The Importance of Capital and the Basel Accord - Coursework Example

Student’s name Course code+name Professor’s name University name Date of submission The Importance of Capital and the Basel Accord Despite their significance to the growth of economy, banks are susceptible to failure. Just like any other business, banks can go bankrupt. Unlike businesses, if banks fail, especially large ones, their implication on economy can be far-reaching. As recently witnessed during Great Depression or rather, during financial crisis, the welfare of bank system if affected, can trigger economic calamities affecting thousands of economies. As a consequence, it has become imperative that banks operate in sound and safer manner to avoid failures. There were some risks such as those arising from maturity and liquidity transformation which in the past, has been mitigated by central banks acting as lenders of last resorts. However, credit risks have been a big issue to deal with. This is the reason why Basel Committee on Banks Supervision (BCBS) was introduced. Its main purpose has been to promulgate guidance on affairs critical to ensuring that banking services across the world are healthy. Duncan (2005) adds that Basel Committee acts as international advisory on matters to do with bank regulation. One of the issues that have called for regulation is the capital. As a matter of fact, this has led to promulgation of capital adequacy levels that regulators from different countries can implement. This is what is termed as Basel Accord (Basel Committee on Banking Supervision, 1988). The Accord has elicited mixed reactions from different countries but still stands as the most vital formulation for regulatory policy regarding bank capital. At the heart of the debate regarding the Basel Accord has been the regulation of bank capital. This has been well documented in some literal materials as developing strategies or rules that ensure banks maintain sufficient levels of capital. Therefore before understanding the idea regarding Capital Accord (in this case Basel I and the Market Risk Amendment), there is a need for understanding the concept of capital. Just like any profit making business, banks have a balance sheet comprising of equity, assets and liabilities. And they are able to fund their assets through equity and liabilities. In such case, liabilities will reflect bank’s debt. On the other hand, there is the assets (another side of the balance sheet) that comprises of its loans to customers. If we have a bank with its assets exceeding its liabilities then the difference is the bank’s capital. If the same bank has its liabilities exceeding its assets then it is capitalized negatively. This is why it is advisable that banks keep positive capital so as to manage repayment of its liabilities. Other than its ability to protect insolvency; capital is essential to banks in a number of ways. First, according to Cornish (2012), capital protect against risk loss that are inherent in bank’s asset. This is so when loan borrowers default and banks use capital to pay depositors. Secondly, capitals are important to banks as they protect against the volatility in its liabilities. As it is known, banks depend on customers’ deposits as their major assets. These deposits are equally risky source of income since these customers may demand repayment. This is common especially when customers withdraw large sums forcing banks to allow withdrawals of its capital as banks cannot liquidate some of its assets immediately (for instance loans). When this goes on, the bank finally exhausts its capital thus resulting into insolvency. In the just concluded financial crisis, the issue of risk insolvency was vital matter confronting a number of banks in Australia. Because these banks were significant to the growth of the economy, their failure would have posed significant risk to the financial system thus dubbed, “too big to fail” (Cornish, 2012 p. 23). This is what has made the government through institutions such as The Reserve Bank of Australia; intervene by pumping capital into these banks so as to prevent them from collapsing and thus failing the entire financial system. Talking of Reserve Bank of Australia, it needs to be noted that Basel Capital Accord is not a one country document. Its operation finds backing from different countries. Australia being one such prides herself as it can influence rule-making powers. This is done by implementing the BCBS policies within the country. When this happens, a country is represented in Basel Capital Accord. According to Australian Treasury (2011), Reserve Bank of Australia plays this role. On the other hand, capital has also been serving the purpose of preserving sound and safe banking. By ensuring there is enough amounts of capital, financial institutions can be able to ensure they are capable of meeting their roles to their creditors. On the other hand, a bank with sufficient capital will