Resilient Banks and Banking Systems - Term Paper Example

BASEL III AND ITS APPLICATION: A CRITICAL LITERATURE REVIEW Contents Introduction 3 A Global Regulatory Framework for More Resilient Banks and Banking Systems (Supervision, Basel Committee on Banking, 2010) 4 Thinking Beyond Basel III: Necessary Solutions for Capital and Liquidity (Blundell-Wignall & Atkinson, 2010) 5 Basel III: An Evaluation of the New Banking Regulations (Blaylock & Conklin, 2012) 6 Basel III: A Study of Basel III and whether it may Protect Against New Bank Failures (Johansson & Schaefer, 2012) 8 Basel III and Its Consequences (Confronting a New Regulatory Environment)(Auer, Von Pfoestl, & Kochanowicz, 2011) 9 Basel III: Issues and Implications (Greenlee, Kelly, Fogarty, Dutta, & Baraybar, 2011) 10 Conclusion 11 Bibliography 14 Introduction Globalisation has prompted the need for some degree of cooperation amongst the Central Banks of nations around the world. Basically, the decision-making systems and processes of sub-national actors and regulatory authorities have been criticised for being so local, inconsistent and somewhat creating gaps between nations (Barr & Miller, 2006). This has created the lack of accountability and the lack of credibility in the international monetary system (Barr & Miller, 2006). The need for some kind of coordination culminated in the Basel I round of deliberations in 1988 meant to publish standards for capital requirements for Central Banks around the world. As a background to the Basel I Accord, it must be noted that the Group of 10 Industrialised Nations utilised the Bank for International Settlement (BIS) in Basel to coordinate international financial matters amongst Central Banks in 1974. The BIS states on it website that their mission is: “...to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas and to act as a bank for central banks.” (Bank for International Settlements, 2014). The principles of the Basel I Accords formulated rules on the evaluation of credit risk and risk-weighting of assets (Scott, 2013). This included the streamlining of the assets of banks in their measurement, recognition and reporting of their activities. The Accords were adopted by the 13 nations who were members of the G-10, but over 100 countries later adopted the principles of the accords. A second round of accords was signed in Basel II which was held in June 2004 to provide more checks and controls over banks in nations around the world. This included risks and credit control, risk management and capital management standards for banks to prevent bank exposures that could be detrimental to the public finance system of nations (Zhou, 2011). This included elements and aspects of operational risks that was to culminate in various supervisory mechanisms that were encapsulated in the ten principles of Basel II (Akkizidis & Bouchereau, 2005). However, the disastrous fate that befell Basel II as a result of the global financial crisis indicated that the principles of the Basel II Accord were not robust enough in ensuring financial stability through proper regulation and oversight of the national and international banking system. This prompted the need for a new set of rules about the regulation of the financial sectors of nations around the world. The purpose of this paper is a literature review of the elements and principles of the Basel III accords that came after the Basel II Accords failed to meet its set objectives. To this end, the paper will review five fundamental articles about the Basel III Accords to provide information about essence and aims of Basel III principles for managing banking and credit risks that come with it. A Global Regulatory Framework for More Resilient Banks and Banking Systems (Supervision, Basel Committee on Banking, 2010) This is the official presentation of the BIS concerning the new arrangements they made about the Basel III Accords. This document outlines the main trends and processes and ends that the new Basel Accords seek to achieve. The report begins by providing an insight to the vision of the accords which include promoting consistency, quality and transparency in reporting on the capital base of banks. This is limited to 15% of banks in Tier 1. Also, enhancing risk coverage involves the expansion of the scope of risks to prevent banks from exceeding them. This includes counterparty risk requirements and the restatement of market-to-market losses through the revaluation of capital risks. The new leverage ratio is enhanced in response to the financial crises, and the use of a cyclicality framework for defining minimum leverage requirements. Also, the leverage provisions are forward-looking and will be reviewed as and when the need arises. Capital conservation is put in place to ensure that firms promote the investment in a better and a stronger asset base. Excessive credit growth is encouraged by the Basel III rules. And this is to encourage banks to get a stronger and more guaranteed process or system of growth. Systematic risk and interconnectedness are addressed through the formation of an international or global banking standard framework. This includes a stronger liquidity coverage rate and the integration of other monitoring