Implications of Basel III Proposals - Case Study Example

Running Header: Implications of Basel III Proposals Surname: First Names: Student Number: Institution: Course Number: Course Name: Assignment Due Date: Introduction Following the aftermath of the 2007-2008 financial crisis, many financial institutions world over were faced with numerous challenges which affected their performance both locally and globally. The problem was enhanced by the fact that many banks were highly interconnected in such away the change of policy of one bank affected almost the rest of the sector and all other key players. The crisis was as a result of fast growth of the banking industry more especially from the developed countries which made advance to serve their customers by operating globally. In the process of doing this, the banks were expected to move the traditional models of doing business to new ways in order to verge with the competition globally (Walter 2008). This step made the industry more complex and very competitive to operate in. Following the collapse of financial institutions, The Basel Committee on Banking Supervision was formed in 2008 to propose some of the recommendations that could be used to help sort out the financial crisis. The committee was composed of representatives from America, Asia and Europe continents. The Committee was expected to address the issue of market failures that had led to many banks to collapsing by failing to break-even (Reinhart and Rogoff 2009). The committee was charged with the responsibility of establishing the regulatory framework that helps strengthen banks and enhance their resilience in response to any stress. The framework was also supposed to develop a macropriudential focus that will address the risks that are found in the wider network of the banking sector. The primary objective of this article is to discuss the major implications of the Basel III reforms and more recent regulatory initiatives on the banking sector in the UK. Main Basel III reform proposals In April 2009, the Committee and the member countries agreed to come up with several reforms that will be used to improve the resilience among individual banks and the sector as a whole. The Basel Committee on Banking Supervision (BCBS), at the end of 2009, provided a various guidelines and proposals that that will be used to the bank resilience. By the end of September 2010, a good number of proposals had been agreed on (Basel Committee on Banking Supervision. 2009). The key components of the BCBS proposals included: 1. Ensure higher and better quality service delivery by use of common equity policy and loss absorption policy features. 2. Introduction of the leveraged ration system that is non-risk for use as a measure. 3. The other key component in the proposal is the one that talks about the tighter liquidity standards including liquidity asset buffer, liquidity coverage and long-term funding requirements to regulate the maturity mismatches. 4. Better recognition of risk for both the market and the other counterparty risks. 5. Capital reservation buffers As a guideline to the framework, the Committee was of the view that having a common equity will play a major role in representing higher proportion of capital and consequently enhance loss absorption rates. The minimum loss absorption will be expected to increase to 4.5% from 2% in the current standards. The 2.5% increase is the capital conservation buffer. Global liquidity was considered by the committee as a major key factor to the reform. The Liquidity Coverage Ratio (LCR) should be used to make sure that banks which are active globally have up to 30 days to access high level and quality liquidity assets to manage their short-term bank activities and other related systematic shocks as well ensure that the bank is protected from depending on wholesale liabilities such as secured funding (Roger & Vlček 2011). This reform is supposed to take effect as from 2015 and it is aimed at helping banks to avoid depending so much on financial sources that are real volatile and therefore promote internal asset development to manage shocks whenever they arise. Development of policies that enhance macro-prudential approaches has also been given a consideration under the proposals. Implications of the reforms in the UK This part of the article will discuss the major implications of the Reforms on the financial institutions in the United Kingdom. The discussion will mainly focus on the implication of new capital requirements on the local as well as the liquidity requirements (Evans 2010). The primary aim of this discussion is to explore critically how banks that are operating in the country will be influenced by the new structures and policies and how their business strategies are likely to be affected. The exploration will look into the impact of capital and liquidity requirements. Implications of capital requirement reforms Currently the quality levels and compatibility structures differ greatly from one country to the other whereby the United Kingdom is one of them. This means that the banks that operate in the UK have to place themselves strategically with the policy by ensuring that compatibility levels with the reforms are met (Barth 2008). According to the committee, the current position with regard to the total assets held by the banks have a very weak gong concern and that loss-absorbency features are relatively high in terms of average as opposed to other banks with a Tier capital and consequently meaning that there is a lot of variance in different banks that operate in different countries (Van Den 2008). Currently, the banks in the united kingdom quotes the highest ratios of the total assets at 38% banks followed by the banks from the North America which quote their total assets ratios as 32%. According to the reforms, the banks now will be expected to less much of the assets from the equity party of the capital as one way on way of improving their quality capital and match with rest of the world. Based on the proposals, the banks now will be expected to eliminate about 24% of their regulatory capital. Currently shares differ greatly from one country to the other ranging from 5 to 30% reflecting how individual bank businesses vary from one bank to the other. If the proposed reforms are applied immediately, then it will mean that the deductions will see the core Tier 1 capital reduced significantly from 8.6 percent to 6.7 percent and then 5.8 percent. The investment banks will be the most impacted ones in the market in terms of the risk weights. This is because of the amount of share that is traded and the securitization of the business mix. The effect of this is that banks will be expected to offset some of its retained earnings that have been accumulated until the proposals are fully implemented. In general the proposal will have much effect on the banks that operate both in the UK and the United States. In the United Kingdom the banks