International Banking Regulation and Principles under Basel III - Essay Example

International Banking Regulation Student’s Name: Course: Tutor’s Name: Date: Q.1: The Revision of Basel II Initially published in 2004, Basel II, which is the second set of accords containing recommendations on laws and regulations for the banking sector, is substantially being modified. The revisions on Basel II were triggered by the 2008/09 global economic crisis, which provided the opportunity for a fundamental restructuring of the approaches used in handling risks and regulations in the financial sector. Consequently, the Basel Committee on Banking Supervision (BCBS) collectively agreed to revise previous accords for purposes of strengthening ‘the global capital and liquidity rules with the goal of promoting a more resilient banking sector’, hence Basel III (Bank for International Settlements (BIS), 2011a, p. 1). Basel II was founded on three pillars namely- minimum capital requirements; supervisory review; and market discipline (BIS, 2004). Minimum capital requirements is meant to address risks faced by banks where by banks are required to maintain regulatory capital that can sufficiently secure the institutions from credit, operational and market risks (BIS, 2004). The supervisory review under Basel II was on the other hand meant to give regulators enhanced ‘tools’ to deal with residual risks faced by banks. Such risks include systemic, pension, strategic, concentration, reputation, legal, and liquidity risks. Under supervisory review, banks are entitled to review their respective risk management systems. On its part, market discipline was meant to compliment the first and second pillars (i.e. minimum capital requirements and the supervisory review) through the development of disclosure requirements that would enable market participants to determine the capital adequacy of specific banking institutions. Under pillar three, banks are required to disclose the capital structure, interest-rate risks and capital adequacy among other things (Brummer, 2012, p. 228). The key principles under Basel III include capital reforms, which are meant enhance the ‘quality, consistency and transparency of capital base’ in banks, capture all risks, control leverage, and enhance buffers (BIS, 2011a, p. 2). Another principle under development is the liquidity standards, whereby the short-term and long-term standards have been addressed. The third approach relates to the systemic risk in banking institutions and the interconnectedness among the systemically important banks otherwise known as ‘too big to fail’. Here, the use of capital incentives in central counterparties (CCPs) for over the counter (OTC) derivative is recommended. Additionally, Basel III will have higher capital for both inter-financial exposures and systemic derivatives. It also proposes the use of contingent capital, capital surcharges, and bail-out capital in systemic banks as part of an integrated approach to reduce the risk exposure of such banks (BIS, 2011a). Unlike the Basel II accord which was agreed upon and implemented over a 9-year period between 1999 and 2008, Basel III has been rapid in both the deliberation phase, and it is expected that its implementation will be similarly swift (BIS, 2011b). Starting July 2009, BCBS commenced on Basel II revisions, which begun with the enhancement of the Basel II framework. Revisions were also made to the market-risk framework as well as to the guidelines used in computing capital for purposes of gauging incremental risks as used in banks’ ‘trading book’. In December 2009, capital proposals were made for purposes of strengthening the banking sector’s resilience. Additionally, liquidity proposals were made for purposes of enhancing the international framework and standards used in liquidity risk measurement and monitoring. July 2010 was marked by proposals on counter-cyclical capital, and this was followed by agreements on capital and liquidity (BIS, 2011b). In August 2010, BCBS released the almost final version of the capital and liquidity standards on banks. This was closely followed by guidance issued by the same committee on January 2011, where minimum requirements relating to regulatory capital instruments were issued (BIS, 2011b). It is scheduled that Basel III will be fully integrated into respective national laws by January 2013 (BIS, 2011b). Like other international agreements however, the Basel III accord will be implemented progressively, with full implementation scheduled for 2019 (BIS, 2011b). It is expected that Basel III will be applied consistently on a global scale in order to reduce risks associated with financial institutions moving their operations to areas with less stringent regulatory regimes. This does not however mean that the accord will have uniform implementation around the world; specifically, the implementation timing might differ between countries. Large banks will especially be affected by Basel III since they will need to change their operating frameworks. Specifically, the big banks will need to undertake significant upgrades on their processes and systems, particularly in capital management, liquidity management and stress testing. Basel III will also impact on banks’ operations since the new requirements will necessitate the use of new processes and/or procedures in order to comply with the specified functionalities. Additionally, banks will need to implement additional processes and/or controls in order to meet the new reporting and disclosure requirements. Banks may also have to rationalise their processes through streamlining their reporting and disclosure processes and production activities. Such is especially relevant to banks that have international operations. Finally, training of bank employees may become necessary as regulations become complex, hence