The Objectives and the Economic Rationale for Capital Adequacy Regulation - Coursework Example

Running header: Accounting Student’s name: Instructor’s name: Subject code: Date of submission: Introduction The objectives and the economic rationale for Capital adequacy regulation The financial market world over has undergone various financial crisis at different times in history. National and international regulatory bodies in their attempt to reduce the chance of bank failures have been involved in capital adequacy regulations that are ever becoming stricter (Kupiec 2004). For instance, this has seen the imposition of capital adequacy requirements for banks world over such as the ones proposed by the Basel frameworks. But what are the objectives and rationales for these capital adequacy regulations? The aim of the capital adequacy regulations is that of making banks more resilient hence reducing the chances of occurrence of financial crises. This is seen in for instance requiring banks to hold more capital of better quality for covering risks in the assets they hold. The regulations are thus aimed at increasing the stability of national and international banking systems by lowering the probability of bank failure. This is because negative externalities exist in banking causing risk to systematically underprice. This implies that for instance the fortunes of bank A will influence those of other banks. Market participants unfortunately are unable to comprehend fully the interdependences and hence their implications are not adequately reflected in prices. In addition, implicit or implicit forms of deposit insurance allow market participants to pass their unwanted results to third parties (Kashyap and Stein 2004). As such, capital adequacy regulation attempts to correct the market failures and hence raise the level of social welfare. It may thus be argued that the aims and objectives of capital adequacy regulation include; i) Making the financial system more resilient hence reducing the probability for a financial crisis, ii) Ensuring that banks as well as financial institutions maintain adequate levels of capital that will guard them against risk of loss that may result from their business activities thus shielding themselves against bank failure (Danielson, 2002) iii) Helping promote and maintain third party confidence in the banking and financial system by shielding them against the effects of bank failure and /or financial crisis. The strengths and weaknesses of the Basel framework in the light of global financial crisis: Since the global financial crisis that saw the collapse of major multinational banks, calls for more stringent supervision and regulation of international banking system have intensified. The Basel three pillar frameworks that regulates banks operations has been blamed for not doing enough in protecting the financial meltdown that almost brought the world economy to a halt from occurring . However, despite the criticism, regulators argue that the crisis would have been more severe were it not for the Basel framework (Mercy and O’Hara, 2000). Regulators credit the framework for providing the necessary incentives for drastically improving risk management processes at the international bank system. The framework is credited for accelerating IT infrastructure as well as comprehensive measurement for financial risk to a moderate level. This greatly helped banks in minimizing risk and giving information to third parties during the crisis thus boosting their confidence on financial institutions. This acted to prevent the crisis from escalating. Despite the strengths credited to the Basel framework during the financial crisis, it should be noted that the framework did not prevent the crisis from occurring. The specific weaknesses attributed to the framework and hence its failure to prevent the global financial crisis from occurring includes the following; Obsession with capital regulation at the expense of all other financial concerns The Basel framework‘s main weakness that was noted during the crisis is that it was obsessed with financial institutions capital levels while excluding all other financial concerns. Capital is the resources available to a financial institution to repay trading partners and depositors in case unexpected losses occurred and hence it is critical to the bank’s financial health (George, 2009). However, despite this being the case, it should be noted that from the events unfolding during the financial crisis, some banks which had adhered to the frameworks capital requirements still went under due to low liquidity in the frozen credit market. The Basel framework unfortunately had failed to mandate any rules regarding liquidity of bank assets which proved to be a costly omission in hindsight. Basing the capital requirements on mistaken capital risk The Basel framework was also blamed for having contributed to the crisis due to its basing the capital requirements on mistaken risk assessments. It should be noted that the differences in risk weights that were assigned to assets under the Basel framework provided banks with the opportunity to free up capital through shifting portfolio exposure from high risk weighted assets to low risk weighted asset portfolio. This is referred to as a form of regulatory arbitrage. Unfortunately under the framework, residential mortgages that constituted the underlying assets in the majority of the assets backed securities that were at the root of the crisis and that had been allocated lower risk weights that made them a favored class of assets for banks. The effect of this was the creation of an incentive for retail lending that was securitized against residential mortgages (Yamamura, 