will be expected to reduce their assets (Jenkins 2010). This is as a result of high level of concentration of many international banks which have established numerous subsidiaries in the country alongside the establishment of bank-insurance related business. The changes will also see many banks many especially those that are universal and investment oriented by the reduction of the capital ratios. The capital ratios for universal, commercial and investment banks are expected to fall by big margins. However, local banks are expected not be affected so much by the changes because of the simpler way of doing business locally. Large banks are expected to experience great deductions more especially on the risk assets that are market weighted (Osborne 2010). Universal banks operating in the country are also expected to be impacted by the combination of different weighted risks which are attributed to their trading in business where minority interests that are related to the insurance businesses are taken care of. The banks will also be expected according the BCBS proposals to fill the capital gap that currently by the use of the retained earnings. This means that the banks have to create enough through which they ensure that they are able the necessary adjustments without necessarily interfering their balance sheets (Murphy and Masters 2010). The ability of the banks to banks to achieve the capital requirements will depend on their ability to capitalize and the capacity to re-energize their capital by utilizing their retained earnings. Incase there are no retained earnings; the banks will be expected to mobilize over $360 billion in addition of capital in order to comply the 7% major capital requirement. However, it is expected that banks that are not likely to meet those requirements will increase to about 50 banks by the end of 2019. In essence therefore, the banks in the country are expected to raise a substantial amount of capital if they want to succeed under the new reforms. From the survey on the implication of the capital requirements, it can be argued that banks will only be able to meet their targets by use of the retained earnings (Roeger 2010). The banks can also reduce on their dividend payments in order to achieve the expected capital buffers. Implications of liquidity requirements According to the proposals it is estimated that many banks from the United States and the United Kingdom are likely to meet the proposed Liquidity Coverage Ration (LCR) and those that will not be able to do so, they can still manage the liquidity gap. Research has shown that Asian banks have better short-term liquidity base followed by the banks from Europe. The strength of the Asian banks is built on their simple and less complex balance sheets which reflect clearly the structures of their securities and better funding profiles which are skewed towards their deposits (King 2010). This means that for the banks in the United Kingdom to reach their counterparts from Asia, there is need to restructure internal policies in order to improve their Liquidity Coverage Ratios. The proposals mean that there is need for the banks in the United Kingdom to have a more robust framework accompanied with stronger capitalization policy that will ensure lower risk premiums that will be used debt issuance. In terms of risk management, particularly those that have a global outlook are likely to be faced with funding related challenges. This is if tight requirements can lead to a tendency whereby decentralization of operations by banks will limit them from accessing liquidity from the banking groups (Schantz 2010). Incase where banks are expected to manage their own liquidity risks by away of holding certain liquidity assets and not by use of government bonds, then the risk profiles are likely to be affected once the assets are likely to become less favorable as result of the threats by the LCR. Implication on business strategies The Basel III proposal is not a not a neutral business model and that it is main objective is likely to have a great impact on the overall investment and banking activities. Therefore this means that the banks are expected to introduce certain liquidity ratios that will allow for smooth execution of the new rules with having to create so much pressure on the banks’ capability to mature the transformation process. In order to achieve this, the banks are expected to do some substantial deleveraging ratios without passing the burden to the customer (Quinn 2008). The Basel proposals are likely to be less difficult to implement for those banks in the United Kingdom that are ready to put their focus on commercial activities and that are ready to take time to adjust. However, it is evident that the time ahead is likely to be very difficult for some banks especially in trading as well as securitization of business activities under very tight requirements. This implies that the requirements will be costly as provided by the Basel proposals and that only better liquidity and capital requirements will see a bank succeed in the new era. Conclusion In concluding this paper, it is important to highlight some of the important lessons that have been drawn from the review. First, globalization and interconnectedness of banks is the main cause of the financial crisis of 2007/2008. This is because the step taken by one bank in one way or the other affects the other financial institutions. The Basel III has proposed as a remedy in order to bring harmony and sanity in the banking by establishing a framework that will be followed by all banks while commercializing. The Basel III proposal is built on two main elements which are management of liquidity and capital requirement. In general terms, the proposal has got numerous positive and negative implications both to local and universal banks that operate in the United Kingdom. This means that there is need for overall adjustment of the banking policy in the country to ensure compatibility with the new requirements. References Barth, R. 2008, ‘Bank Regulations are changing: For Better or Worse?’ Comparative Economic Studies 50 (4), 537–563. Basel Committee on Banking Supervision. 2009, ‘History of the Basel Committee and its Membership’. Bank for International Settlements. Evans, S. 2010, ‘British Banks Still Face Breakup Threat,’ Businessweek. May 17, 2010. Jenkins, P. 2010, ‘German banks try to fend off Basel III.’ Financial Times September 6, 2010. King, M 2010, Mapping capital and liquidity requirements to bank lending spreads‖, BIS Working Paper, No. 324. MAG. 2010, Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements – Final Report, Basel Committee on Banking Supervision, December. 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Schantz J. 2010, The long-term economic impact of higher capital levels, Bank of England, mimeo. Walter, A. 2008, Governing finance: East Asia's adopt of international standards, Ithaca, NY: Cornell University Press. Read More