necessitating the need for different banking institutions to reorient their staff members on the new requirements. There is little doubt that Basel III will make the world financial environment safer. Specifically, the introduction of a 2.5% extra buffer in common equity for Tier 1 capital will most likely cushion banks and other financial institutions and their stakeholders during economic and financial stress. The 0%-2.5% countercyclical capital buffer further introduces a regulation concept that will raise the cost of credit in rapid credit growth periods and lower the same during downturns hence creating an economic incentive whereby banks can increase or decrease their credit exposures depending on the prevailing economic situations. Through liquidity ratios, Basel III has laid a framework where banks will be required to have liquid asset buffers that can sustain them for a 30-day stress period (short-term liquidity), and a stable funding that can sustain them for a 1-year stress period (long-term liquidity). Through the proposed Liquidity Coverage Ration (LCR), Basel III intends to ensure that ‘banks have sufficient unencumbered, high quality assets to offset the net cash outflows it could encounter under an acute short-term stress scenario’ (BIS, 2011a, p. 9). The Net Stable Funding Ratio (NSFR) on the other hand places a minimum amount requirement on stable funding sources in banks relative to their asset liquidity profiles, and their likelihoods for needs beyond their prevailing balance sheet commitments (BIS, 2011a). The NSFR is aimed at limiting the over-reliance that banks have on ‘short-term wholesale funding during times of buoyant market liquidity and encourage better assessment of liquidity risk across on- and off-balance sheet items’ (BIS, 2011a, p. 9). Although the implementation of liquidity ratio requirements is scheduled for January 2015 and January 2018 for LCR and NSFR respectively, it is still a step in the right direction, in that it will ensure that banks are shielded from the short- and long-term shocks that led to or precipitated the 2008/09 economic crisis. Overall, and as has been noted by Brummer (2012, p. 256), Basel III has strengthened ‘the financial resilience of banks’. However, it has been stated that strengthening the financial resilience of such institutions is not enough to prevent a recurrence of an economic crises in future. Specifically, Brummer (2012) argues that the implementation gap between now and 2019, when full implementation is scheduled, leaves a void during which the world can very well experience one or more economic crises. This then means that in addition to the Basel III recommendations, other medium-term solutions could have been developed in order to cater for the transition period. The problem with the latter argument is that while financial and economic commentators are almost certain that another financial crisis will occur in the future, none of them can tell with absolute certainty what will occasion such a crisis. As such, it remains the responsibility of regulators to ensure that there is prudent financial management in the institutions they oversee in order to minimise the risk of the financial crises occurring in future. It is also the responsibility of such regulators to ensure that the financial institutions have the resilience needed to overcome a financial crisis, should it occur, without hurting their stakeholders. As Brummer (2012) further notes, the flexibility of Basel III leaves a void where regulatory arbitrage can take place especially through shadow-banking practices. This is especially likely due to the ambiguity surrounding complex issues such as pension fund liabilities among others. To this end, it would have been better if Basel III was more specific in risk-weight calculation issues in order to avoid loose translations of the provisions in the accord, which may end up creating room for activities such as shadow-banking, and ultimately jeopardise the apparent security created by the same accord. Specifically, there is need to make the capital requirements in different countries all-encompassing in order to net other non-mainstream financial institutions such as hedge funds, trading houses, and private equity firms among others into the capital requirements regime. Leaving the non-mainstream financial institutions in the largely unregulated environment means that they too can experience financial difficulties, which could very well spread into the mainstream financial institutions addressed under Basel III; and by so doing, they could trigger financial difficulties which could end up in another financial crisis. This would especially happen if such ‘financial vehicles’ are supported by banks, in which case, shocks in their part would reverberate in the ‘supporting’ banks. The Financial Stability Board (2011) published some recommendations, which, it argues would play a critical role in strengthening regulation and oversight functions of the regulators in order to minimise the occurrence of shadow banking. By increasing banks’ minimum regulatory capital, Basel III has effectively reduced the risk of the losses that banks can suffer in relation to their exposure in future. Additionally, by enhancing the regulatory capital, Basel III has improved the financial institutions’ ability to absorb losses that may come their way as a result of a disruption in the normal functioning of an economy. As has been noted by BIS (2011a, p.12), ‘the global banking system entered the crisis with an insufficient level of high quality capital’. Moreover, the banking system, despite its interconnectedness, did not have consistent definitions of ‘capital’ in different jurisdictions. To make the scenario even more complex was the fact that the global banking system lacked disclosures, thus making it hard