Analysis of Basel I, II, And III Agreements - Essay Example

Basel 2 and 3 Introduction Basel I accord was the whole deliberation by financial s such as the central bankers from all over the world and in 1988; the Basel committee published some rules and standards for minimal capital requirements for financial institutions. The Basel II accord aimed at implementing laid down guidelines while in response to financial crisis in the world, Basel III accord was formulated to address the issue of financial crisis. The Basel agreements are some of the most significant accords in modern international finance. These accords were drafted in 1988 and 2004. Basel I, II, and III agreements have given birth to a new era of international banking cooperation. Through technical, qualitative and quantitative analysis, these agreements have assisted in harmonization of banking supervision, capital adequacy standards and regulation across the eleven member states of the Basel Group and the emerging economies. Contrary to this, the strength of these agreements-their technical and qualitative benchmarks limit the comprehension of these accords within policy circles causing confusion among people while interpreting them and wrongly applied to majority of the world’s political economies. However, even in situations where the Basel system has been rightly applied, neither accord has secured long-term stability within nations banking system or sector. Therefore, a full comprehension of the intentions, rules, and shortcomings of the three Basel accords is significant in assessing their impact on international banking and financial system. With the recent collapse or major investment banks, such as Bears Sterns, Lehman Brothers, AIG and others regulation has become increasingly important in today’s economy. The lack of regulation allowed these banks to borrow massive amount of capital and invest in high-risk securities. The Basel Committee attempted to force these banks to hold cash reserves in order to prevent a total banking collapse; sadly, the international banking system thwarted any attempt to do this thus making the collapse inevitable. Basel I accord The Basel I accord was a set of global or international banking regulation installed by the Basel committee to enhance bank supervision, which laid down the minimum capital requirement of banks and other financial institutions with the aim of minimizing credit risk. Banks that operated globally are required to maintain minimum amount of capital based upon a percentage of risk-weighted assets. After the Basel committee in Switzerland, the G-10 members started to discuss formal way to ensure that there was maximum and good capitalization of internationally active banks. In the 1970s and 80s, some international financial institutions were in a position to skirt regulatory bodies by exploiting and utilizing the inherent geographical limits of national banking legislation available. In addition, internationally active financial institutions especially banks encouraged a regulatory strategy to race to the bottom whereby they were required to relocate nations with minimal or less strict regulations. In 1988, the first Basel Accord was made enforceable by law in the G-10 countries and put in place several parameters. These included requiring a minimum risk-based capital adequacy amount, increasing stability, decreasing competitive inequality, defining, and enforcing a bank capital ratio. The Basel Committee required all international banking institutions to maintain a minimum of 8% of capital based on their risk-weighted assets. The committee also defined assets by placing them in specific categories: mortgages, consumer lending, corporate loans, exposures to sovereigns. The Basel I agreement required lenders to calculate the minimum level of capital based on a single risk weight for each asset category. Despite this increased regulation, many banks were able to partake in regulatory capital arbitrage, or moving capital across markets in order to take advantage of the difference in market prices, which made the agreement very ineffective It is important to note that the Basel one system was created to enhance the harmonization of capital and regulatory adequacy standards within the G-10 member’s states only. The G-10 nations are the industrialized states with developed markets, therefore the accords aimed towards the banks operating within such markets. The accord stated that it was not intended for developing or emerging economies and due to unique regulatory and risks concerns in these major economies, should not be viewed as optimal developing banking reform. The constituent of capital The Basel one accord stipulated that the constituents of capital included what kinds of on-hand capital are counted as reserves for banks and how much of each kind of reserve capital banks were liable to hold. The capital contained two types of funds, which includes; capital that the bank pay for the sale of bank equity and cash reserves that are disclosed. The main aim for creation of this capital reserve was to cover potential losses that could incur on loans, hybrid debts, holdings of subordinated debt and gains that may accrue from the sale of assets bought through the sale of bank stock. The Tier 1 capital reserve considered all the stock issues and stated that reserves like loan loss be set aside to cover future losses that might incur or for rubbing off income variations. Risk weighting The Basel II committee called for consideration in creating a system for banks to risk weight their assets or loan books. The risks included all the assets that appeared on the bank’s balance sheet. For instance, there was the 0% effectively describing these assets as of fewer risks. The riskless assets according to the Basel accord meant cash held by a bank, debt held and paid or funded in domestic currency, OECD debt and other demands on OECD by the government. Then there was the 20% risk, which expressed instruments in this category of riskless. in this category, security comprised of bank debts created by banks included in the OECD, multilateral development bank debt , collections of items in cash, OECD guaranteed loans on all public entities and non-OECD bank debt that has matured in less than one year. The zero variables included the demands on domestic public sector entities that are valued at 0 or 50 % depending on the discretion of the central bank. Target standard ratio It stipulates a universal standard in that 8% of the bank risk weighted assets should be covered by Tier 1 and Tier capital reserves. In addition, Tier 1 only covered 4% of the banks risk weighted assets. This ratio was viewed as minimally