Basel Core Principles on Developing Countries - Essay Example

Basel Core Principles on Developing Countries Introduction Countries cannot ignore their financial and banking sectors. Failures in the banking system can be very costly, especially for the developing countries. Its occurrence and recurrence must be prevented at all times and at all costs. A trial-and-error system should never be resorted to. Thus, safe and sound banking practices must be sought to minimize the risks and weaknesses of financial institutions. This is where many developing countries can best explore the standards provided by the Basel Core Principles. Compliance with the Basel Core Principles has long been seen as an effective platform to pave the way for financial stability. The Basel Committee The Committee on Banking Regulations and Supervisory Practices (Basel Committee) was established in 1974. The Committee was comprised of the central bank Governors of the Group of Ten countries. These countries in particular are Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom and the United States. The repercussions of the turmoil in markets and international currency created the need for this congregation. The Basel Committee was tasked to oversee and supervise financial institutions and to issue recommendations and standards on banking laws and regulations. It serves as the forum for cooperation on sound banking practices for member countries. 1998 Accord In 1988, the Basel Committee gave birth to Basel Capital Accord, or the 1988 Accord. The 1988 Accord was to serve as the international standard to be followed by financial institutions. This has come to be known as a stabilising instrument in banking institutions that foster cooperation among participating countries. The aim of the 1988 Accord was to give a new framework that will strengthen the stability of the banking system and to make sure that the framework will be fair and consistent in application to various banks to reduce inequality among international banks. It provided a system for capital measurement and stated the minimum requirements for international banking business. The most significant aspect of the 1988 Accord is the provision imposing a regulatory capital requirement. It required the minimum capital-to-asset ratio of financial institutions to equal to at least eight percent (8%) of the risk-weighted assets. Thus, if all of the institutions assets are exposed to 100% risk, then its capital at hand must be valued at least 8% of its assets. The changes in the 1988 Accord were proposed in 1999. The proposal aims to formulate a capital framework that has evolved to the needs of the time. Thus, the International Convergence of Capital Measurement and Capital Standards: A Revised Framework or the Basel II Accord came upon in June 2004. Core Principles for Effective Banking Supervision A remarkable benchmark was made through the Core Principles for Effective Banking Supervisions or the Basel Core Principles. The Basel Core Principles aim to respond to the weaknesses in the banking systems that can threaten countries, regions and even the international community. This document was issued on September 1997 after examinations and studies made by the Basle Committee, the Bank for International Settlements, the World Bank and the International Monetary Fund. Compared to the 1988 Accord, many developing countries participated in the drafting of the Basel Core Principles, like Chile, Thailand, China, Argentina, Brazil and India among others. The Basel Core Principles are made of 25 basic Principles that are supposed to guide the regulatory or public authorities in the countries into implementing or maintaining an effective financial system. These 25 basic Principles are classified into seven sections. Principle 1 deals with the Preconditions for Effective Banking Supervision. Principles 2 to 5 discuss the Licensing and Structure. Principles 6 to 15 break down the Prudential Regulations and Requirements that are supposed to be followed by the banking institutions. Principles 16 to 20 outline the Method of Ongoing Banking Supervision. Principle 21 enumerates the Information Requirements to be sought and adopted by the banks. Principle 22 lays down the Supervisors' Formal Powers and may serve as basis for delineating the authority of supervisory bodies in developing economies. Finally, Principles 23 to 25 provide for the Cross-border Banking options. According to the document, the Principles embodied above are mere minimum requirements to be followed by banking systems. Financial institutions need to go beyond mere compliance to address any particular risk or difficulty. After meeting the standards of the Basel Core Principles, banks must seek further financial designs to respond to situations that are specific to a country or region. The Basel II Accord: Essential Requirements The Basel II Accord is believed to provide the best practice in terms of managing risks and the optimum standards to be followed by banks to be globally competitive. Basically, the Basel II Accord improved and updated the provisions of the 1988 Accord. It is aimed to be more responsive to the experiences of institutions in participating countries. The framework offered by the