for regulators and other stakeholders to objectively carry out assessments and comparisons on the quality of capital which banks in different jurisdictions had. By agreeing on quantitative standards to regulate liquidity in the banks, Basel III is also perceived to have remedied the most critical shortcomings in Basel I and Basel II, which led to diminished liquidity once the financial crisis started unfolding. The two previous accords focused on capital and had not addressed the need for quantitative standards to address liquidity on an international scale. The question on whether Basel III addresses the causes and consequences of the recent financial crisis still remains contentious among economic and financial analysts. On one part of the divide are critics who argue that the high capital requirements imposed on banks are too high and would hence hinder their contribution in economic growth through reduced lending, and reduce profits. The other side of the critical divide argues that the capital requirements in Basel III accord are still insufficient to prevent a recurrence of an economic crisis. For example, Larson (2011) notes that some banks in the United States had capital levels similar or in excess of what is proposed in Basel III. However, such banks were still unable to absorb the losses occasioned by the financial crisis. These observations indicate that the capital requirements may be insufficient to avert a financial crisis, and even if they were sufficient, they would not be effective without addressing other areas that Basel III has not addressed. Such include the fact that Basel III does not address problems related to how Basel II assigned risks to assets owned by banks. Additionally, Basel III does not address the different IRB approaches that would prevent differences in bank-to-bank risk weighting methodologies. Through its failure to address such weighty issues in the global banking system, Basel III has not improved the denominator of the capital ratio, meaning that while the accord has tried to improve the capital ratio in banks, there are still issues that may erode such capital in stress periods, hence causing a financial crisis of lesser, equal or more proportions to what was witnessed in the 2008/09 period. Overall, and owing to criticisms of Basel III, it is clear that there is still room for improvement in the global financial system if financial crises are to be averted in future. While the accord is a step in the right direction, there is little doubt that a lot more preventative improvements need to be put in place in the sector if the risk of another financial crisis is to be lowered considerably. Q. 2. Should a new regulator be created in Europe to supervise directly the biggest banks? The blow-up of banks in Spain is a reflection of the systemic inadequacies in the regulatory frameworks by national regulators in the larger Europe, where several other banks have experienced severe difficulties. Commentators have suggested that a consolidated regulator would be more fitting for the eurozone, especially in regard to the top 25 banks that have cross-border operations. Citing Postner (2009), Brummer (2012, p. 56) for instance notes that the European Union does require a “single set of EU standards and regulations” now, more than it did in the past. While such an approach has been debated extensively in both academic and new media, it is worth noting that the new supervisory body would still miss capturing the triggers that led to Spain’s banking woes. Specifically and as noted by Jenkins and Barker (2012), a merger among 25 small saving banks in Spain precipitated the banking crisis, and this would obviously, and for practical reasons evade being noted by a central regulatory authority whose focus would have been on big banks. This not withstanding, I argue that a single regulatory and supervisory authority is desirable in the EU for purposes of ensuring that problems that occur from the plurality of national regulators in the region are addressed. Specifically, when cooperation is called for on the regional stage, most of the national regulators respond in a soft and vague manner, and this creates disharmony in the financial regulatory approaches in the region (House of Lords, 2009). Notably, such disharmony would be remedied or reduced significantly by a central regulatory authority since independent national regulators would have to yield their powers to the central regulator. As noted by Verdier (2009, p. 129), ‘shifts in rulemaking and supervisory responsibilities among the European Commission, EU legislative institutions, the European Central Banks, and National regulators’ are on-going, and the introduction of a common financial regulator in the region may enhance the odds of finding an effective outcome especially when jurisdictional feuds arise within EU member countries. Notably, a single regulatory and supervisory authority in the eurozone would not come without challenges. To start with, the current EU treaty would have to be amended in order to transfer the financial supervisory powers from the national regulators to the new joint regulator. An amendment of the EC treaty would be important for the new regulator formed to supervise the big banks to be legal. With the legality of a new regulatory authority out of the way, a central regulatory authority in the eurozone would be better placed to reduce the complexity brought about by 27 regulatory and supervisory regimes in the eurozone. Notably, the fragmentation occasioned by national regulators is most likely responsible for the duplication of ‘internal systems and processes for cross-border banking groups’, thereby creating extra costs and risks for banks and their host economies (House of Lords, 2009, p. 32). A new central regulator would also enhance the possibility of having