Objectives of Basel Committee - Essay Example

Effectiveness of Basel II accord in Achieving Objectives of Basel Committee Introduction Initiated in the year 1974, Basel committee is charged with the responsibility of ensuring that there is financial and monetary agreement with regard to the world’s related central banks. This institution discusses several issues among them issues of the supervisory matters that touch on the major financial institution of the central banks in the world. Members of the committee includes and not limited to Italy, United Kingdom, Switzerland, United States, France, Belgium, Canada and et cetera (Chorafas 111). The secretariat of the committee is constituted by the supervisors from all the central banks including other approved authorities for the rest of the member’s countries. As a policy, there are guiding principles in which the committee operates in relation to its discharge of duties. One of the overarching principles is the fact that there should be no bank allowed to operate without the provision of adequate supervisory roles. This policy informs that the operations of the banks in this regard are highly supervised to curb any act of undercut that can be played by the major financial institution in the world. In realizing their mandates, the committee operates in four folds; the Accounting Task Force, the Accord Implementation Group, the Policy Development Group, and the International Liaison Group (Chorafas 119). These four subcommittees do work in tandem in realizing the objectives of the committee. The committee meets quarterly every year to meet the governors of the central banks of the member’s countries and offers advisory services to the members. It has to be noted though that the advisory services of the committee is not in any way binding since there is n legal provision for the same. Basel II Basel II was founded on June 2004; the Basel III of the same organization is supervising the body that is found in the second phase of the Basel Accords. In its responsibilities, the Basel II is mandated to device the international standards that relates to banking policies in which they are expected to adopt (Chorafas 134). This is meant for the bank regulators and the focus at this point is the determination of controls of the extent of what the capital banks needs to reserve in the interest of guarding on the possible financial and operational risks involved in the banks and those that they might face. This was deemed necessary as it stood a better chance in cushioning the banks from such risks. The main interest of the Basel II is to ensure that there is no financial crisis in the event that major financial institution collapses, a situation, which led to the financial meltdown in 2008. The implementation of the advisory services of the Basel II suffered a political blow which led to the failures of the nations involved not adhering to the advisory services given then (Chorafas 149). Objectives of the Basel II As any other regulatory body in any other institution, the Basel II subcommittee of the Basel committee is also charged with a number of objectives that has to be fulfilled in the process of delivering its services. The Basel II has the objective of ensuring that the capital requirement that is also referred to as the dancing regulatory capital is more of risk taking and that it can cushion the banks in cases of financial crisis. This provision demands that the capital reserve of the banks must show certain degree of adequacy in comparison with the amount lent by the same bank. In other words, the capital adequacy ratio must be at all the times ensure that they do not partake in holding in investment that demonstrates increased risk in default. Moreover, if they do, they have enough capital reserve to ensure that any loss will not directly affect the financial status of the financial institution (Stein and Kashyap 7). In addition to the capital requirement control, Basel II also drives the agenda that the financial institution are suppose to disclose all the requirement that will make the market participants to make informed choices by making adequate assessment of the capital nature of the institution. This move is designed to cushion the participants from making uninformed choices that might lead to financial losses at the end of the business. In the effort to ensure that he the provision of the information of the financial institutions are correct and up to date, the subcommittee ensures that the operational risk, market risk, and credit risk are given honest quantification directly considering the available data (Stein and Kashyap 11). The Basel II also in its objectives tries to pare down the extent of the regulatory arbitrage by making deliberate attempt to conform the economic and the regulatory capital to relate closely. This will allow for the reduction of the risks involved in the financial institutions. In as much as the Basel II has tried to rationalize issues relating to the economic capital and the capital requirement (Stein and Kashyap 16). This is what is being discussed in the regulatory arbitrage; there is still a lot of divergence of the two areas making regulatory arbitrage a nightmare. Following this information, it will be appreciated that the Basel II has four main objectives to meet in the duty. The Three Pillars In its operation and to accomplish their objectives, the Basel II operates in three main pillars; these includes, minimum capital requirement- this pillar is solely responsible for addressing looming risks in the financial institutions, supervisory review, and the Market discipline pillar. The First Pillar In this pillar, Basel II critically considers reducing the risks involved in the regulatory capital, which is determined after considering the main risk component that banks do face that include