Basel Accords Analysis - Example

Table of Contents 1. Introduction 3 2. Basel Accord I and its Basic Principles 4 2.1 Positive and Negative Views on Basel Accord I 5 3. Basel Accord II 6 3.1 Transition to Basel II and the difference between Basel I and Basel II 6 3.2 Basel II and its Basic Pillars 7 3.2.1 Pillar I: Minimum Capital Requirements 8 3.2.2 Credit Risk 9 3.2.3 Operational Risk 10 3.2.4 Market Risk 11 3.3 Pillar II: Supervisory Review Process 12 3.3.1 First Principle of Pillar II 12 3.3.2 Second Principle of Pillar II 12 3.3.3 Third Principle of Pillar II 13 3.3.4 Fourth Principle of Pillar II 13 3.4 Pillar III: Market Discipline 13 3.5 Positive and Negative Views on Basel II 14 4. Basel III Accord and its Basic Principles 14 4.1 Positive and Negative views on Basel III 15 5. Conclusion 16 6. References 17 1.0 Introduction This paper looks to highlight the basic governing Basel Accords to enable the readers with a clear understanding of the various Basel norms and its principles. The paper initially throws light on Basel I Accord and its basic principles along with positive and negative views on the same. The report then move to show the manner in which Basel II was adopted along with the major differences among them. The paper is also characterized by various pillars of Basel II and its major characteristics and impact on banking system. The report then moves to draw inferences of negative and positive views on Basel II accord with an understanding of Basel III accord and its positive and negative views on the same. The report finally ends with a conclusion to provide both theoretical and practical understanding of the topic under study. 2. Basel I Accord and its Basic Principles The Basel Accords which implies the Banking supervision accords are issued by the Basel Committee on Banking Supervision (BCBS) which acts as a set of norms and recommendations for banks to ensure healthy regulations in the Banking Industry. Prior to 1988, the Banking sector lacked a uniform international regulatory standard which could set the minimum capital requirements of Banks. In 1988, the Basel Committee of Banking Supervision came up with Basel I to find out the capital needs (Ferguson, 2003a). The Basel I Accord highlighted two basic principles. Firstly it defines the amount of capital determined by Tier 1 and Tier 2 capital which is based on its protecting the creditors. In Tier 1, equity and retained earnings are given the most importance as the same are equipped in absorbing unexpected losses to a significant level without actually disrupting the normal trading zone. Tier 2 capital subordinated debt is not characterized by loss absorbing technique but however acts as a protection to the depositors in cases where banks fail as the same is the last layer of debt to be paid by paid in case of its insolvency (Ferguson, 2000). Secondly the Basic principle associated with Basel I is the amount of capital that banks hold to reduce risk. The major risk felt by any bank is the asset held on its Balance Sheet. Thus, Basel I calculate the minimum capital requirements for banks as a percentage of its assets which it holds (Ferguson, 2003b). To further adjust the different risk weights are found out. More importance are given to more risky assets like corporate loans whereas less importance is given to less riskier assets like exposures to government. A total risk-weighted assets amount is thus calculated. Basel I thus set the minimum total capital requirement which is a summation of Tier 1 and Tier 2 which should be a minimum 8% of the total risky, 50% of which should comprise from Tier 1. Hence it can be concluded that the basic principle is to recognize that banks need to reduce the riskier assets from their financial statement by use of risk controlling strategies like collateral and guarantees and to further ensure a lower bank capital requirements. However Basel I exposed the different risk to the banking sector which are not provided in the financial (Ferguson, 2003c) 2.1 Positive and Negative Views on Basel I Accord The committee has pointed out two fundamental positive views on Basel I Accord which are Basel I accord has helped in strengthening the soundness and stability of international banks and hence has enhanced competitive equality among the active international banks. Basel I had been successful in exercising continuous pressure on the banking industry to have a sound capital ratio which has grown over time. Thus ensuring a positive contribution to the objective of competitive equality. Despite the Accord’s accomplishment, the same is characterized with the following negative view points. During the past 10 years financial world has developed rapidly and the present performance of the banking sector might not be a good indicator of the financial sector of a bank due to the risk associated with credit exposure which has not been differentiation between the borrowers with differing default risks (Heller and Todd, 2005). Banks still can enjoy arbitraging their capital requirements as per regulations and exploit the divergence the different risk which are observed and measured under Basel I Accord. Hence the process fails to regulate the capital arbitrage prominent among international banking system (Heller and Todd, 2005) The Basel I accord fails to provide a proper incentive for risk mitigating techniques. Thus we see that Basel I accord has its own advantages and disadvantages which to mitigate in a substantial manner the committee came up with Basel II accord. 