a lender of last resort for the pan-European countries - a role that many argue should be played by the European Central Bank. In addition to setting up an institution that would act as a lender of last resort, the House of Lords (2009) argues that a central regulator in Europe would necessitate the formation of organisations that would have the ability to provide swift fiscal support to individual financial groups in the region on a needs basis. A central regulatory authority would also be a step in the right direction especially noting that ‘national differences among the EU states undermined potential efforts to show a unified front and maintain a common position’ in regulatory matters (Brummer, 2012, p. 46). Regardless of the national differences, the EU is increasingly taking charge in the financial oversight of services in member countries as noted by Brummer (2012), and this means that while the Union has internal divisions and structural flaws that hinder regulatory mainstreaming, there is still some semblance of regulatory unity that member countries will need to recognise. With banks being central in the financial systems in Europe and elsewhere, the EU member countries cannot, in my opinion, afford to ignore the interconnectedness of the region especially when bargaining with other regions or individual countries on financial issues. Specifically, the replacement of the Lamfalussy Committees by ‘three new EU supervisory authorities in the areas of securities, banking, and insurance and pensions’ is indicative of the possibility that the region is adopting a more integrated approach in how it handles issues in the financial sector (Brummer, 2012, p. 57). Opponents of a single EU regulatory authority have argued that such an authority would: make finance ministers in member countries less accountable; ignore the fact that ‘the largest banks are global, not simply European’; fail to address cooperation issues outside the European Union (House of Lords, 2009, p. 32). While these are valid arguments, one can argue that they are not a justification for the EU member states not to adopt a central regulatory. Specifically, and in regard to the concluding remark that a central regulator would fail to address cooperation issues outside the Union, one could argue that the federal regulation approach by the US can serve as a perfect example that a central union does not in anyway hinder a region’s ability to cooperate with other regions. In any case, the territoriality regulatory concept in the EU as has been noted by Brummer (2012, p. 48) could very well afford the central regulating authority potential ‘extraterritorial prudential and supervisory power’ as international businesses adopt regulations that would make doing business in the region easier. Brummer (2012, p. 48) notes that the wide spread adoption of Sarbanes Oxley Act followed a similar concept where regulations meant for the US received widespread acceptance in the international arena owing to their practicality in the international financial services sector. The observation by Washington (2012, p. 3) that ‘...everyone outside Germany thinks euro members should share responsibility for each other’s banks...’ also suggest that while individual central banks have a responsibility in the national jurisdiction, such responsibilities do not always count when a country is hit by financial woes in the banking sector. As witnessed in Greece, problems of a national character soon become regional, and hence the need for a central regulatory authority which would work independently without succumbing to influences from the social, economic and political influences in the domestic environment in member countries. The structure of a central regulator in my opinion, should seek to bridge the inconsistent implementation of financial regulation in the EU as identified in the Larosiere report (cited in Black, 2010, p.29). Owing to such reasons, I would propose a structure where a eurozone-level body would be mandated to monitor and assess possible threats that could jeopardise the financial stability of the region due to macro-economic developments and other developments in the financial system which would require macro-prudential supervision. Such a body would oversee risks in the entire financial system for purposes of providing early warning signs about risks that build up in the financial system. Where necessary, the same body would issue recommendations to the region as a whole, or /and to member countries on how best to deal with identified risks. To compliment the main body, I would recommend another body that would bring together financial supervisors from all EU member countries. The latter body’s responsibility would be to combine supervision of firms on a national level with centralised tasks on a European level for purposes of fostering harmonised rules as well as enhancing coherence in the supervisory and enforcement practices. To enhance the regulatory role of the second body, I would recommend that EU member countries foster the principles of flexibility and partnership in order to forge lasting working relationships amongst themselves. To address cross-border risks effectively, the latter body would also need to ensure that there are trusting relationships between host supervisors and regulators towards those from other EU member countries. The lack of frankness and trust among supervisors and regulators in the EU member countries has been blamed as one of the factors that shielded the vulnerabilities that individual firms faced, and this compounded the financial crisis even further (de Larosiere Report, 2009). Notably, and assuming that the host supervisors and regulators have a better understanding of the prevailing social, political and economic environments, I would recommend an arrangement where they