System of International Banking Regulation and Its Weaknesses - Essay Example

BASEL II The Extent to which the Basel II Accord Document Satisfies Requirements for a uniform System of International Banking Regulation and its Weaknesses Name: Instructor Name: Unit Name: Date: Introduction Since the early seventies, there has been a paradigm shift in the jurisdiction of banking regulation from national policy making to a more international cooperation. This came about due to the rise in intercontinental lending and growth of multinational banking institutions which made it necessary for regulators to cooperate globally in their activities. This was triggered at first by penetration of local banks by overseas establishments which resulted in a need for clarity on who was in charge of which sector of banking. The result of these intermarriages was a rising of the stakes of national banks in international stability of the banking industry as adverse events in one jurisdiction could affect operations in other nations. The primary trigger was the intermingling of local and foreign banking institutions which resulted in a need for clarity on just who was in charge of which area. This situation resulted in an interdependence of financial stability and the solidity and security of banks in one area could be adversely affected by a converse situation in another jurisdiction. Lastly, the rise in global banking competition meant that local regulators recognised the need to level the playing field in order to avoid unfair advantage by one player due to national regulatory concessions. The current trend is geared toward increasing globalisation, exacerbated by the removal of exchange restrictions, a steep rise in intercontinental investment and easier accessibility of local institutions to foreign banking entities. Other challenges faced by regulatory bodies include the diversification of banking from a purely financial facility to other service addition such as securities. This development distorts the boundaries between bank loan services and securities market funding. The marked interest that banks have displayed in the volatile development of over-the-counter derivatives has produced a huge debate over the jeopardy associated with their trading and what should be done to regulate it. Lastly, the banking sector faces many competitive challenges from various directions. Locally, there is the disintegration of domestic market price cartels, managed interest rates and restrictions; due to breaking down of trade and other barriers there is increased competition across borders (e.g. the European market); and the advent of outside players in the lending and short-term savings game, that are encroaching on the banks’ turf – notably the securities companies and insurance firms (Dale, 2001). The Basel II Accord The New Basel Capital Accord, otherwise known as Basel II is a paper that sets out the minimum financial parameters that every globally operational large bank from the group of ten countries must meet. It is a publication of the Basel Committee on Banking Supervision which is a department of the Bank for International Settlements (BIS), whose purpose is adoption by all G10 jurisdictions. Although the expectation is that sections of it may be used by other non-member banks. The accord has three main pillars; I. Involves determination of the minimum capital requirements by setting out the exact methodology and criteria using credit, market and operational risk. II. Sets out the supervisory requirements to be adhered to by the local institutional regulators. III. Is an insight into the BIS standpoint on market control, stressing the nuclear disclosures that member institutions must comply with in order to ensure the security and solidity of the banking sector (McCormac, 2003). In the United States the accord would seem to apply to about six to ten banks, although other institutions that meet the requirements for in-house and regulation framework standards for management of risk and reporting are eligible to apply for utilisation of Basel II’s progressive criteria for capital calculation. This is anticipated to affect a similar number of additional institutions for purposes of competition (McCormac, 2003). The Basel II offers a choice between two control infrastructures to calculate asset requirements for credit assessment; Standardised Approach (SA); is a widespread risk assessment of capital using the SRO credit rating agency rating of the particular borrower or a general risk evaluation based on the asset rank. Internal Ratings-Based (IRB); based on the individual bank’s internal criteria for proprietary capital model and approved by the United States regulators. 1 There has been a revision of the risk weighting of capital classes of 1988 in Basel II; 2 Claims on sovereigns; Credit Evaluation AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated Risk Weight 0% 20% 50% 100% 150% 100% Table 1: claims on sovereigns as illustrated in CEBS (2010). . Claims on Sovereigns Table Courtesy of CEBS (2010) For the above claims, overseers may acknowledge the country risk scores allotted by the Export Credit Agencies (ECAs). These agencies qualify by publication of risk scores and subscription to the OECD- approved style. The choice to use risk scores published by single supervisor-recognised ECAs or those achieved through agreement in the ‘Arrangement Officially Supported Export Credits’ is one that is left to the banks. The claims on banks that are highly rated that is, Multilateral Development Banks (MDB) like the World Bank, the IMF, African Development Bank, etc, are given a 0% weight risk. Other MDBs will be weighted based on external credit evaluations (CEBS, 2010). Basel II compliance in Canada