Requirement of Basel III - Assignment Example

? Basel III No: Basel III has already faced considerable criticism. Two of the main criticisms are that it is overly complex (proposed four layers of capital) and that the capital requirements therein are unrealistic. Some also argue that compliance with the new framework would actually involve competitive disadvantage! Critically evaluate this statement. Introduction The Basel 111 reflects the global authority concerning capital adequacy ratio, stress test market risk, credit risk and liquidity risk of the banks mutually agreed upon by the members of the Basel Committee on Banking Supervision in the year 2010 and in the subsequent year 20111. There is a need to develop more stringent standards for the banks to address the deficiencies that come on the surface in the financial crises of late 2000. The introduction of Basel-111 aims at to strengthen the capital requirements of the bank and the regulatory requirement of bank liquidity and bank leverage. In Basel II, the risk management was out sourced to third party. The Ratings of financial instruments were conducted by the outsource agencies Fitch ibca, moody and poor and standard without intervention of official agencies. The AAA ratings on mortgage backed securities, credit default swaps and other instruments in practice evidencing extremely bad credit risks. The implementation of Basel III surely will decrease annual GDP growth to the extent of 0.05 to 0.15 percentages. It is responsibility of the directors of the company to keep an eye on market liquidity condition that enables them to hold major assets for the accountability of material losses2. Requirement of Basel III The Basel III primarily addresses and focuses on the liquidity risk, capital adequacy ratios and stress testing. It requires banks to follow the requirement of Basel III and to compute the liquidity and leverage ratios accordingly. Therefore, the banks are to keep themselves align with the new requirement in order to integrate all relevant data to develop a new approach of data analysis and modeling. Basel III demands sufficient transparency and zero rated documentation ever than before to ensure that the deployment of funds would bear fruits3. Banks must ensure creation of new models that ensure compliance of Basel III requirement. It is a matter of fact that most of the institutions are reluctant to implement it in its true spirit due to reasons best known to them. However, they have no other option but to implement it in order to avoid penalty from compliance and monitoring watch dogs. In other words, compliance of Basel III requirement is mandatory and not optional. Keeping in mind the necessity, the banks are developing infrastructure and models for the banks to make best use of its capacity to pin point and respond to the profit making opportunities4. According to Simon Nixon, “no one disputes the broad thrust of Basel III, that banks should hold much higher levels of higher-quality capital. Indeed, all major European banks have well-developed plans to meet the new rules ahead of time.”5 It is a matter of fact that in today’s world each and every organization including banks heavily relies upon latest technology to meet the requirement of customer satisfaction besides regulatory compliance by the banks. The more efficient business decision making are based on the reliability of their quality data. Any bank who successfully receives the data through reliable domestic sources within the bank to position its data warehouse on sound footings coupled with technology infrastructure stands to deliver the goods efficiently in terms of compliance and better business6. “Basel III tightened up the rules on what could be counted as core capital, increased the risk-weights that determined how much capital a bank should hold against a particular exposure and finally introduced a tough new minimum ratio of core capital to risk-weighted assets, set at 7% for small banks and rising to 9.5% for the largest banks deemed to have global systemic significance.”7 The requirement of Basel III for the banks is to hold common equity of 4.5% that is up to 2% above of the Basel-11 and 6% above of Tier I capital of risk-weighted assets. Basel III is in favor of additional capital buffers which are a) mandatory buffer 2.5% and b) a discretionary buffer 2.5% during the course of high credit growth. In addition to that Basel III requires a minimum 3% leverage ratio coupled with liquidity ratios. To meet the Liquidity Coverage Ratio bank has to hold high-quality liquid assets in abundance to provide cushion to its total net cash outflows over a period of 30 days. Net Stable Funding Ratio requires stable funding should exceed over a period of one year of extended stress8. Survey Report of OECD According to survey report of OECD, medium term impact on GDP growth should be in the range of .05 % to 0.15 % per year. The rise in lending price to meet the capital requirement of customers affects the economical output of a country. In accordance with Basel-111 to meet the capital requirement, which will be enforced in the year 2015, banks are compelled to increase lending spreads on their funds approximately 15 basis points. The capital requirements of the banks which will be operative in the year 2019, 7% for the common equity ratio and the 8.5% for the Tier 1 capital ratio leads to increase lending spreads up to 50 bps. This would be a great impact on GDP needs to be addressed by the regimes in their monetary policies9. Two Pronged Strategy Basel III is a two pronged strategy devised by the competent committee for the banks. It does provide an opportunity for the banks as well as challenge for the banks. There is no doubt that it will provide concrete foundations for the development of the banking sector besides avoidance of repetition of distasteful history of some of the giants in the past. Basel III is providing a new path for the banks to manage their risk and finance10. The unity of risk management and the finance will go a long way in mitigating the risk. This has put the responsibility on the shoulder of CFOs and the Senior Credit Risk Manager in delivering or achieving the objectives of a business. There is no doubt that rigorous implementation of regulatory requirement might hampered the flow of business of banks. As per the requirement of Basel-111, the risk management division of a bank has to restructure its plan in line with the structure of finance. The Basel Committee on Banks and Finance which is an apex regime for the banks provides frame work to manage the risks that are in the way and to take the decision accordingly11. New Liquidity Ratio Since insertion of new liquidity ratio under the Basel-111 programmed, it comes under fiery criticism from who hit with this insertion after introduction of first draft in the year 2009. No remedial measures have so far been taken by the regulators in this direction. The majority of the regulators are of the view that liquidity ratio should be minus from the scope of capital requirement. The liquidity measures are divided into two segments a) liquidity coverage ratio and b) net stable funding ratio. The prior strategy is designed in a way that the bank has to ensure high quality assets to survive at least 30 day period under stress. The NSFR is there to address mismatch of funding by implementing minimum acceptable amount of stable fund based on the firm’s assets and financial activities over a period of one year. Therefore, we have to recognize the role of NSFR in terms of development. Of course, there may be many more impacts that have to identify. In the present scenario, the NSFR have to travel a long way to come to its final conclusion12. The Basel Committee is in final process of fine tune the Basel-111 to implement it in phases and to complete it by 2018. The final revision should be completed by 2016. During that process the apex committee will closely observe the recommendations of Basel-111 and make necessary changes if need arises. In spite of the intentions of the cited committee to make changes where found feasible, bankers are showing their concern on the futuristic knocking impacts at the hands of newly introduced ratios13. The amount so required for stable funding (RSF) is judged by way of supervisory assumptions on the key factors of liquidity risk of a firm’s assets and off-balance-sheet items. The RSF factor is assigned to each sort of asset with those liquid assets, showing lower RSF factor. Under the requirement, cash has a 0% RSF factor whereas the unencumbered loan to retailers and small business entities attracts 85% RSF factor14. General Perception The general perception of introduction of Basel II is to discourage banks from lending to risky areas. It encourages lending to risk free areas. Before introduction of Basel I and II, banks were free to finance in a more risky areas against moveable and immoveable assets. By that time, structured finance was available to risk free areas. The reasons of nonperforming loans of Citigroup and the Bank of America are those companies who were enjoying the reputation of AAA wherein risk assessment and its mitigates were not properly worked out. Had risk assessment and its mitigation had been worked out properly, the situation would not come to such an impasse as in the case of mentioned banks. With this debacle in the financial world, now the Banks have to hold sufficient equity against their risk weighted assets. The experts are of the view that lending to AA rated sovereigns still carries a zero risk weight. This is very encouraging for the banks that under Basel II regime they can lend to the sovereigns15. Let us find out the cause of collapse of Lehman. It was due to paucity of funds. In that perspective Basel III does a