rules and regulations to ensure that the system of banking is better. These standards of the Basel III Accords are examined and reviewed by other writers and authorities who present various arguments about the accord. These are discussed below. Thinking Beyond Basel III: Necessary Solutions for Capital and Liquidity (Blundell-Wignall & Atkinson, 2010) This provides an exegesis into the reasons and backgrounds for the new Basel III rules. The researchers identify that the main reason why Basel II failed was that there were some huge and influential financial entities that were able to override the rules and regulations relating to the financial rules and regulations. Hence, the new rules were mainly made to change and modify the framework. The problems that led to the collapse of the first two regulations are identify to include the invariance of portfolios and the fact that there was just a single global risk factor which was inadequate in dealing with risks and issues. The regulations of Basel I and II were not presented in a way that could streamline the rules and regulations relating to “promises” which include government bonds, mortgages and lending between banks. The new approach and the rules of Basel III try to provide rules and frameworks within which the governments of nations can take these promises seriously. Also, the new rules are likely to have an impact on the marketing of these products by banks in order to provide an important framework and system that will be able to seal the loopholes and provide better solutions. The need to put in place controls was the main motivation for the creation of Basel III. This is because the old rules were outdated and there was no basis for banks to deal with the problems and issues relating to the activities that are seen to be extreme and excessive in different processes and issues. These loopholes were to be sealed, albeit with a broad scope of rules and regulations that nations could interpret in ways and means that they considered to be best. Basel III: An Evaluation of the New Banking Regulations (Blaylock & Conklin, 2012) This paper commences with a discussion on the need for limits in capital targets that were set by the Basel III Accords. The limit indicates that the capital ratio was to be somewhat between 5.7% and 7% and failure to meet those levels meant that banks were to be restricted from taking various forms of cuts and payouts. The new rules also require various ratios to liquid investments to be achieved by 2015. Blaylock and Conklin go on to examine the background of the Basel III rules. They identify that the global financial crises changed the terrain and this called for stricter regulation of financial markets and bank liquidity ratios. However, the main challenge that came with it was that different nations had different financial systems and hence, the approach of getting a unified system was problematic and challenging and also makes it difficult to predict international crises. Therefore, the Basel III system had to be evolved as a means of providing the best possible solution to the situation. In attaining this end, the Basel Committee had to focus on capital adequacy in order to create a framework of regulations and this has been the focus of the Committee’s previous regulations and recommendations. This was the case of Basel I where the focus on capital adequacy and investment targets were checked. Basel II in 1988 focused on the use of better calculation methods, but upon the realisation of more facts, the Basel III accords came into operation. Basel III provided the bold initiative of changing the “quality, consistency and transparency of banks’ capital base”. Aside that, there is the need to declare common equity and retained earnings as the predominant form of Tier I Capital. This indicates that Basel III became more definitive and more straightforward in setting the parameters for the regulation of banks. The main strength of Basel III is steeped in the fact that it reacts to the economic crises and its variables. The weakness of Basel III is that it is not realistic because in these times, banks will struggle to raise the required capital. The Basel III leverage ratio puts the risk exposures of banks in a reasonable range, but the implementation may have unintended consequences like discouraging risk taking that might be rewarding. Basel III has a counter-cyclical buffer that seem to provide a realistic solution to the need for protection against exposures and this has the disadvantage of creating high levels of surplus and cause major issues with profitability with these banks. Other measures to limit counterparty risks and standardised liquidity ratios include measures to limit risks when counterparties fail and provide mandatory levels of cash to be held by banks respectively. This prevents banks from seeking more assets with financial institutions which creates obvious risks like the Lehman Brothers issue that led to the collapse. This will encourage banks to work within their scope and attain results that are more realistic. The downside of this is that might increase the cost of conventional and everyday arrangements like hedging which is essential to run