is expected to affect about six large banks and in Europe, a localised criterion is being devised by regulators assisted by the European Commission. The expectation is that Basel II will be adopted by most of the financial institutions in Europe and indemnity and asset management subsidiaries will enact some elements of it (McCormac, 2003). Weaknesses of the System The financial industry is at the heart of the economy and there are concerns that the global economy is collapsing (Bowles, 2008). This situation has been precipitated by a number of factors, chief among them being a rapidly expanding innovative money market, and previously unheard of awakening of many market economies resulting in the expansion of players that has brought the situation about (Borio, 2007). Financial developments have enhanced a propensity toward pro-cyclicality viz. the expansion of credit leads to economic growth and this air of abundance fuels optimism and minimises awareness of risk (Bowles, 2008). This encourages recklessness and a rate of borrowing that is unsustainable. The resulting collapse then becomes predictable as a function of risk that was misjudged, underestimated and mispriced creating a system extremely vulnerable yet whose opacity disguises the source of exposure. It is a requirement of the Basel II accord that all Authorised Deposit-Taking Institutions (ADIs) submit a daily risk prediction to the relevant authority at the start of each trading day; using the appropriate models to assess Value-at-Risk (VaR). The VaR estimates are then utilised to calculate capital needs and concomitant asset costs of ADIs as a function of preceding violations; cases in which the actual losses surpassed the VaR estimate. The disadvantages of Basel II can be summarised as; concerns over the possibility of introduction of even more procyclicality, loss records accessibility – especially for institutions with infrequent defaults, potential for higher model risk, the possibility that several levels of supervisory vigilance will cause a stasis in capital levels, inconsistency in application across borders, and the risk of ethical jeopardy of regulators. The emendation of the first Basel Accord was for the purposes of validating and promoting financial institutions whose risk management systems were advanced. A process was introduced in which the concrete takings were compared with the forecasted VaRs in order to evaluate the calibre of in-house models in use by ADIs. Where the internal systems produced a higher than expected number of violations, then the institution was expected to hold an elevated amount of capital. Failure to which, penalties are imposed that impact profitability. In Europe, Basel II was operational only from the year 2008, and it was not implemented in the United States hence is not culpable in the global financial crisis that emanated from there (Cannata and Quagliariello, 2009). The daily capital charges (DCC) must be placed at the maximum VaR of the previous day or the mean VaR of the previous sixty business day as a function of (3+k) in order to determine violation consequences; where the violation is stipulated as concrete negative returns in excess of the predicted VaR negative returns for the day. The penalty, k, is dependent upon the evaluation by the designated authority using the ADI’s risk control criteria and the outcome of a straightforward back test. It is obtained by the amount of times the tangible losses are in excess of the day’s VaR prediction (Basel Committee on Banking Supervision, 1996, 2006). The least multiplication factor (i.e. 3), is invoked to correct for many mistakes that may be inadvertently made in model execution; these include simplification, assumptions, logical approximations, miniature sample partialities and arithmetical errors that can distort the true risk reporting of the model (Stahl, 1997). This is intended to raise the level of confidence inferred by the number of violations observed to the 99th percentile, which is a prerequisite set out by regulators (McAleer, 2008; Jimenez-Martin et.al. 2009; McAleer et.al. 2009). There has been some indication in experimental studies (Berkowitz & O’Brien, 2001, Gizycki & Hereford, 1998 and Perignon et.al. 2008) that there is an overestimation of market risk by some financial institutions to their regulatory authority. This can entail an expensive limitation to bank trading. Therefore, ADIs could have a preference for submitting raised VaR figures to escape interference from the regulating authority. This trend implies that competency advances are possible. Specifically, since ADIs are sufficiently equipped to evaluate market risk without compromise to quality needs. Therefore it is possible for them to cut down on every day capital charges by executing a context-dependent market risk revelation guideline (McAleer, 2008 & McAleer et.al. 2009). The global financial crisis of 2009 was a litmus test for banks and a number of weaknesses were exposed according to the Bank of International Settlements (BIS). The key areas to which stress testing procedures broke down include; The use of problem evaluation and incorporation in risk management; involvement of the upper echelons of management is key to cement utilisation of stress testing in this area. This encompasses outlining parameters, crystallising scenarios, debating the outcomes, with an eye to examining possible measures and making decisions. Methodology; the intricacy of the tests can differ widely from the simplest of sensitivity evaluations to involving tests aimed at assessing the results of an extreme macroeconomic traumatic occurrence on the capital market. The magnitude of the tests may vary from a single instrument to an organisational