3 Basel II Accord As mentioned in the previous section Basel I Accord has been characterized with several negative viewpoints. To reduce the weakness and have a better framework which states the minimum capital needs a Basel II framework was developed in 1999. 3.1 Transition to Basel II and the differences between Basel I and Basel II The framework of minimum capital standards introduced in Basel I in 1988 so that the banking system could ensure financial soundness and have a playing level field where every player was treated fairly and equally. This was done with the objective of determining the minimum capital needs and was known for its objectives but started to be criticized due to poor capital requirement which increased the risk as banks started to take advantage by indulging themselves in a regulatory capital arbitrage. To further look upon this difficulty the committee in 1999 decided to come up with Basel II framework which relied on three basic pillars namely minimum capital requirement, supervision and market performance so that a better banking system can be developed. The Basel II was designed with a more clear objective of incorporate a regulated market based policy which would not discriminate banks according to their ratings. The process was aimed towards reducing risk i.e. the Pillar 1 and the governing pillars of 2 and 3 will aim towards reducing the bank risks taking incentives. Basel I states that the lenders has to find out the minimum capital needs based on a single risk weight instrument for given assets like, mortgages, consumer lending, corporate loans etc. Basel II brings change in Basel I and provides the opportunity there the lenders can use their own risk measurement models to find out the capital needs. Further the same help in maintaining a culture with risk management is an important aspect for managers at all levels. To further distinguish Basel I from Basel II, both Basel I and Pillar I of Basel II, focuses on the capital requirement rule which banks should maintain to control the risk. However, Basel I helps to find out the risk sensitivity but Basel II looks at improving the same with other pillars looking after the supervisory review and the market discipline techniques and its associated rule thus enhancing the scope and coverage of banking regulation norms. 3.2 Basel II and its Basic Pillars Basel II introduced the capital needs which will help to reduce risk for banks. It builds itself on Basel I where sensitivity is used to reduce the overall risk for the banking sector. In addition to the same it identifies different risk which includes local, national and international risk which the banking sector has to face. Let us have a look the main objectives which Basel II looks to highlight on. To ensure that capital allocation reduces risk for the banking sector. To ensure the enhancement of disclosure requirements so that the different capital adequacy needs can be properly met. Bringing together the economic and regulatory capital needs so that a closer linkage helps to reduce arbitrage. Ensuring that credit risk, market risk and operational risks are identified and quantified based on formal techniques. Basel II is characterized by three Pillars which forms the base of the accord and are namely Minimum Capital Requirement, Supervisory Review Process and Market Discipline. 3.2.1 Pillar I: Minimum Capital Requirement This pillar specifies the manner in which banks have to determine the capital requirements so that the risk for the banking sector is reduced. This pillar makes the most important aspect for Basel II as its primary objective is to find out the capital needs based on risk sensitivity and align both so that the capital needs can be fulfilled. The major risk includes market risks, credit risks, securitization risk and operational risks. This pillar thus deals with the capital adequacy ratios of three types of risks: credit, operational and market risks with the use of two concepts namely Regulatory Capital and the Risk Weighed Assets (FDIC, 2006). Capital Ratio = Total Capital / (credit risk+ operational risk+ market risk) which should be greater than or equal to 8%. All the Basel reforms looks towards having the same capital definition and looks to strengthen the capital needs so that the financial sector is able to perform in a better way. Now let us have the all three associated risks in detail to understand the impact and importance of same in the Pillar I of Basel II. 3.2.2 Credit Risk Credit risk is the risk associated with lending and underwriting and needs to be controlled to ensure financial liquidity within the system. The committee has envisaged a new treatment to credit risk by introducing two different new approaches which are the Standardized Approach