adequate to guard against credit risks when depositing risk insurance supported by international bank in all G-10 members. The central bank was mandated to come up with a strong surveillance and enforcement criteria to ensure that the Basel agreement are followed and that all transition weights are given to enable all the banks aligned to G-10 can get used to a four year time to the standards of the agreement. The Basel agreement was successfully implemented in some G-10 countries whereby large financial institutions or banks saw it as a sign of regulatory strength and capital stability in developing economies, which made capital hungry nations such as Mexico to agree to the terms of the accord in order to get cheaper bank financing. The first Basel accord was narrow in scope and only aimed to cover the G-10 countries. It did not guarantee adequate financial stability in the international capital or financial sector. In addition, the accord deliberately omits market discipline, which gives countries leeway to ignore the accord guidelines, which in turn results to accords inability to influence banks and countries to adhere to its guidelines. The elimination of the emerging economies from the Basel accord created unforeseen impact on industrializing economies. It impacted negatively on the risk weights bank debts since non-OECD bank debts is usually risk weighted at lower relative degree of riskiness rather than its long term debts which in turn has motivated international investors to shift from holding long run developing markets bank debts to encouraging acquisition and holding of short run emerging markets instruments. Basel II accord Basel II accord contained the recommendations on laws of banking and regulations given by the Basel committee on major supervision of banking institutions. this accord aimed to establish international standard that banking regulators would use when creating regulations concerning how much capital banks need to be preserved to protect against all kinds of operational and financial risks banks face while maintaining sufficient consistency in order to eliminate any form of competitive inequality among international banks. In 2004, the second Basel Accord was created and became enforceable by law in the G-10 countries. The Basel II agreement focused on considering risk of capital allocation, transparency in capital adequacy, quantifying all risks, and lessening gap between economic risk and regulatory position. This agreement was implemented in 2004 as a response to cover the shortcomings of the Basel I accord. It covers new approach to credit risks, cover markets, operational, and interest rate risk, adapt to the ensurance of bank assets and inclusion of the basic surveillance and regulation by major banks. Minimum capital requirement This move allowed banks to take in additional risks while domestically and cosmetically to minimum capital adequacy demands or requirements. It incorporated new scope of financial regulation to add or include assets of the holding firm of an internationally vibrant bank. This is carried out to avoid risk that a bank will not disclose by transferring its assets to other banks and include financial stance of the entire company in calculation of the whole capital demands for its subsidiary bank. Operational and Market risks The Basel II accord extends its guidelines into the assessment and protection against any risks that might incur from operation. The bankers were required to use the basic indicator approach in order to calculate the reserves required to protect against failures in internal processes of the bank. By this approach, banks hold capital that is equal to 15% of the average gross income gained by a bank or financial body in the last three years. All regulators are given room to adjust 15% in accordance to the level of risk assessment of their respective banks. In addition, bankers were allowed to use the standardized approach whereby banks are divided by business lines to come up with the amount of funds it must possess to guard itself against operational risks (Jones 40). Lastly, regulators and banks alike were required to apply the advanced measurement method, which required banks to develop their own calculation reserve for operational risks. This method brought market discipline and surveillance into banking laws and eliminated any form of wiggle room a situation where banks tend to obey regulations in rule and standards but not in spirit. The Basel two accord also evaluated market risks whereby it outline what banks need to do when held due to market risks such as the risk of loss because of movement in banks assets prices. The agreement made clear differentiation between other products and fixed income such as commodity and equity that may lead to market risks (Frieden et al 45-51). Total capital adequacy After the bank has successfully calculated the reserves it requires holding in order to guard against market and operational risks and has adjusted all its assets in accordance with credit risk, then it is in a position to calculate its capital reserves it requires in attaining capital adequacy. The Basel two agreements gave much room for banks to calculate their reserve requirement. In addition, it holds that no shift is given to both demands that Tier 2 capital reserves must be same to the amount of Tier 1 capital reserve and that 8% reserve demand for credit default capital adequacy for banks. Regulators have the mandate to assess and review the bank’s capital assessment policy and are in a position to hold senior managerial position responsible if the bank fails to represent its risk position. In addition, banks were authorized to draft or come up with their own risk profile and if this move is not implemented, then authorities have the powers and rights to penalize the at-fault bank. Regulators were also mandated to create a “buffer” capital demand in addition to the already minimum capital demands for banks this ensured capital adequacy objectives as stated in the agreement. In addition, banks were required to take early measures if capital reserves fell below minimum requirement this would help countries in financial problems like what had happened to china, Japan and Russia during financial crisis. In order to increase countries banking sector, disclosures of banks risk positions and capital were only accessible by regulators are now recommended to be released to the public according to Basel II agreement. For instance, risk weighted capital adequacy ratios, capital reserves demand for credit, operational and market risks once held by the bank wererequired to be released to the public. The main aim of this action is to motivate