are given the appropriate authority to set policies relating to issues such as consumer protection and financial stability in their respective domestic jurisdictions. In any case, the formation of a new regulatory system is not absolutely necessary. As suggested in the de Larosiere Report, (2009, p. 42), the European Commission Bank could play a ‘major role in a new European supervisory system in two respects: a role in macro-prudential supervision and a role in micro-prudential supervision’. In micro-prudential supervision, it is suggested that ECB could analyse financial stability in member states; develop early warning systems that would indicate emerging vulnerabilities and risks; conduct macro-stress tests to gauge the resilience of financial sectors in member countries; and define the reporting and disclosure requirements that will be used in the region. On the micro-prudential supervision level on the other hand, it is recommended that ECB could assume responsibility for the supervision of banks in the eurozone. This would call for the transfer of supervisory authorities currently held by national authorities to the ECB. Following such an arrangement, the ECB would be responsible for licensing institutions that want to operate in the financial sector, enforce stipulated capital requirements and conduct on-site inspections in all countries in the eurozone. The sovereign debt crisis plaguing the European Union member countries arguably calls for some form of stabilisation through sufficient regulatory powers on systemic institutions. A central regulator could ensure macro-prudential control prevails in all large banks within the eurozone by putting in place all the necessary supervisory oversight. Blaming Basel II for being a major cause of debt crisis in Europe is in my opinion, escapist. After all, the accord’s implementation in the EU begun in January 2008 just as the economic crisis was taking shape. However, it is clear that the national regulators failed to forecast and recommend mitigation measures that could have prevented the deterioration of the financial sector following the onset of the crisis. As has been recommended by the Financial Stability Board (2011), the EU needs stricter rules to govern the off-balance sheet vehicles in the big regional or international banks. Additionally, the EU needs to agree on comprehensive, clear and common definitions, which clarify hybrid instruments in Tier 1, and whether Tier 1 instruments should be limited to equity and reserves in future. A central regulator would be better positioned to champion the need for the identified agreement and also assess whether or not banks in individual member states are upholding the agreed definitions for Tier 1 instruments. In conclusion, it is worth noting that the 2008/09 financial crisis illustrated that most countries in the eurozone lack powers to supervise and sanction the financial sector’s business frameworks in their respective jurisdictions. Specifically, the difference in how different countries in the eurozone use sanctions to dissuade insider trading among other ‘irresponsible’ behaviour in the financial sector could encourage regulatory arbitrage. A central regulator is hence appropriate for strengthening and harmonising supervision and sanctions in order to instil financial discipline in the entire region. The central regulator could also play a pivotal role in detecting financial crimes that may occur in the region and deter the same through sanctions and other appropriate measures. Overall, it is worth noting that the cross-border regulators just give rise to diversity, which jeopardises the likelihood of regulatory harmony in the region. Specifically, the diversity could give rise to competitive misrepresentations among banks in the region, and this would encourage regulatory arbitrage. Additionally, the diversity would discourage eurozone countries against adopting group-based risk management, and at times capital allocation approaches hence reducing efficiency in the region. Lastly, cross-border regulators in the eurozone would make the management of crises occasioned by institutional failures more difficult to handle. Combined, these reasons justify the need for a central regulator in the eurozone. References Bank for International Settlements (BIS) 2004, ‘International convergence of capital measurement and capital standards- a revised framework’, Basel Committee on Banking Supervision, Basel, Switzerland, pp. 1-239. ___2011a, ‘Basel III: a global regulatory framework for more resilient banks and banking systems’, Basel Committee on Banking Supervision, Basel, Switzerland, pp. 3-69. ___2011b, ‘Progress report on Basel III implementation’, Basel Committee on Banking Supervision, Basel, Switzerland, pp. 1-8. Brummer, C 2012, Soft law and the global financial system, Cambridge, Cambridge University Press. De Larosiere Report 2009, ‘The high-level group on financial supervision in the EU’, Brussels, Belgium, pp. 1-85. Financial Stability Board 2011, ‘Shadow banking: strengthening oversight and regulation’, pp. 1-43. House of Lords 2009, ‘The future of EU financial regulation and supervision’, European Union Committee, 14th Report of Session 2008-09, vol. 1, pp. 5-84. Jenkins, P & Barker, A 2012, ‘Clamour for change on Europe’s banks’, Financial Times, viewed 18 June 2012, Larson, J 2011, ‘What are the Basel Capital accords?’ The University of Iowa centre for International Finance and Development, ebook, viewed June 18, 2012, < http://ebook.law.uiowa.edu/ebook/uicifd-ebook/what-are-basel-captial-accords> Verdier, P 2009, ‘Transnational regulatory networks and their limits’, The Yale Journal of International Law, vol. 34, no. 113, pp. 117-130. Washington, P E 2012, ‘The many things that prey on our minds- a big hairball of risk’, The Economist, pp. 1-5. Read More