which relies on external credit assessment and the Internal Ratings Based Approach identified the internal risk for the banking sector. The following paragraphs explain the two approaches. Standardized Approach The Standardized Approach is based on the Basel I approach is used to find out the capital needs of the banking sector. The approach is so designed so that the process of Basel I is used and the minimum capital needs of the banking sector is found out. This approach focuses on identifying the on and off balance sheet item and assigning different weights based on the risk so that the capital requirements which will ensure liquidity can be determined. This process helps the credit agencies to find out the capital needs and ensure better accuracy. Higher rated loans are characterized to have lower capital requirement which was not the case of Basel I Accord where all corporate loans were treated as the same regardless of its rating associated to the same. This thereby helps to understand the capital needs and provides an opportunity to manage the capital needs of the banking sector. Internal Rating Based Approach This approach represents a significant development in calculating the minimum capital requirement from Basel I Accord. Under this method banks use their own mechanism to develop the internal rating system so that the different risk can be found out. To rate the different risk banks use their own measurement models which helps to find out the manner in which the risk managing strategies can be developed. One such approach is the IRB capital formula. There are four areas which have been identified with each assets namely Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Maturity (M). Further the banks through the different mechanism look to find out the different risk and assign different ratings so that strategies can be developed to mitigate those 3.2.3 Operational Risk Operational risk is the risk which arises due to internal process, people and system as the inefficiency to use the same results in increasing the risk. An example highlighting the operational loss is the failure of Barings Bank in 1995 which was due to lack on internal control and speculation leading to losses. Operation risk is a new element which is added to the Basel I Accord. Basel II requires banks to have a minimum capital so that the risk can be reduced. On an average operational risk provisions constitutes 20% of the capital which is determined by banks at all level (Calomiris, and Richard, 2002). The process uses three different approaches to operational risks namely the basic indicator approach, standardized approach and Advanced Measurement Approach (AMA) which has been discussed as under. The Basic Indicator Approach This approach is less sophisticated and least advanced to banks. This process helps banks to develop a standard method which helps to identify the credit risk and determine the approach which will reduce the risk for banks. The credit required under this approach is a simple calculation of 15% of the bank’s total gross income (Herring, 2004b). The Standardized Approach The standardized approach is more developed and sophisticated for banks specially, for those banks which select to run on the standardized approach to credit risk. The process calculates the capital needs by making a differentiation between businesses and providing different betas based on the risk associated with each object. The capital need is found by multiplying the beta by gross income. It has further been found that there are 8 business lines where different ratings like 15% and 12% have been provided to different weight age and looks at finding out the risk associated with different objects (Herring, 2004b). The Advanced Measurement Approach Once the bank adapts to the IRB approach it looks at developing credit risk measurement strategy to measure the risk. This approach ensures that banks identify the capital needs by finding the different risk associated with it. Minimum capital requirement here depends on Banks internal loss estimate. Banks must fulfill both qualitative and quantitative measure before adapting this approach (Herring, 2004a). 3.2.4 Market Risk Market risk refer to the risk associated with different financial instruments which are available in the market and varies based on different objects like interest rates, exchange rates and equity values. The preferred approach here is the Value at Risk (VaR). Given the fact that portfolio holder does not know the market value of a week from today, additional capital is required to comprehend such risks. The value at risk approach requires market risks to be calculated as the summation of interest rates, risk measurement system, exchange rates, equity prices and commodity prices (Kane, 2007a). 3.3 Pillar 2: Supervisory Review Process While Pillar I of Basel II identifies find the main risk for the banks based on Pillar II of Basel II focuses on banks having adequate capital to face all type material risks in their business. It ensures additional role of supervisor to monitor the capital needs which has a broad implication on failures of banking system. It thereby ensures proper monitoring and helps to find out the different risk so that risk management strategies can be incorporated. The second pillar proposes 4 basic principles which a bank must incorporate in its supervisory practices which have been explained in the following paragraphs (Kane, 2007b). 