great job by tightening the rules in terms of bank’s liquidity. There cannot be two opinions that if the banks comply with Basel requirements so far introduced, will save them from bankruptcy and its subsequent affects16. It makes us believe that Basel III parameters extended yeoman services to the banking industry in reducing the expected and unforeseeable risks. Despite Banks are in favor of securitization of assets against extending facilities to low, medium and big size business entities17. Role of Basel Committee on Banking Supervision Now the Basel Committee on Banking is developing global banking rules for the banks to address the future generation economy related issues. The aims of framing such rules are to protect the world economy from futuristic chaos in the financial sector. The committee’s aim to minimize the risk of banks, so that the governments will not come forward for the rescue of the banks and their depositors18. The new rules will look into the successes and the failures of the financial sector in implementing the Basel II to counter the global financial crisis. Under the Basel II, the banks have to hold a big chunk of capital and more liquid assets as buffer to meet the unforeseen challenges in the days ahead. Bankers repose confidence in the newly introduced banking system who believes that changes are always better. Mr. Mervyn, the Governor Bank of England, is of the view that the Basel III has the capacity and the capability to avert future financial crisis. He further stated that the Basel III is not a silver bullet to afraid. It makes sense to have belt and braces in the financial sector19. Yes, of course the Basel III can benefit banking and financial system in view the strong set of rules and regulations to deal with bank’s capital and the liquidity. Global banking regulations that include Basel requirements in fact are the safety valves for the banks to face the consequences. Non compliance of the Basel requirements by the banks may attract penalty from the Regulator. The Regulator’s directives in the shape of prudential regulations are to be complied by the banks20. Regulatory Process The regulatory process to boost up the capital is being written keeping in mind the certain jurisdictions where the local and foreign banks operate. The mentioned requirement is secondary. The first and foremost requirement is to touch upon the issue the uncertainty. How much capital has or have to hold by the bank/banks to provide a buffer. We all know that with the passage time these requirements are going up. The uncertainty in financial sector merits more risk oriented planning especially in terms of profitability, which will be more difficult in the coming years21. In Europe, banks are bound to comply with the rules and regulations of European Banking Authority (EBA) to meet core tier 1 capital level at least 9% by June 2012. In order to reduce the fears of the major stakeholders, key banks are planning to meet the new capital ratio target ahead of them in the years to come. To comply with the requirement of Basel III, banks are required to submit their action plans about reaching new capital target22. The individual country is at liberty to implement rules and regulations, which suits their ground realities. However, the Basel III provides uniformity to some extent as stated by Donald Angel of Ernst & Young. The Basel III defines new horizon of good capital and how much of it should be kept. The Basel committee yet to determine how much additional capital should be earmarked for the extraordinary events. G-20 has left this issue to the individual sovereign to decide23. We agree with the views of Richard Herring that mentioned proposals impose certain layers of capital requirement. This indicates a minimum of 4.5% of equity against risk weighted assets coupled with 2.5 % as an additional buffer. The additional layer is mandatory in case the banks fall below the capital restriction may face ugly situation. Take the example of firm say ‘A’ which may be deprived from paying dividends and bonuses. Adding fuel to the fire, the Basel III permits few capital issues to be excluded between a firm and the regulatory authority. As far as the regulators are concerned, they are free to pen down their own requirements24. The Challenges As per the rules and regulations of Basel III, banks are bound to provide accurate and updated information relating to their capital status at any given point in time. There are number of hindrances, which prevent banks from disclosing an accurate status of risk and capital25. Usually a bank may extend its area of operations to offshore locations in a number of countries around the globe. The banks in the offshore locations are to comply with the rules and regulations of the host countries. Further, the banks in question should remove the inconsistencies in the implementation of mutually agreed G 20 standards. At