Basel II Accord is composed of three pillars. Gathered together, the three pillars are essential in maintaining a secure and effective capital framework. The First Pillar is on Minimum Capital Requirements. This expanded the standardised rules of the 1988 Accord and comprised the majority of the document. The first pillar provides for the same eight percent (8%) capital-to-asset ratio requirements. It requires banks holding assets that are exposed to more risks to have more capital or cash on hand. Conversely, those who have less risk in their portfolios would not have as much requirement. The significant aspects offered by the Basel II Accord are the alternatives in Simplified Standardised Approach (SSA), Standardised Approach (SA), and Internal Ratings Based Approach (IRBA.) SA allows the use of evaluations gathered by private ratings agencies to designate the risk-weights. This approach is intended for banks that have no necessary internal models. Banks that can use their own internal models to assess ratings use the IRBA.1 The Second Pillar focuses on Supervisory Review Process. Essentially, it tasks regulatory agencies to supervise financial institutions and it has the authority to adjust the capital requirement of individual banks above the eight percent (8%) minimum, if called for. It stipulates four key principles to be followed in reviewing the capital adequacy and internal assessment procedure observed by banking institutions.2 Primarily, the bank has responsibility to determine internal processes to evaluate capital adequacy. Second, it underscores the responsibility of the supervisor. Third, supervisors must be capable of requiring banks to go beyond simply meeting the minimum capital requirement. Finally, supervisors are demanded to intervene at the very early stage whenever problems arise in financial institutions. The Third Pillar is on Market Discipline. This pillar is stipulated so that appropriate disclosure arrangements and other sound banking practices may be instituted or further buttressed. The disclosure requirement covers figures on how the financial group has been consolidated, the capital structure and capital adequacy.3 The market discipline pillar also ensures that banking agencies shall be given supplemental reviews. Which Standard to Implement Some developing countries may have the immediate reaction of imitating the developed ones in terms of adopting the provisions of the Basel II Accord in their local settings. This is because the developing countries believe that they need to use the same standards to ensure survival in the global economy. This will be a clear disregard of the fact that the configurations of Basel II Accord are based largely from the experiences of the developed countries that participated in its formulation. Thus, it may be difficult to conceive how the Basel II Accord can easily apply to developing countries. It may be proper to review first how the implementation of Basel II Accord has influenced or will influence the developing countries. Some proffered the view that the Basel II Accord was "not designed for, nor is appropriate, for developing economies."4 Developed countries and their use of the Basel II Accord may cause a number of negative consequences upon the developing countries, such as high cost lending and reduced lending to developing economies, curtailment of credit to developing countries, higher interest costs and competitive advantage of corporate borrowers, impact on infrastructure development, shorter term to maturity of lending, impact on capital flows and impact on companies.5 One significant repercussion is the irregularity in the costs of bank lending to the developing countries. Developing countries are disposed to being less creditworthy. Extending loans to them will of course subject the lending bank to higher capital requirements. Necessarily, the bank will have to impose higher borrowing costs to cover the capital requirement. This aspect is also critical as the loans granted by banks in developing countries are crucial in financing local commercial ventures.6 The increase in the costs of loans indirectly affects the local economy of the developing countries. We can also see that if developing countries are more exposed to risks, then they will have larger capital requirements, as opposed to the decrease in capital requirements for larger international banks that have safer assets. If such is the case, then larger banks, with less capital requirements, will be able to gain more customers from the market. In the end, the competition becomes more uneven and unfair to the smaller players. This will subvert the ideal situation of fostering fair competition. A Resort to Basel Core Principles It was found that out of the 34 countries that are going through a critical period, only five have been employing 'adequate' legal and supervisory frameworks and even these five have remained lackadaisical in enforcement and supervision.7 The arguments stated previously highlight the complexity of Basel II implementation in developing countries a more judicious decision should be made. Adoption of Basel II provisions may very well be a step to show pride and determination on the part of the developing countries to initiate