The Implications of Basel III and More Recent Regulatory Initiatives on the Banking Sector in the UK - Case Study Example

Student Name: Tutor: Title: The Implications of Basel III and more recent Regulatory Initiatives on the Banking Sector in the UK Institution: Due Date: Introduction In today’s economy, strategic business decisions must be supported by a thorough understanding of the firm’s risk environment as well as the linkage to the financial performance. Therefore, senior management in the financial sector needs to consider their institution’s capital budgeting and the risk management decisions in a single approach. This will eliminate the practice of taking them as separate and distinct activities. This is a clear indication that risk management activities must be an integral part of the general business strategy, and thus need to be ultimately aligned with the institution’s financing decisions. Cash Flow at Risk (CFaR) is a powerful and more versatile management tool that can help the top executives to make a comprehensive strategic, financial and risk integration within a uniform decision framework (Harrington & Niehaus 2003). On September 2010, the Basel Committee for Banking Supervision (BCBS) approved the annex that it had previously issued, specifying more on the details for capital requirements. This particularly concerned the target ratios as well as the transition periods through which banks are required to adapt to the new financial regulations. The outcomes of the discussion have now been supported at the recently-concluded G20 meeting in Seoul. Therefore, Basel III, as the universally accepted new rules is fundamentally complete. The new regulations are expected to make the European banking system safer by ensuring that the flaws reflected in the financial crisis are redressed. Therefore, improving the quality as well as the depth of capital and a strong focus on the liquidity management is meant to spur banks to develop their fundamental risk-management capabilities. This provides a crucial implication that if banks fundamentally revamp their understanding of the risks associated with their banking services, a situation commonly known as a new risk paradigm, there will be significant performance improvement for their business as well as consumers, investors, and governments. As a result, banks are already creating their capital, funding stocks and undertaking risk from their books through various ways in response to the new regulations. The three sets of actions considered as important guidelines to implement the current Basel III and other regulations include, improved capital and liquidity management, restructuring of the balance sheet, and the capability to adjust business-models (Basel Committee on Banking Supervision 2010). Assessing the implications of Basel III rules on European banks The Base III rules text were issued by Basel Committee issued, indicates the essential aspects of the international regulatory standards. Banks are required to adhere to such standards to enhance their capital adequacy and liquidity as agreed by the Financial Governors and Heads of Supervision. The rules cover both the micro and macro-prudential elements of the Basel III framework that sets out better and high-quality capital, improved risk coverage, the integration of a leverage ratio as a baseline to determine the risk-based requirement, measures to endorse the increase of capital to be drawn down in times of stress as well as the introduction of global liquidity standards. The new regulations of the Basel Committee framework on bank capital and liquidity increases the resilience of the international banking system not only in the European banks, but also in financial institutions across the world. This is achieved by raising the quality and quantity as well as global consistency of the bank capital and liquidity, restrict the increase of financial control and maturity mismatches. Additionally, there is introduction of capital buffers above the required or minimum to be drawn upon during bad times (Hanson, Kashyap & Stein 2011). It is apparent that the new standards will remarkable reduce incentive of banks to take high risks, minimize the likelihood as well as the severity of their future crises, and thus enabling banks to survive rather than relying on the extraordinary government support. This will eliminate the stresses of a magnitude banks faced with the current financial crisis. As a result, a banking system necessary to better support the stable economic growth will be developed. It is important to note that the Basel Committee on Banking Supervision (BCBS) regulations is crucial as it provides an opportunity to make regular cooperation on matters related to banking supervisory. Furthermore, it seeks to endorse, strengthen banking supervisory as well as risk management practices across the globe. Therefore, a strong and resilient banking system plays a great role in the achievement of sustainable economic growth. This is because banks are put at the forefront of the credit intermediation process that is between the savers and investors. Additionally, banks offer critical financial services to consumers, large corporate firms as well as small and medium-sized enterprises and governments who largely depend on them to run their day to day business, both at a national and international level (Basel Committee on Banking Supervision 2010). Research indicates that capital management as well as corporate risk management is considered two effective sides of a single coin, finance theory and its associated practices have treated the two as separate aspects over time. Management of risk exposures and capital availability separately leads to a significant cost since it ignores the actual causal impact of the risk exposures on a given cash flows in relation to the cost of capital. Therefore, it is important to overcome such an isolated treatment of the two aspects risk management in financial sector by adopting a comprehensive decision-making framework. The management of financial institutions is required to use appropriate tool set for risk modeling, particularly with features to complement as well as extend the techniques of capital budgeting (Shmpi 2002). Basel III would lead to a reduction in return on equity (ROE), particularly for the average banks in Europe as well as in the United States. Banking segments such as the retail, corporate, and investment banking to a larger extent will be affected in various ways. Apparently, the retail banks will not be affected so much. However, institutions identified with the lowest capital ratios may face significant pressure. Basically, corporate banks will be affected in the areas of specialized lending as well as trade finance. On the other hand, Investment banks will experience a number of core businesses intensely affected, in particular the trading and securitization businesses. This implies that banks with the capability to own substantial capital markets and the trading business will possibly face considerable business-model challenges within the next few years (Basel Committee on Banking Supervision 2010). Banks are seeking the best ways to manage ROE