3.3.1 The First Principle of Pillar II The first principle highlight that banks need to find out the capital requirements based on the risk profile so that the required capital needs can be identified. Oversight of broad and senior management, sound capital assessment, assessment of risk at comprehensive level, monitoring and reporting and a strong internal review are the prerequisites to strengthen upon the actions of first pillar of Basel II. Under this principle banks are advised to demonstrate their supervisors that they hold adequate capital in proportion of the risks they faces (Herring, and Jacopo, 2007). 3.3.2 The Second Pillar of Basel II Banks internal capital adequacy and strategies should be reviewed and evaluated by supervisors to find and monitor the capital needs of the business so that liquidity can be maintained. Supervisors must ensure to take appropriate actions if they are unsatisfied so that changes can be done. Supervisors are further advised to indulge in on-site examinations, off-site reviews and periodical reporting along with other measures they may deem fit (Herring, 2002). 3.3.3 The Third Pillar of Basel II This principle advices supervisors to expect that there banks should work over the minimum capital needs and ensure that they have the required resources which is required for the minimum needs of liquidity (Calem and James, 2005). Supervisors can take different measures to ensure capital level declining below the minimum criteria like to establish firm specific targets, to adopt a single ratio above 8%, to evaluate and process around the firms target to ensure value of whether a process is acceptable or not etc. 3.3.4 The Fourth Pillar of Basel II This principle require supervisors to seek and look towards making changes in the capital needs if it falls below a certain level so that risk mitigation strategies and assets can be purchased through which required liquidity is maintained within the system and the banks are able to carry their functions diligently (Berger, Allen N., 2004). Supervisors must assess such actions on a continuous basis and develop corrective actions against the same. 3.4 Pillar III: Market Discipline Market discipline is often referred to as the market participants having an interest in the ensuing banks to ensure that banks are adequately capitalized and to behave in a prudent manner. The objectives of market discipline are relative straight forward as when the participants have a clear picture of taking risk and determining the capital adequacy so that risk can be minimized and liquidity ensured within the system. The committee encourages that banks maintain a minimum disclosure requirement which will provide participants a clear access to information on the scope of application, capital, risk exposure, risk assessment and hence a better adequacy picture. Pillar 3 hence requires banks to clearly disclose their qualitative and quantitative information in relation to nature of risks, risk measurement processes and capital adequacy (Hannan, and Steven, 2004). 3.5 Positive and Negative Views on Basel II Basel II has a positive impact in the sense that it eliminates the weaknesses of Basel I. Firstly discrepancies between economic capital and regulatory capital is reduced to a great extent as the reliance of regulatory requirement on banks to identify their own risk assessing methods. Secondly the scope of capital arbitrage is significantly reduced as the accord focuses on risk sensitivity including the treatment of securitization. Further a market discipline process and supervisory principles provide banks to mitigate the risk of failure to a considerable extent (GAO, 2007). Basel II has its own potential disadvantages the important concerns here are. The process is more complex therefore demanding more supervisors and unsophisticated banks. Strong risk differentiation can adversely affect the borrowing status and position of risky borrowers associated with banks. There is scope of increased pro-cyclicality as the capital requirements are more sensitive which can vary largely over the cycle. 4. Basel III Accord and its Basic Principles Basel III Accord was implemented in 2010 to overcome the shortcomings of Basel I and II. It was formulated with a purpose of expanding the treatment of capital qualification and higher capital requirement. It introduced short term Liquidity Coverage Ratios and long term Net Stable Funding Ratios to ensure bank stability (Federal Reserve Board, 2006). It primarily focuses on the required level of bank loss reserves for various classes of loans, investments and assets that a bank held. It basic key principles include the following. Capital Requirement It requires bank to hold 4.5% of common equity (2% in Basel II) and 6% of Tier-1 capital (4% in Basel II). It also requires an additional mandatory capital conversation buffer of 2.5% and a discretionary counter-cyclical buffer (Federal Reserve Board Staff, 2006). Leverage Ratio It introduced a system of minimum Leverage Ratio which is in excess of 3% and was further increased to 6% in 2013. The leverage ratio is calculated on basis of dividing Tier-1 capital by the total average consolidated asset of bank (Credit Suisse Group, 2003). Liquidity Requirement It introduced two liquidity ratios which are “Liquidity Coverage Ratio” which a bank is expected to maintain as a cover of its total net cash flow outflows over a period of 30 days and a “Net Stable Funding Ratio” to ensure a stable funding over a period of one year extended stress (Carey, 2002). 