operational, credit and market risks. The calculation of the various risks takes different perspectives, which depends on the kind of risk to be assessed. For instance, in the calculation of the credit risk, several approaches can be engaged which includes Foundation IRB - Internal Rating-Based approach, standardized approach, and the Advanced IRB. General IB2 Restriction is also used for the assessment of the same (Gordy and Howells 9). Operational risk has three approaches that it uses in making the assessment the basic indicator approach, (BIA), internal measurement approach that in advanced status is referred to as advanced measurement approach (AMA), and the standardized approach (STA). Market risk on the other hand has its preferred approach being VaR-value at risk. These are the information that informs the first pillar in the Basel II subcommittee (Gordy and Howells 19). The Second Pillar Similarly, to the first pillar, the second pillar also strives to make a rational assessment of some of the situation that might need to be made available for scrutiny by the participants. Essentially, the second pillar is a continuation of the first pillar in terms of the regulatory responses, as it offers regulators tools, as availed to them from the Basel I, and provides framework for managing the risk discussed in the first pillar. These risks include the liquidity, strategic, pension, legal, systematic, concentration, and reputational risks; this is effected though the Internal Capital Adequacy Assessment Process (ICAAP) (Gordy and Howells 26) The Third Pillar The capital level of adequacy is supposed to be gauged by the participants in the financial institutions. The third pillar strives to find a lasting solution to the problems of the minimum capital requirement of the financial institution and providing supervisory trends by standardizing the level of disclosure of the materials required for the above minimum capital to be determined. The main aim of the third pillar is to allow for the market discipline in which all the market players feel that they have a sense of responsibility in disclosing the relevant information that can help any of the players in reaching an informed decision. This information is important to other banks, gauging agencies, investors, and analysts (Heid 5). The third pillar of the Basel II helps in the instilling discipline in the financial sector that will make other players to reach realistic decision. This disclosure according to the Basel II should be made available twice annually for disseminating crucial information. The Basel II subcommittee has made it contribution in the financial sectors in the most responsible way possible. The 2008 financial crisis can be cited as one of those that defied the Basel II cushioning plans but in critical look, it will be found that the financial institution in the major financial players in the world out of political grounds failed to conform to the advisory services that were issued by the body. All the financial players then wanted to make extra cash and failed to conform to the advisory policies of the body hence the financial meltdown realized then. Effects of Basel II in the Recent Economic Crisis  The worldwide economic crisis of the 2007/2008 is one of the events that led to the institution of Basel II that intends to cushion the world from the reoccurrence of the 2007 crisis. In this relation, the Basel II in 2007 global financial crisis made several attempts to normalize the situation bearing in mind that the provision of the committee were adopted much later after the crisis was already started (Heid 10) Basel II put several damage controls in the event a crisis. Such as with regard to pillar I, the Basel II examined the suitability of the capital charge for the securities since there was already high corresponding risk in the same. It was realized that that the value at risk criteria of assessment of the capital obligation for the securities at a low volatile period failed to reflect with precision the risk in the event of sudden increase, which was the sequence of event in the 2007 case. This has made the Basel II to realize consideration of the value at risk criteria in terms of its shortcomings so that a more stringent system can be put into place. A credit default was also developed in a bid to cushion on the risk related to the structured credit, which have no liquid secondary market (Decamps, Rochet and Benoˆıt 10). In pursuit of the provision in pillar II, they proposed that he there should be a widened risk management system in the banks that will include credit contingency to cushion in the event that the banks decides to reverse their collaterals on reputational grounds as seen in the 2007 scenario. The disclosure provisions were also reviewed in line with the conduits, securitizations, and vehicle balance sheet sponsorship. The 2007/2008 global financial crisis took place because of the dishonesty that engulfed the financial players in the world. They did not reveal the true reflection of their status as demanded by the Basel II so that the participant can have a chance to scrutinize and reaching informed decision with the available materials. The events that preceded the financial crisis include the sudden rise and boom of the housing deals in the US between the period of 2002 and 2005 this was also coupled with the exponential growth of the sub-prime housing loans given that the prime loans doubled in the 2001 and 2003 (Decamps, Rochet and Benoˆıt 24). The sub-prime banks and the prime loans differ because they allow even those with questionable ability to repay their loans to advance such. This was particularly encouraged in the US to allow those with limited resources and that could not take loan from the prime loans to have the opportunity to do so. The cycle was particularly interesting given the