give depositors confidence that the bank will be able to repay them. After the basic information regarding capital Accord (in this case Basel I and the Market Risk Amendment), it is prudent introducing Basel I and the Market Risk Amendment. Before doing this, it is worth noting that banks were without strict regulations before. It was upon countries to determine how banks within their borders are regulated. However, this notion changed when Herstatt Bank of Germany failed. Explaining what happened to Herstatt, by the time it failed, there were a number of unsettled international transactions regarding Herstatt Bank and America banks. Such transactions included American banks paying Herstatt Bank some deutschmarks, but in return, the American banks did not receive dollars owned to them. Before this transaction could be completed, Herstatt failed bringing major losses for its American counterparts. The incident that befell Herstatt brought attention of other banks in other countries. It called for comprehensive and coherent international cooperation so as to minimise future risks that come as a result of international banking. This is the reason why Basel Committee on Bank Supervision made capital their focus. As a matter of fact, capital has been viewed as solvency issue even before the rise of Herstatt Bank and America banks saga. What still needs to be explained is whether assets from banks in as much as they are risk, able to repay liabilities. To understand this issue, first, Bank for International Settlement (BIS) needs to be mirrored. BCBS is working under the auspices of BIS. Now answering the question whether assets from banks in as much as they are risk, able to repay liabilities, BIS is under the operation of several central banks and its main responsibility is to ensure it acts as central bank to its members. In that capacity, even if assets from the banks will not be able to repay liabilities, BIS will. Putting this case in a practical term, assuming there are two banks governed by different capital standards. Bank A should hold amount of capital up to 2% of its assets while bank B is needed to hold capital amount of 8% of its assets. Bank A is worth $100 of its capital. It means A can lend up to $ 5,000. For bank B, the same $100 of capital gives it an edge of lending up to $1,250. Looking at this case, the higher capital owed puts bank B at disadvantage (competitively). These efforts resulted in Basel 1 Capital Accord, or simply Basel 1. One of the features or importance of Basel 1 is the determination of capital adequacy. This was done through the adoption of a capital ratio. This ration was to measure capital against bank’s assets. Another important aspect that was contentious in the Basel 1 Capital Accord was risk-weighted assets (RWA). These were value adjusted for banks’ risk level. This translated that capital ratio was therefore expressed as capital/risk-weighted assets---meaning every bank had the obligation of maintaining a capital ratio of at least 8%. Of course there were some issues that were argued by banks. Culmination of such arguments ultimately made BCBS. Under Basel 1 the definition of bank capital was broken into two components; tier 1 capital and tier 2 capital. Tier 1 capital was made up of core capital. As explained by Duncan (2005), core capital, also referred to as common equity are items arising from pure ownership in the financial institution (banks) and constitute the paid-in value of common stock. This also include retained earnings (the amount of any reserves) On and off-balance sheets were also suggested during the Accord. As on-balance will be analysed, off-balance sheet are items held by a given bank and do not appear on the bank’s balance sheet. This is why credit conversion factors were deemed necessary to convert off-balance sheet risks into risk-weighted assets. As I mentioned above, on-balance sheet on the other hand have risks and such are converted using risk-weighted assets (RWA). This can also be linked with trading book and banking book. While trading book is made up of positions in financial instrument and commodities held as either with trading intent or to hedge other aspects of trading book, banking book is related with on-balance sheet. In most cases, on-balance-sheet netting in the banking book is always permitted subject to a given operational standards. References Australian Treasury (2011), ‘Financial Claims Scheme – Consultation Paper’, May. Available at http://www. treasury.gov.au/documents/2025/PDF/CP_Financial_ Claims_Scheme.pdf Basel Committee on Banking Supervision, Basel I and Market Risk Amendment, http://www.bis.org/list/bcbs/tid_21/index.htm. Cornish, S. (2012), ‘Prudential Regulation and Supervision’, in The Evolution of Central Banking in Australia, Reserve Bank of Australia, Sydney, pp 79–91. Duncan W. (2005). Governing global banking: The Basel Committee and the Politics of Financial Globalisation Read More