their emergence in the international playing field. Developing economies may think that it can help attract investments and business ventures. It is important to also acknowledge that there is pressure to comply with Basel II so that international banks can open or maintain branches in developing economies. Considering that the illustrations above make it manifest that the Basel II Accord is not the proper route to take for developing countries, it is high time to ardently highlight the role of the Basel Core Principles. This is the prudent option because it reflects the clear ability to prefer safe and sound banking practices rather than merely being part of the bandwagon. Developing countries, in order to protect the interests of their banks and their aim for expansion must do the more prudent act of adopting the Basel Core Principles instead. Installing a system of safe and sound banking practices will definitely help and ensure the long-term financial stability of the country. In a study conducted by Kunt, et. al., compliance with the Basel Core Principles has been shown to have a positive correlation with the soundness of banks in participating developing countries.8 The twenty-five principles embodied in the Core Principles for Effective Banking Supervision may be very significant to developing economies. The report is very essential in creating a sound financial system. It can pave the way for institutional and financial market infrastructure, institutional governance, market discipline, competition, regulation and supervision, and appropriate strategies for financial liberalization.9 Problematic Factors in Developing Countries There are also problems inherent in the developing countries that are relevant in the implementation of the Basel Core Principles. Honohan discussed that there are isolated bank failures may happen in developing countries due to factors that are beyond the control of any regulating body. There is a possibility of a systemic breakdown that can be identified through a pattern of three failure syndromes in the developing countries. These syndromes are the endemic, the macroeconomic and the epidemics.10 A number of banking system crisis experienced in the developing countries are characterized as endemic. The problem tends to be identified in a particular country and is brought about by the political and social culture of the people. This can be found in countries whose financial systems are largely controlled by the government.11 For example political turmoil can pose a threat in the financial sector because the latter will always have to weigh decisions based on the political atmosphere, and not based on the policies that must be upheld. The play with power in the local political arena can affect the decisions made. We can also look at the would-be experience of the regulators in this setting. The regulators are given power to exercise discretion in reviewing and monitoring banks. If they are regularly subjected to political pressures and corruption, then financial policies may be sacrificed in exchange of politics. Secondly, Honohan puts forth the role of macroeconomic factors as material in shaking the financial systems in the developing countries. Disturbances such as decrease in national productivity and higher interest rates are not favourable to banks. There are some banks that may survive, but where there are many that succumb to the disturbances, then it is a systemic problem. The macroeconomic factor only serves as a trigger that exposes the concealed weaknesses of the banking system.12 We can also connect the third aspect of epidemic system failure to the macroeconomic factors. Most of bank failures happen because of poor management of its resources and policies. This becomes epidemic when in time of trouble, one bank reacts inadequately and the rest take on the same attitude. This systemic failure may be attributed to the poor decisions of bank in giving out loans, fast-paced credit expansion and exceeding technical capacities for short-term goals.13 Prerequisites to Impose on Developing Countries We are aware that any economy is fragile as it gets subjected to different forces and factors. Thus it is not surprising if economic policies of the developing countries attempt to pattern it from the experience of those that successfully dealt with the difficulties. In this regard, at the very least, the developing countries must be required to take certain steps so they can adequately adapt to the changes the economies. Thus, what follows are the steps or prerequisites to take in adapting the Basel Core Principles in developing countries. Adequate risk management systems should be implemented. Risk management is something that most economies overlook, even among those who implement the Basel Core Principles. Thus, it is best that economies in the initial stage of implementation be able to improve risk management systems. Thus, the legislative sector of the country must espouse for this, coupled with a strong executive policy to implement the rules. There must be a thorough review of resources to use and costs to meet. There will definitely be costs in implementing the Basel Core Principles. For example, the Principles require that there be an