2010). As such, when the prices for the local housing market collapsed, banks did not have sufficient capital to cover the unexpected losses on the mortgages. Assigning a relatively lower risk on residential mortgages implied that a considerable part of the banks portfolio was composed of lending in terms of residential mortgages. This exposes a weakness of the Basel framework in terms of portfolio invariance implying that the riskiness of a given asset does not depend on how much asset is added to a portfolio. This implies that the framework did not factor in portfolio diversification meaning that the risk that arose from failure from failure to diversify was never factored in hence allowing banks to reduce capital through shifting portfolio exposure to a lower risk weighted portfolio of residential mortgages. Similarly, lending to security firms who were assigned a lower risk than other nonbanks also played a great role in the crisis. Credit ratings As stated above, the Basel framework has been credited with introducing new approaches to calculating credit risk using internal ratings adopted by the financial institutions themselves. The aim of this was to eliminate regulatory arbitrage. However, as the financial crisis proceeded, the performance of the banks internal models was disastrous and failed to shield the banks from huge losses arising from collapse of national housing market prices as well as the international economic turndown. It has been argued that the banks internal credit rating approach resulted in large reduction in capital for the banks that applied the internal credit rating models (Cannata, 2009). This is because the credit ratings were purely based on historical data which is not a good indicator of future default rates and during a crisis, previously uncorrelated assets become correlated and result into larger losses that expected. In addition, internal ratings provided banks with an easier way of reducing capital without lowering risk especially for large banks that could expect government bailouts whenever they become insolvent. The way forward Generally, the global financial crisis has been attributed to two causes. This included keeping substantial amounts of mortgage backed securities with exposure to subprime risk on banks balance sheets. This saw the perceived risk of mortgage backed securities significantly increase with the deterioration of the housing market. This forced the banks to dispose the assets they could no longer finance leading to prices of the assets falling below their fundamental values leading to fire sales and further depressed prices. In addition, banks financed the above and other risky assets using short term borrowed capital. This is because banks view capital financing as being more risky than debt financing (Tarullo, 2008). As such, it seems capital adequacy regulation was not able to prevent the financial crisis as explained above. As such, there is need for banks and regulators to seek a better alternative to capital adequacy requirements. One such alternative is for regulators to require banks acquire insurance policies that will provide instant capital during a crisis. In addition, such a policy would shield the banks from the cost of additional capital thus dampening the banks incentive to engaging in regulatory leverage that is largely to blame for the crisis. It should further be noted that capital adequacy regulations by the Basel framework failed in provide resilience by banks during the financial crisis. In fact, such requirements are not a source of strength for banks but a tax (Pagano, 2008). As such, banks regulations should now focus on targeting higher levels of capital with specific statutory and forceful ladder of increasing sanctions that should have a minimum point where deficiency is either satisfactorily redressed or failing institutions are shut down. In conclusion, it can be noted that the response to the global financial crisis by the framework has led to further concentration of the financial system (Kaufman, 2008). As such, there is need for greater intervention and regulation that will encourage competition and prevent oligopolistic behavior in the banking system. In addition, unless the Basel framework is adjusted to be responsive to the needs of the financial system during crisis, there is need to develop new regulatory mechanisms such as the ones suggested above to prevent a financial crisis in future. References: Kupiec 2004, ‘Capital Adequacy and Basel II’, FDIC Centre for financial Research Working Paper No.2004-02. Kashyap, A. and J. Stein (2004), ‘Cyclical Implications of Basel II Capital Standards’, Economic Perspectives, 28(1): 18–31 Danielson, J2002, The emperor has no clothes: Limits to risk modeling, Journal of banking and finance, vol. 26, pp. 1273-96. Mercy, J&, O’Hara, M (2000), Solving the corporate governance problems of banks, Journal of Banking and Finance, vol. 38, no. 2, pp. 19-33. George, S2009, Costs and benefits of capital adequacy requirements: An empirical analysis for Switzerland, Labor market and Industrial Organisation Research Unit, University of Basle. Yamamura, M2010, Significance of capital adequacy regulations and relationship banking in Germany retail banking, Oxford, Oxford University Press. Cannata, F2009, The role of Basel II in the subprime financial crisis, Retrieved on 27th March 2013, from: www.carefin.unibocconi.eu Tarullo, D2008, Banking on Basel – The future of international financial regulation, Peterson Institute. Pagano, M2008, The subprime lending crisis: Lessons for policy and regulation, UniNews, Unicredit, July. Kaufman, G2008, Turmoil reveals the inadequacy of Basel II, Financial Times, 28 February. Read More