shareholders to implement discipline in the reserve holding and risk taking methods of some banks where banks that take too much risk and hold too few reserves are punished by shareholders for such steps (Jones 36-38). Basel III accord The Basel III accord is a new international regulatory standard on bank liquidity and capital adequacy agreed by upon the G-10 member states. This accord was created in response to deficiencies exposed by international global financial problem. This accord strengthens capital demands or requirement for banks ad brings new regulatory measures on liquidity of the bank and bank leverage. This accord brings new additional buffers to the financial institutions and 3% minimum leverage ratio and liquidity ratios. The liquidity coverage ratios demands banks to hold surmountable amount enough for high liquid assets to cover banks net cash flows for over one month. Basel III accord will demand financial institutions to hold 4.5% of common equity (higher by 2% of the Basel II accord) and 6% Tier capital (high from 4% in Basel II accord) of risk-weighted assets. Basel helped many banks to recover from financial crisis by bringing new buffers in the market in that allowed for a mandatory capital preservation buffer and discretional countercyclical buffer which authorizes regulators al domestic or local level to demand up to 2.5% of capital during times of high credit growth. In addition, this accord allowed for a minimum of close to 3% advantage ratio and liquidity ratio. The financial crisis would have caused serious and permanent damage to the economies of the world leading to massive unemployment to many people all over the world if some regulations were not implemented. The financial crisis showed that some securities that were seen as capital instruments were unusable in times of deadly financial crisis. Capital is only significant when it is applied to absorb losses in order to guard other parties. Regulators of financial institutions were blocked from forcing that loss absorption in times of subordinated debt. Placing major banks into insolvency was perceived as a dangerous move by policy makers especially after insolvency caused severe market turmoil to Lehman brothers. as an aftermath, subordinated debts are being placed under tighter conditions to avoid issues of insolvency among banks. in addition, the crisis demonstrated how much counterparty credit risk existed which led the Basel committee to make the rules more tough stipulating how much fund was needed to address these risks and how much capital was to be aside. Therefore, there was need for distinction on amount of capital required to support exchange-traded derivatives, which in turn would encourage low counterparty risks. Changes to the Capital Base The accord states that the quality, transparency, and consistency of the capital base will be increased tremendously. Whereby, the Tier 1 capital must same or common shares among banks. In addition, the capital instruments for banks will be harmonized accordingly to ensure success of banks and avoid financial crisis. Risk Coverage of Capital Framework The Basel III accord outlines that the risk coverage of the capital framework will be strengthened in order to promote more prudent and integrated management of counterparty credit risk and markets. In addition, new tool was added in that the credit valuation adjustment was introduced to avoid diminishing in counterparty credit ratings. The counterparty credit was boosted by strengthening the capital demand for counterparty credit due to interaction with banks. Other measures introduced for coverage of capital framework includes raising counterparty credit risk leadership standards by incorporating the wrong way risk, giving additional incentives to strengthen risk management of the counterparty credit exposures to financial institutions (Balaam et al 56). Leverage Ratio Introduced The Basel III committee introduced leverage ratio as a supplementary or alternative measure to the risk-based framework of Basel II. The leverage ratio aimed at setting up a floor under the already established leverage in the banking system. In addition, this measure ensured protection against measurement error and model risk by substituting the risk based policy with a cheaper and simpler policy that is based on gross exposures (Santos 99-111). Liquidity Coverage Ratio Requirement The Basel III committee came up with a global minimum liquidity standard for all internationally vibrant banks that incorporates 30-day liquidity leverage ratio demand or requirement intertwined by long-term structural liquidity ratio known as the net stable funding ratio. Net Stable Funding Ratio Basel III introduced the net stable funding ratio as a new set of capital demand for banks, which will in future replace the Basel II. This kind of funding ratio is calculated by considering the proportion of long-term assets, which are supported financially by long term, and stable funding. In this manner, stable funding includes customer equity and deposits while the long term funding come from interbank lending markets. Conclusion Basel I did much to introduce regulatory harmony and development across international banking system but on the other hand, it allowed banks to interpret rules in their own ways, which was a major blow to implementing its strategies. Basel II brought in limelight factors such as operational, credit and markets risks, regulatory and surveillance measures that brought sanity in banking system. Basel III has tried to keep financial institutions stable by introducing net stable funding ratio. in addition, Basel III will make big difference to the working or operation of the banks and other financial institutions. International banking will be safer but expensive in addition to long implications throughout the entire economy. Works Cited Santos, Joao. “Bank Capital Regulation in Contemporary Banking Theory: A Review of the Literature.” BIS Working Papers, No 90, September 2008. Basel II - A Guide to new Capital Adequacy Standards for Lenders. The United Kingdom Council of Mortgage Lenders, February 2008. Balaam, David and Dillman, Bradford. Introduction to International Political Economy. New York: Longman, 2010. Print. The new Basel Accord: An Explanatory note. Secretariat of the Basel Committee on Banking Supervision, Bank for International Settlements, January 2001. Freiden, Jeffry, Lake, David and Broz, Lawrence. International Political Economy. New York: W.W Norton & Company, 2009. Print. Jones, David. “Emerging problems with the Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues.” Journal of Banking & Finance, No. 24, pp. 35-58, 2000. Read More