effective supervisor. The supervisor will come from an industry of professional with high level of experience and expertise. Thus, to be able to recruit the qualified persons for the job, the regulating agencies in developing countries will have to match the right offer of compensation. There were also studies by the International Monetary Fund that showed the incidence of compliance to the Basel Core Principles as higher in countries with more than adequate income compared to the low-income ones. This is primarily attributed to the fact that the technical aspect of implementation can be costly. Thus, developing countries must assess its resources and seek out venues to access technical assistance. The role of supervisors must be properly laid out and understood by the key players in the developing countries. Core Principle 22 provides for the Supervisor's formal power or authority. These supervisors are given the power to exercise their discretion and expertise. Thus, it is important to define their role and powers definitively so that the aim to create a stable financial system may be viable. However, in developing countries where corruption or political turmoil may pose problems, it is important to seek strong and independent supervisors. If this cannot be assured, at the very least, the laws of the country must make the supervisor responsible and accountable for the consequences of his or her actions. Where there are effective supervisors, there must also be a definite mandate and strong support system. This is to ensure that in their performance of their job, political pressures will be minimized, if not eliminated.14 Furthermore, the laws must ensure that the supervisors' exercise of power is consistently applied to all. Encourage healthy ties with the State. Bailey suggests that most of the banking systems in developing countries are able to survive despite the banking system being tied up or heavily led by the state system.15 He claimed that this arrangement is not necessarily detrimental. It even allows the state to help in mitigating the risks or losses faced by the banks in times of trouble. The partnership can also help the financial institutions in mobilizing funds. Pursue governance and transparency. There are many elements to consider in understanding how and why developing countries confront economic turmoil such as weak currencies and high debt-service costs. This is further aggravated by lack of transparency and political certainty. Thus, it is not surprising that these developing countries do not have the confidence of international market players. This is why there must be installed a system of transparency must be strengthened.16 The policy function should also be coordinated with regulation to ensure that the reviews of the system effectively translate to responsive legislation. Other objectives to aim for are increasing the scope for regulatory forbearance and corruption, developing capital markets and conducting regular assessments of the standards adapted. Conclusion If left alone, developing countries will have to anticipate a number of precursors before necessary changes can take place. Even if there are considerable costs, timeframe and the holistic adjustments in the implementation of the Basel Core Principles, it is still best to resort to this rather than leave the financial system weak and vulnerable. The suggestions stated above are aimed to facilitate these economies to safe and sound banking practices if ever they choose to utilize the Basel Core Principles. BIBLIOGRAPHY Akhtaruzzaman, Md. (2009), 'Potential impact of Basel II in developing economies: experiment on Bangladesh'. International Research Journal of Finance and Economics 23, pp. 46-61. Bailey, R. (2005), Basel II and developing countries: understanding the implications. Development Studies Institute. Working Paper Series Number: 05-71. Basel Committee on Banking Supervision (1988). International convergence of capital measurement and capital standards. Switzerland, BIS. Basel Committee on Banking Supervision (1997). Core principles for effective banking supervision. Switzerland, BIS. 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(2006),'Safe & sound banking, 20 years later: what was proposed and what has been adopted. In: Federal Reserve Banks of Atlanta and San Francisco and The Journal of Financial Services Research. Conference on safe and sound banking: past, present and future. pp.1-37. Griffith-Jones, s., Segoviano, M.A. & Spratt, S. (2003) Basel II and Developing Countries: Diversification and Portfolio Effects. Brighton, IDS. Honohan, P. (1997), Banking system failures in developing and transition countries: diagnosis and prediction. Bank for International Settlements. Working Papers number:39. Lindgren C., Garcia, G & Sal, M. (1996), Bank Soundness and Macroeconomic Policy, International Monetary Fund, Washington D.C. Powell, A. (2004), Basel II and developing countries: sailing through the sea of standards. World Bank Policy Research Working Paper: 3387. Seelig, S.A (2003), The Future of Banking, Quorum Books Place, Connecticut. Shende, S.N. (2002), Improving Financial Resources Mobilization in Developing Countries and Economies in Transition, United Nations. Read More