a series of schemes targeting both prevention and bailout. Such institutionalization leads to further implications. For example, when Northern Rock failed panic felt throughout the region because, rather than the total sum of money involved there was much publicity given to the outcomes of the failure. Northern Rock did not anticipate a final rush by depositors to withdraw their cash. When it was clear that all depositors wanted their money at once the truth became even stranger. Insider dealings had paved the way for the cumulative impact (den Heuvel, 2008). Institutionalization in Europe does not end here. It has a further dimension. In addition to new institutions coming in to existence there is a host of other processes such as new policy measures to meet the contingency demand created by the first wave of failures. For example, the ECB put in place a series of measures including information gathering and dissemination on possible bank failures even before such failures could become a reality. The worst scenario case was drown on the planning boards of policy making bodies Measurements and the standards that are basically connected with operational risk management also have an impact on liquidity risk management by banks indirectly. For example convergence measurements and standards are inherently loaded with financial performance related outcomes such as well balanced liquidity ratios and growth related liquidity risk management techniques. As such overlapping institutional arrangements have been necessitated due to bailouts that have been designed to overcome the above shortcomings through the creation of institutions. Institutionalization has led to the current level of ignorance by banks and many others who are responsible for the policy making and implementation. Excessive institutionalization can be attributed to the GFC and its direct and indirect impacts on policy environment. Fear among bankers and policy making bodies can be one such compulsions that have acted to bring about the current level of degradation and direction loss (Repullo, 2004). Finally, the overall principled effort of Basel III Accord has been to establish an internationally accepted system of banking regulations that address both risk and insurance aspects of banking industry at large (Rochet, 1992). While the effort itself is laudable enough the outcomes so far have not been so desirable because despite general adherence to them by banks, the global banking and insurance industry has been experiencing a roller-coaster ride as of lately. This latest development has refocused the attention of the global financial community on the feasibility of Basel III as a practical document to bring about financial stability through good banking practices. These are the primary reasons for the establishment of the Basel III Accord. Yet institutions have forced authorities to depend on them more than ever. Insurance related aspects have been ignored too much in this instance. REFERNCES 1. Angelopoulos, P & Mourdoukoutas, P 2001, Banking Risk Management in a Globalizing Economy, Praeger, Westport. 2. Barrios, VE & Blanco, JM 2003, ‘The effectiveness of bank capital adequacy regulation: A theoretical and empirical approach’, Journal of Banking & Finance, vol. 27, no. 10, pp. 1935-1958. 3. Bhattacharya, S, Boot, AWA & Thakor, AV 1998, ‘The economics of bank regulation’, Journal of Money, Credit and Banking, vol. 30, pp. 745–770. 4. Blaško, M & Sinkey, JF 2006, ‘Bank asset structure, real-estate lending, and risk-taking’, The Quarterly Review of Economics and Finance, vol. 46, no. 1, pp. 53-81. 5. 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