arrangement. All variations of risks are tested including market, functioning, liquidity and credit. The crisis has however exposed the inherent weaknesses that abound. The efficiency of risk management criteria was compromised by the flaws in framework that hindered identification and aggregation of exposures. The use of prior data relationships to evaluate present risk created assumptions that were unrealistic. Also, the scenario failed to take into account the market reactions to a stress event that was extremely volatile creating repercussions that exacerbated the initial shock and affected every system in an unanticipated and unpredictable ways. Choice of scenario; Extremity of stress was not provided for in most evaluation tools used by banks. In fact most did not have anything that came close to correlating with real time events. Most stress tests were intended for insignificant bumps, of short duration and miscalculated the impact of inter-bank relationships and the potential domino effect. Evaluation of particular innovations and risks; several risks were not evaluated in exhaustive detail by the stress tests. Some of these are the performance of multifaceted products under extreme liquidity situations, core risks vis a vis prevarication planning, securitisation risk, conditional risk and subsidiary liquidity risk. The safeguards did not go far enough during assessment before the crisis hit, to a large extent, due to misplaced confidence in historical statistics (Lekatis, 2009). Uniformity When formulating international guidelines in any field, there is inevitably going to be compromise as happened with the original Accord. The major triggers to concern were the inequality in competition and security of both the national and global financial institutions. Therefore leading to establishment of a minimum equity asset level of four percent and on the whole, a minimum capital level of eight percent. This set parameters that ranked banks using the criteria of relative risk. Loans to governments were generally considered to be of the least risk, followed in order by banks, government-adjacent agencies, residential mortgages, and then other types of loans. The formulating committee also preferred a simplified across the board risk weight rather than complicating it. Unfortunately this facilitated arbitrage due to the lumping of credits of varying risk profiles in the same class. Since contemporary financial convergence and single regulators post-dated the Accord, it failed to provide for credit risk alleviation in financial entities that are not banks. A 50% risk weight or 4% capital charge was the consequence of this for residential mortgages. The evaluation of risk in this area was based on relative risk between asset classes without experimental ascertainment of the appropriateness of the criteria. They also failed to recognise that the calibre of management of the mortgage process had an impact on the relative risk of the mortgage loan operations of the financial institution. The simplification of the process caused the committee to view it in a straightforward way; security for residential mortgages was collateral – the lending of which required considerable equity from borrower, and was done at a largely local level, as opposed to national or international,- therefore, reduced risk of unfair advantage or contamination of the market. Furthermore, government intervention to cushion market recessions in the property market was routine. The route, by which these guidelines were arrived at, was characteristic of traditional bank supervision routines, not on regulatory procedures. The stress was on fundamental rules, augmented at the discretion of the supervisors. A wider, inclusive consultation was not conducted, neither was an attempt made to understand the inter-workings of the financial system i.e. the banks, other financial entities, insurers and capital markets investors. It was not anticipated that the Accord could be utilised by policymakers outside the original parameters and a specified group of globally active banks (Klopfer, 2002). Conclusion Following the global financial crisis, a working infrastructure to facilitate cross-border cooperation in supervision is increasingly urgent. Due to technological and financial advancements, the global village grows ever smaller, but the supervisory framework has failed to keep up with this. In order to progress to a more stable, secure financial system it has become necessary to harmonise the parameters by which local banks govern themselves while still leaving room for them to adjust for local conditions, there needs to be collaboration in empirical and enforcement tools as well as expansion of the supervisory colleges and resolution processes thus facilitating the organised winding down of financial institutions that are crucial to the system but are not banks (NY.gov., 2009). In recent years there has been a wave of innovation to hit the financial sector that has inadvertently exposed the weak underbelly in the originate-and-distribute model; this model being an intricate part of the system. This has resulted in an increased imperative for players to understand the potential risks, be able to evaluate the magnitude of these risks accurately, and take action to avoid them. The perspective of risk has shifted at the realisation that it results from a gradually increasing trend of risk-taking, overstretched financial balances and accelerated credit extension. Bold action is called for to avoid a repeat of this event. Greater transparency in transactions should be encouraged along with accountability, disclosure, valuation. The utilisation and functionality of the credit rating must be reviewed and capital infrastructure enhanced. A