economies. The article also identifies that the Basel III recommendations are not binding and must be adhered to on the best principles for nations around the world. Some use rule based systems whilst others use principle based systems. Basel III: A Study of Basel III and whether it may Protect Against New Bank Failures (Johansson & Schaefer, 2012) This is a study conducted by two postgraduate students into the possibility of the new Basel III framework as a tool for the protection of banks from collapse and the elements of the global financial crises of 2005-2007. To this end, the researchers interview various authorities in the banking sectors of England and Finland. The fieldwork basically asserts that the new rules and regulations of Basel III Accords are not robust enough to prevent new bank failures in future. However, most of the respondents who are top supervisors in the banking industry of England and Finland identified that Basel III is a much larger improvement over the previous processes. They hold the same views as the strengths identified by Blaylock and Conklin (2012). In spite of this, they all assert that the new processes and regulations do not provide a foolproof guarantee against failures in future. This is mainly because of the gaps identified by Blaylock and Conklin including the lack of realistic evaluations of the situation and the likely issues that will come up after the institution of the standards and rules. One unique point of view that the respondents identified included the fact that the risk weights are not robust enough since there were numerous possibilities of banks to override these systems and limitations. They all seem to assert that the previous financial crises were mainly linked to the possibility and actual override of the existing regulations relating to bank supervision regulations. The risk weighting system of sovereign banks were not reviewed. This means there is the possibility of the re-enactment of the issues that occurred in the past. There is also the risk of financial innovations being done to override the changes. This is because the modifications of the rules did not take into consideration the possibility of some realist views and realist actions that might be done in a way and manner that will modify the existing rules and regulations. Basel III and Its Consequences (Confronting a New Regulatory Environment)(Auer, Von Pfoestl, & Kochanowicz, 2011) This article by partners in Accenture Consulting provides a basic and a practical insight into the new arrangements of Basel III. They group the requirements in five main classes: Regulatory Capital, Risk Coverage, Leverage Ratio, Procyclicality, and Liquidity Standards. This is just a restatement of the presentation of the BIS Report. However, it is presented in a basic format that focuses on proposed timeline and requirements for implementation. They identify that banks have to face stricter requirements and expectations. This will require that for all practical intents and purposes, banks will have to examine the possibility of re-securitization. However, they identify that significant banks are having challenges meeting all the requirements. And this indicates that there must be some degree of flexibility in the implementation. The presentation of this document indicate that better options can be attained if Central Banks take a more proactive role in examining results and making demands from banks. This is because a quick and a strong upturn for these banks will bring various negative results that could be somewhat detrimental for the banks and financial institutions. They also identify that there will be functional specification and functional integration which will lead to some technical incompatibilities. Also, profitability gaps are to be expected as a natural consequence of this system and process. Basel III: Issues and Implications (Greenlee, Kelly, Fogarty, Dutta, & Baraybar, 2011) KPMG partners identify that the elements of Basel Accords III were accepted by G-20 nations and implemented by the Central Banks after the consensus was met. However, they identify that the rules lack clarity that will aid an across-board implementation. Therefore, these KPMG partners provide an insight into the issues and matters relating implementation. They identify that the implementation comes with some degree of turbulence because of the lack of consistency and the risk of abuse and overrides that will occur in the process of implementation. The paper focused on the impacts and the issues that will occur amongst various members of the society. This article fundamentally targets corporate entities that might be working with the banks that will be affected by these issues and matters. They identify that the impact assessment of these changes are something that ought to be reviewed and analysed at regular intervals by corporate entities and banks to identify how they are doing. This is because implementation requires some degree of change management in order to position a firm to attain the right results and its strategic objectives within the framework of change. Secondly, the governance framework and systems of firms will have to change so that they can monitor