within the new environment through cost-cutting and price adjustment measures. However, more interventions, both general and specific to the Basel III must be considered by banks including a set of “no regret” interventions in order to minimize both capital and liquidity inefficiency from the suboptimal execution of the new financial rules. In addition, balance-sheet reforming must be implemented so as to enhance the quality of capital as well as reduce the capital needs that arise from the Basel III’s deductions and more effective management of the insufficient balance-sheet resources achieved. Business-model adjustments will be crucial in creating the capital- and liquidity-resourceful business models, products and change of the scope and viability of some business lines (Abiad, Leigh & Mody 2009). Despite the extensive change period that results from the Basel III regulations, compliance with its new processes as well as reporting must be fundamentally completed. For instance, an average midsize bank, it can be estimated that for only technical implementation about 30 percent to 50 percent will be added to the large expenditure already incurred for the Basel II. Therefore, successful implementation of the new rules will be achieved only if the three distinct initiatives are taken. These include strategic planning for the global Basel III, capital and risk strategic approach as well as implementation management (O’Brien 2006). The recently issued rules in September contain essential amendments. Basel III now incorporates a timeline to meet within the new regulation. However, the major question that arises is to what extent and how promptly banks will respond to the new regulations based on their earnings power, mitigation capability as well as their capital-raising capacity. Incase full implementation of all the envisioned measures in Basel III is made by 2019, and prior to any mitigating actions taken by banks, it means that the pretax ROE of all European banks would decline drastically in percentage points from the original state or pre-crisis percentage level of 15%. The lowest range does not include the impact caused by net stable funding ratio (NSFR) and lacks the new rule to govern the long-term funding. On the other hand, the highest range includes the NSFR as currently defined. It is important to note that the NSFR consultation is under development, and thus the ratio is extensively expected to have fewer errors once it is confirmed (Committee on the Global Financial System 2010). The ROE reduction is due to the capital and funding impact. For instance, capital side if it is fully implemented by 2019 effects, capital quality ill achieved, increased risk-weighted assets (RWA) as well as increased capital ratios will be realized. This implies that the leverage ratio will reduce ROE percentage points where on the funding side, the ratio will increase due to more points from the expense incurred from holding extra liquid assets and from the cost associated with investing more in long-term funding (Saita 2007). In contrast, some institutions in the financial services industry that are currently operating within the up-and-coming European banking sector, view the changes adopted in the Basel framework as a major threat to their own banking model. As a result, Basel III pretenses significant threats, particularly to the main-subsidiary funding relationships which have had a long-term service in a given region. This provides the view that capital requirements castigate what have entirely been comparatively defensive exposures, particularly to the small and medium-sized enterprises (SMEs). Therefore, on-set introduction of the Basel III in emerging European banking sector could disrupt a promising recovery in credit as well as causing adverse effects to the economic growth (Alexander, Micol & Tabak 2011). Furthermore, changes within the risk weights for specific asset classes may lead to impact credit provision. The proposed Basel rules through its unclear CRD IV translation, coverage of the trading book as well as counterparty risk will result in more expenses. Preliminary estimates suggest that the CEE banking sector in Europe will not be largely affected by major challenges in when satisfying the requirements. This is because local banks widely comprise of commercial banks with comparatively traditional businesses. However, a negative impact could arise due to the imposition of extra capital charges on the trade finance instruments, including letters of credit commonly known as contingent lines of credit as well as for the small and medium-sized enterprises (Marrison 2002). Conclusion Basel III, being the universally accepted new rules is fundamentally complete. It is important because it contains rules that cover both the micro and macro-prudential elements which sets out better and high-quality capital, improved risk coverage, integration of a leverage ratio as a basis to determine the risk-based requirement, measures to support the increase of capital that can be drawn down in times of stress as well as the development of global liquidity standards. Risk management activities must be an integral part of the general business strategy, and thus need to be ultimately aligned with the institution’s financing decisions. Separate management of risk exposures and capital availability causes a significant cost since it ignores the actual causal impact of the risk exposures on given cash flows with regard to the cost of capital. The new regulations of the Basel Committee framework on bank capital and liquidity increases the resilience of the international banking system not only in the European banks, but also in financial institutions across the world. Bibliography Alexander, L., Micol, L and Tabak, P., 2011, Basel III and regional financial integration in emerging Europe, Financial stability and regulatory implications lessons from the crisis, London, One Exchange Square. Abiad, A, Leigh, D & Mody, A, 2009, Financial integration, capital mobility, and income convergence, Economic Policy, 24(4), 241-305. Basel Committee on Banking Supervision, 2010, Guidance for national authorities operating the countercyclical capital buffer, Retrieved 1 January, 2012 from, < www.bis.org/publ/bcbs187.htm> Committee on the Global Financial System, 2010, Funding patterns and liquidity management of internationally active banks, CGFS Papers no. 39, Basel: BIS. Harrington, S.E. & Niehaus, G.R., 2003, Risk Management & Insurance (2nd Ed.), Singapore, McGraw Hill. Hanson, S, Kashyap, A & Stein, J., 2011, A macro-prudential approach to financial regulation, Journal of Economic Perspectives, 25(1), 3-25. Marrison, C., 2002, Fundamentals of Risk Measurement, Maidenhead:McGraw-Hill. O’Brien, T. J., 2006, Risk management and the cost of capital for operating assets, Journal of Applied Corporate Finance, 18(4), 105–109. Shimpi, P., 2002, Integrating risk management and capital management, Journal of Applied Corporate Finance, 14(4), 27–40. Saita, F., 2007, Value at risk and bank capital management, risk adjusted performances, capital Management and capital allocation decision making, Burlington: Academic Press. Advanced Series. Read More