re-evaluation of supervisory authority is overdue and Basel II must be used to increase market discipline, develop even better infrastructure for liquidity and risk management at the same time sponsor sensible reimbursement schemes, come up with efficient solutions to reduce the herding effect and eliminate moral hazard. The repercussions of the crisis will reverberate through the finance industry for some time to come. It will trigger modifications, some of which are of a temporary nature, while others will cause permanent change in the way business is conducted. These include an improved structure based on incentives and notable escalation of transparency, responsibility and discovery. These changes are designed to reinforce the system, but will unfortunately not make it impregnable. This will mean that future crises must be anticipated and contingency plans put in place to counter them (Bowles, 2008). The Basel II accord was not designed to be indestructible, but rather was a guideline to anticipate certain possibilities of a given calibre. Despite its failure to curtail the global crisis just past, it is still viable and even after re-evaluation, similar parameters will have to be set for any new accord. It must be remembered that there is virtue to reviewing these infrequent events as they may give lessons otherwise not easily accessed (Atik, 2009). Almost from the beginning of the global crisis, there has been a general consensus that reform is imperative. The Financial Stability Board (FSB) which is the global assembly of Central Banks and regulators began formulating proposals for this from as far back as 2007. Half a year before Lehman Brothers collapsed, the first results of these investigations and proposals were published. Developments are ongoing with the full support of G20 states. The Basel Committee on Banking Supervision has now turned these proposals into a new accord, known as Basel III, first published in 2009 (Harle et.al, 2010). The new regulations are designed to produce a more secure financial system, although it is expected to slow down projected economic growth slightly. While varying repercussions are expected by investors, those that deal with bonds should find the market more secure and the stock market should be more stable. A deeper perspective on Basel III will empower investors to better evaluate the financial industry in the future and enable them to form educated macroeconomic opinions on the state of the financial system and international economy (Perry, 2010). To bring about better regulation the main thing is to have the right incentives. competent regulatory restructuring should address the core of the issue; formulate the appropriate legal atmosphere (rules to deal with bankruptcy, specialised entities, commercial authority, etc). Failure to which, the banking industry will remain ineffective and unstable. REFERENCES Atik, J. (2009). Basel II and Extreme Risk Analysis. Retrieved March 6th 2011 from http://www.asil.org/files/atik.pdf Basel Committee on Banking Supervision. (1996). Supervisory Framework for the Use of “Back testing” in Conjunction with the Internal Model-Based Approach to Market Risk Capital Requirements. BIS, Basel, Switzerland. Basel Committee on Banking Supervision. (2006). International Convergence of Capital Measurement and Capital Standards, a Revised Framework Comprehensive Version. BIS, Basel, Switzerland. Berkowitz, J. and J. O'Brien. (2001). How accurate are value-at-risk models at commercial banks? Discussion Paper, Federal Reserve Board. Borio, C. (2008). The financial turmoil of 2007-?: A preliminary assessment and some policy considerations. BIS Working Papers No 251, Bank for International Settlements, Basel, Switzerland. Cannata, F. and M. Quagliariello. (2009). The role of Basel II in the subprime financial crisis: Guilty or not guilty? CAREFIN WP 3/09, Università Bocconi. Retrieved March 6th 2011 from http://ssrn.com/abstract=1330417. Freixas, X. (2010). The Future of Regulatory Reform. Centre for Economic Policy Research. Universitat Pompeu Fabra and CEPR. Gizycki, M. and N. Hereford. (1998). Assessing the dispersion in banks’ estimates of market risk: the results of a value-at-risk survey. Discussion Paper 1, Australian Prudential Regulation Authority. Härle, P., Heuser, M., Pfetsch, S., Poppensieker, T. (2010). Banking & Securities Basel III: What the draft proposals might mean for European banking. Mckinsey & Company. Banking & Securities. Retrieved March 6th 2011 from http://ec.europa.eu/internal_market/bank/docs/gebi/mckinsey_en.pdf Klopfer, E. (2002). A mortgage insurer's look at Basel II and residential mortgage credit risk. Housing Finance International. Retrieved March 6th 2011 from http://www.allbusiness.com/personal-finance/real-estate-mortgage-loans/953728-1.html Lekatis, G. J. (2009). Basel II Stress Tests - Weaknesses That Led to the Turmoil. Retrieved March 8th , 2011, from http://ezinearticles.com/?Basel-­II-­Stress-­Tests-­-­-­Weaknesses-­That-­Led-­to-­the-­Turmoil&id=2021757 McAleer, M. (2008). The Ten Commandments for optimizing value-at-risk and daily capital charges. Journal of Economic Surveys McAleer, M., J.-Á. Jiménez-Martin and T. Pérez-Amaral. (2009). A decision rule to minimize daily capital charges in forecasting value-at-risk. Retrieved March 6th 2011 from http://ssrn.com/abstract=1349844. Pérignon, C., Z.Y. Deng and Z.J. Wang. (2008). Do banks overstate their value-at-risk? Journal of Banking & Finance, 32, 783-794. Perry, B. (2010). Understanding The Basel III International Regulations. Investopedia. Retrieved March 6th 2011 from http://www.investopedia.com/articles/economics/10/understanding-basel-3-regulations.asp Stahl, G. (1997). Three cheers. Risk 10, 67-69. Read More