risks and issues. This will provide the right way through which monitoring of firms can be carried out in relation to the changes banks will make. This will enable the firms to streamline their governance structures with the changes. Such a proactive move will enable governance to be in sync with the changes in circumstances. Capital and portfolio management in banks are going to change with the new rules and regulations because they must be changed to reflect the changes in the rules. Hence, there is the need for banks to examine their capital structures and make changes as appropriate. Also, there is the need for the reporting systems of banks and even corporate entities in nations around the world to be streamlined so they conform to the regulatory rules of the Basel III rules and regulations. Finally, there must be some adjustments in the calculations from the existing frameworks and systems so that the changes are instilled in all departments and units of a bank. This will also form the basis for banks to regenerate new figures and processes for the conduct of business in different contexts based on the new regulations of the Basel III Accords. Conclusion The different researchers provide various identification and justifications for the Basel III Accords. Some of the writers identify that Basel III was based on the need for the various governments to control bonds, mortgages and loans. These were issues that were not strongly handled by the Basel II and I. Hence, the new rules of Basel III were to evolve to cover all the issues and matters. Basel III involves the creation of new frameworks for an integrated and improved framework for the calculation of risks involving leverage and risk exposures, capital basis and assets in order to find important limits within which banks could carry out various processes. Basel III provides regulations and commonalities and its advantage is that it covers a lot of variables. The weakness includes the fact that it is not realistic because banks cannot raise capital levels to meet the capital requirements of Basel III. Leverage limits are meant to provide the limitation of risks. And this is to ensure that banks continue as a going concern. However, it is risky because it could discourage firms from taking risks. This is an issue that is shared by the counter-cyclical buffer and counterparty risks. Scholars reviewed identify that the application of these rules are likely to come with issues like disparities. This is because the rules of Basel III are not binding. It could be applied in a rules based atmosphere or a principle based framework. Hence, the application is bound to be done in an atmosphere of major gaps. Some researchers have also identified that authorities in the field of Banking identify that the risk weighting systems are not robust enough. And these new systems are susceptible to financial innovations which could lead to various overrides. This could mean that the application and implementation of rules might not be as smooth as envisioned by the people who brought the rules into practice. Some accounting authorities identify that functional challenges could occur during the implementation of these Basel III rules and regulations. This is because every unit of banks will have to change and there is the need for strong governance and control mechanisms to be put in place by the persons charged with corporate governance of banks. Also, unit heads will have to change their calculation of various risks and rules to reflect the regulatory changes and issues of that sort. This will make the application more thorough and ensure compliance. Bibliography Akkizidis, I. S., & Bouchereau, V. (2005). Guide to Optimal Operation Risk in Basel II. New York: CRC Press. Auer, M., Von Pfoestl, G., & Kochanowicz, J. (2011). Basel III and Its Consequences (Confronting a New Regulatory Environment). Accenture , 1-15. Bank for International Settlements. (2014, April 4). BIS Official Website. Retrieved July 25, 2014, from About Us: http://www.bis.org/about/index.htm Barr, M. S., & Miller, G. P. (2006). Global Administrative Law: The View from Basel. The European Journal of International Law 17(1) , 15-46. Basel III and Its Consequences (Confronting a New Regulatory Environment). (n.d.). Blaylock, D., & Conklin, D. (2012). Basel III: An Evaluation of the New Regulations. Richard Ivey School of Business , 1-15. Blundell-Wignall, A., & Atkinson, P. (2010). Thinking Beyond Basel III: Necessary Solutions for Capital and Liquidity. OECD Journal: Financial Market Trends Issue 1 , 1-23. Greenlee, J., Kelly, H., Fogarty, M., Dutta, S., & Baraybar, J. A. (2011). Basel III: Issues and Implications. KPMG Bulletin , 1-18. Johansson, E., & Schaefer, D. (2012). Basel III: A Study of Basel III and whether it may Protect Against New Bank Failures. Jonkoping International Business School - Masters Thesis , 1-81. Scott, H. S. (2013). Capital Adequacy Beyond Basel: Banking, Securities and Insurance. Oxford: Oxford University Press. Supervision, Basel Committee on Banking. (2010). A Global Regulatory Framework for More Resilient Banks and Banking Systems. BIS Report , 1-56. Zhou, Q. (2011). 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