ever-rising mortgages and the financiers were sure of doing business in the unfolding events. This position allowed for more lending that was pumped into the housing sector until the supply of the houses exceeded the demand of the houses leading to the fall in prices of the houses (Daníelsson, Embrechts and Goodhart 8). Since most of the sub-prime loans were given security from the asset-supported commercial paper, the drop in the housing prices led to two major problems in the financial sector; there could be no any other borrowing given that the interest rate was enormous and was not affordable or viable to consider. The other problem was only security sales were available with the investors and this informs that the primary and the secondary MBS market automatically dried up (Daníelsson, Embrechts and Goodhart 14). The crisis then spread through other structured securities that included the collateralized-debt obligation and credit-defaults swaps. The same also reverberated in the US treasury and other considered safe bonds leading to a widened credit spread, which turned to be a global crisis finally leading to the 2007/8 financial meltdown. This is what led to the global financial crisis and the Basel II has since elaborately included several loophole measures to ensure that the same crisis is artificially prevented given the knowledge and the measures in place (Wellink 7). Basel II Application in the Financial Crisis Considering the objectives of the Basel II as discussed in the above parts, their role was to ensure simply that certain financial information is given to the participants in the market. Otherwise, the financial crisis will continue in case issues surrounding it are not adequately addressed. Basel II in their mandate applies in the financial crisis that occurred in the 2007/8 in the sense that they gave/should have given the following critical information and ensures that the target groups implement them. Banks should be encouraged to have self-assessment criteria. This exercise should be sound and comprehensive credit, operational, and market framework, encouraging stringent supervision of the banks. They should also insist on the transparency and full disclosure of the banks information as well as ensuring that risk sensitivity is optimized with proper alignment of the regulatory capital and the risk exposure (Repullo and Suarez 22). Basel II Benefits and Drawbacks Basel II has the benefit of rationalizing all the issues that might bring financial crisis, it also gives advisory services twice annually on the financial issues to the members central bank governors. This is aimed at preventing unscrupulous business in the banking sector that is a recipe for crisis in the future. Besides this, the Basel II has also been deemed by others players in the financial sector to be limiting in policies that only curtails progress of the financial institutions in the various countries while giving undue advantage to other players (Repullo and Suarez 44). The system of instilling discipline in the main financial players have taken a different direction with other institution remaining dishonest without penalties since the provision of the Basel II has no legal baking and no country including the members are obliged to respect the decision. Estimates by Economists About the 2007 global economic crisis, economists have estimated the close to $ 1.3 trillion was used in the mortgages by the subprime loans in the US (Henry and Majid 19). This is a significant amount of money, that when not productively invested, can lead to a worse monetary situation than what followed in the 2007. Basel II Significance Basel II is a very important committee in the management of economic crisis of the world. Following the mandates and the objectives of the committee, it will be appreciated that they hand le legitimate issues that cannot be trusted in the hands of independent players in the financial sector whose main aims is to make money at whatever cost. Thus, I support the noble contribution of the Basel II and hope that the target groups will always remain supportive to the body and abide by their advisory services on financial issues. Conclusion  Ultimately, financial institution are related in one way or the other internationally, this explains why there was a feeling of financial crisis in the whole world when the major events only took place in the US. It is thus important to note that Basel II is only trying to cushion the world on such crisis and thus deserves to be supported in the strongest terms possible in its endeavors to achieve its objectives. Works Cited Chorafas, Dimitris N. Operational risk control with Basel II basic principles and capital requirements. Amsterdam: Elsevier Butterworth-Heinemann, 2005. Print. Chorafas, Dimitris N. Stress testing for risk control under Basel II. Oxford: Butterworth-Heinemann, 2011. Print. Daníelsson, Jón, Paul Embrechts and Charles Goodhart. "An Academic Response to Basel II." LSE Financial Markets Group (2001): 17. Decamps, Jean-Paul, Jean-Charles Rochet and Roger Benoˆıt. "The Three Pillars of Basel II: Optimizing the Mix." (2003): 30. Gordy, Michael B. and Bradley Howells. "Procyclicality in Basel II:." Can We Treat the Disease Without Killing the Patient? (2004): 30. Heid, Frank. "The cyclical effects of the Basel II capital requirements." Banking and Finance (2007): 16. Henry, Lester and Michelle Majid. "Financial Crisis and the Implementation of Basel II:." Potential Economic Impact for Trinidad and Tobago (2009): 24. Repullo, Rafael and Javier Suarez. "THE Procyclical Effects Of Basel Ii." (2008): 51. Stein, Jeremy C. and Anil K Kashyap. "Cyclical Implications of the Basel-II Capital Standards." (2003): 45. Wellink, Nout. "Beyond the crisis:the Basel Committee’s strategic response." Basel Committee on Banking Supervision (2009): 10. Read More