a micro-level small details of accounting may affect the quality data in order to have a true picture of the organization. This problem is further complicated at the time of merger and acquisition of assets by a bank. Under the mentioned scenario, it would be difficult to gather data from different sources and to shape up as single information to be used for the organization26. In the second stance, each bank’ business model is quite different with the model of other bank(s). For example, global universal bank may have the different view with that of a small size bank established on savings and mortgages. Each bank will subsequently have the individual capital and liquidity needs that make it difficult to have regulatory standards for all and sundry in the similar manner. In particular area, where banks have multiple business options in multiple locations, where strategic information is difficult to understand. The data is often stored in silos makes it difficult for others to gather all the information from horse’s mouth and to create an accurate picture of risk exposure27. “Basel III does not deal with the most fundamental regulatory problem identified: that the ‘promises’ that make up any financial system are not treated equally”28. In most of the banks, gathering quality data as required by the rules and regulations of Basel III is an uphill task. The multiple approaches to resolve the issues within a single institution and the industry may create confusion and misleading information being circulated amongst the market players29. The Solutions To resolve all the identified issues, the bank must look internally. In order to have quality and reliable data, the idea of appointing Chief Data Officer who has to take the responsibilities to provide accurate and reliable data that gathered from different channels thus enabling the senior executives to lay hand on reliable data so as to make critical business decision. Gathering the data from unreliable sources will mar the very purpose of gathering quality data to consolidate the balance sheet of a global institution is not an easy task30. In so many cases, requiring a complete overhaul under Basel III is the need of the hour. However, some strategic changes ensure existing data more reliable, consistent and quality bearing. The positive approach will surely help to have some tangible benefits that relates to business. It is not necessary that the changes may have the same impact on other banks. In the large organizations, strategy and tactical approach may not go hand in hand. For banks that are looking forward by way of out of box approach may have lasting impact. Sitting fingers crossed may not be helpful of quality data management. Hence, this will enable the bank to ensure that data quality is not compromised from top to bottom levels. This will give confidence to the incumbents for meaning full and actionable information in the length and width31. Non Compliance of Basel III Attracts Penalty Being a banker, we all know that the Basel Committee on Banking Supervision Standards no legal authority to enforce it. However, each nation has the authority to implement it in line with the suggested standards of Basel iii through the available channels of national laws and regulations that suits the requirement of a country and its ground realities32. The mandate of a county to strictly adhere to the requirement of Basel standards was undermined as the apex committee prepared and issue Basel III framework for the banks to work within rules and regulations as defined in it. It is a matter of historical fact that four days before the announcement of Basel iii, French government announced that it will implement the Basel requirements in letter and in spirit provided the United States of America will implement the same as is required by the Basel Committee on Banking Supervision. However, so far four federal regulatory banks of US implemented it after going through a lengthy process33. In the majority locations of Europe, the Basel II standards were implemented by the banks on the Capital Requirements Directives issued by the European Union. Since each nation or group of nations, such as the European Union who has or have signed the Basel accords is/are responsible to implement own supervisory and enforcement system within their area of operations. Non compliance of regulatory requirement of Basel iii will attract penalty from Regulatory authorities in shape of fines or revocation of licenses to encourage compliance with Basel standards34. Further, if a bank fails to maintain the required capital buffer in line with Basel iii to meet the eventualities could face restrictions on payments to executives and shareholders35. Conclusion Here, we found negligible disagreement about the enforcement of Basel III. No doubt that every one of us agrees that the Base III requirement and the financial system would ensure that the funds are deployed in a risk free business. However, that at the cost of Snail’s pace economic growth in many years due to higher credit costs and its availability. However, the magnitude of its effects would be harmful. As per the calculation of industrial analyst, it would pave the way for the major and established economy in the years to come as compared to weaker economy. Since it will have the worst impact on the economy of G-20 countries, therefore, it is the possibility that some of the requirement of Basel III would not see the light of the day. As per the calculation of French experts, it will hit the French economy at rate of 6%36. In the eyes of disinterested observers, the impact would be much smaller than expected. As per the estimation of an American expert, larger increase in capital requirements compel increase average loan pricing to the limit of 0.2 percentage points leaving a little effect on availability. There cannot be two opinions that increase in lending rate by the banks would slower down the economy of a country. The lower lending rate will contribute a lot in boosting the national economy37. A threadbare discussion with the European in general and the US policymakers in specific, are of the view that the key decision makers are heavily dependent on discounting analysis instead of focusing on the Basel Committee's recommendations which is in favor of getting more by loosing few. If it is taken for granted then there will be two options available for the beneficiaries a) either confirmed it or b) altered it on the basis of the committee's Quantitative methodology. If the Basel Committee is right in their stance that during the years of no crisis, growth shows a declining trend as compared to the recessionary period, which happens frequently. Recession in the economy speaks for itself mismanagement and lack of vision by the policy makers. Had they focused on the good governance and far sightedness the country would have been saved from heading bad to worst. The non-availability of employment to the educated and skilled people indicates the poor performance of the economy. It is the prime responsibility of the elected or the otherwise government to identify the grey areas of their economy and suggest remedial measures to put the rail on the right track38. Until and unless grey areas are addressed by the economic wizards, the chances of improving the economy will be bleaker. Of course long lasting unemployment situation put the gadgets installed in the factory premises in doldrums. The equipment either sends to junkyard or dies down due to physical deterioration after being out of service for a longer period of time. This grim situation will lead to sharp increase in national and international debts that come under attack of severe recessions. The mentioned scenario culminates the shrinkage of economy up to the significant extent. This state of affairs adds up considerable losses to the economy, which will take time to recover all these losses. Bibliography Books Bernd P. Delahaye, Basel III: Capital Adequacy and Liquidity after the Financial Crisis (Harvard Law School 2011) Greg N. Gregoriou, Operational Risk toward Basel III: Best Practices and Issues in Modeling, Management, and Regulation (John Willey & Sons 2009) L Egaire Humphrey, Basel III (International Book Marketing Service Limited 2011) Richard Barfield, A Practitioners Guide to Basel III and Banking Reform (Sweet & Maxwell Limited 2011) Walter W. Eubanks, Status of the Basel III Capital Adequacy Accord (DIANE Publishing 2010) Journals Adrian Blundell-Wignall and Paul Atkinson, ‘Thinking Beyond Basel III: Necessary Solutions for Capital and Liquidity’ (2010) 1 OECD Journal: Financial Market Trends 1 Simon Nixon, ‘Basel III: Don’t we Have Enough Problems?’ (The Wall Street Journal, 6 May 2012) accessed 29 May 2012 Simon Nixon, ‘How to Escape Basel III Down Loop’ (The Wall Street Journal, 7 October 2011) < http://online.wsj.com/article/SB10001424052970203388804576615081403695262.html> accessed 29 May 2012 Newspapers Felix Salmon, ‘The Biggest Weakness of Basel III’ (Reuters, 14 September 2010) accessed 25 May 2012 James Babicz, ‘Basel III: The Changing World of Banking Regulation’ (gtnews, 8 February 2011) accessed 25 May 2012 Websites Caron Carlson, ‘What is Basel III accord, and what does it require?’ (Techtarget, September 2010) < http://searchcompliance.techtarget.com/FAQ-What-is-the-Basel-III-accord-and-what-does-it-require#enforce> accessed 25 May 2012 ‘Chapter 6: Capital Requirements and Basel III’ (Global Banking 2020, 2011) accessed 23 May 2012 ‘Criticism of Basel III Liquidity Ratios Continues’ (Risk.net, 2012) accessed 25 May 2012 David Walker, ‘Banking Day Backgrounder: Basel III’ (Banking Day, 2012) accessed 23 May 2012 Douglas J. Elliott, ‘Basel III, the Banks, the Economy’ (Brookings, 26 July 2010) accessed 26 May 2012 Read More