4.1 Positive and Negative Views on Basel III Basel III shall enhance the safety for banking system however with additional safety comes additional cost and it shall be expensive for banks to hold an extra capital to be more liquid. Basel III has essentially built a new layer over the old Basel II architecture and has a bad job of reducing the unforeseeable risks and further the value at risk structure pushes the risk into the tail which is not clearly addressed in Basel III. However on a brighter side, Basel III shall help bank to maintain a better liquidity position and fight against risks in a better linear fashion. It further increases the soundness of banking system to meet up financial crisis which is much prominent in today’s world. It is arguably one of the most important responses to international financial crisis. 5. Conclusion This report has been designed to provide a clear understanding of the various Basel Accords. The report highlights the basic principles governing each Basel Accord with the negative and positive views on the same. The report further has been designed in a sequential manner to enable readers with a clear understanding of the transition of one Basel Accord to another along with the major differences among with to ensure both theoretical and practical exposure to the readers. 6. References Berger, Allen N., 2004, “Potential Competitive Effects of Basel II on Banks in SME Credit Markets in the United States,” Working Paper Federal Reserve Board, February. Calem, Paul S. and James R. Follain, 2005, “An Examination of How the Proposed Bifurcated Implementation of Basel II in the U.S. May Affect Competition among Banking Organizations for Residential Mortgages,” working paper presented at the AREUEA Meetings, January. Calomiris, Charles W. and Richard J. Herring, 2002, “The Regulation of Operational Risk in Investment Management companies,” Perspective, Investment Company Institute, September, pp. 1-19. Carey, Mark, 2002. “A Guide to Choosing Absolute Bank Capital Requirements in Ratings, Raring Agencies and the Global Financial System, edited by Richard M. Levich, Giovanni Majnoni and Carmen Reinhart, Kluwer Academic Publishers, 2002, pp. 116-138. Credit Suisse Group, 2003, The New Basel Capital Accord: Comments of Credit Suisse Group, November 3. Federal Reserve Board Staff, 2006, “Memorandum on the Notice of Proposed Rulemaking Implementing New Risk-Based Capital Framework in the United States,” March 22. Federal Reserve Board, 2006, “Draft Interagency Proposed Rulemaking to Implement Basel II Risk-Based Capital Standards for Large, Internationally Active Banking Organizations,” draft Federal Register Notice, March 30 Ferguson, Roger W., Jr., 2000, “Community Banks: Opportunities and Challenges in the ‘Post Modernization Era’,” Remarks before the Independent Community Bankers of America, May 2. Ferguson, Roger W., Jr., 2003a, “Basel II,” Testimony before the Subcommittee on Domestic and International Monetary Policy, Trade, and Technology, Committee on Financial Services, U.S. House of Representatives, February 27. Ferguson, Roger W., Jr., 2003b, “Basel II: A Realist’s Perspective,” Remarks at the Risk Management Association’s Conference on Capital Management, April 9. Ferguson, Roger W., Jr., 2003c, “Basel II: Scope of Application in the United States,” Remarks before the Institute of International Bankers, June 10. FDIC, 2006, “Key Aspects of the Proposed Rule on Risk-Based Capital Standards: Advanced Capital Adequacy Framework,” Financial Institution Letters, last updated September 25. GAO, 2007, Risk-Based Capital: Bank Regulators Need to Improve Transparency and Overcome Impediments to Finalizing the Proposed Basel II Framework, United States Government Accountability Office, GAO-07-253, February. Hannan, Timothy H. and Steven J. Pilloff, 2004, “Will the Proposed Application of Basel II in the United States Encourage Increased Bank Merger Activity? Evidence from Past Merger Activity,” Working Paper Federal Reserve Board, February 18. Heller, Michele and Todd Davenport, 2005, “Congressional Pressure for Consensus on Basel II,” American Banker, March 15. Herring, Richard J., 2002, “The Basel 2 Approach to Bank Operational Risk: Regulation on the Wrong Track,” The Journal of Risk Finance, vol. 4, no. 1, fall, pp. 42-45. Herring, Richard J., 2004a, “The subordinated debt alternative to Basel II,” Journal of Financial Stability, 1, pp. 137-155 Herring, Richard J., 2004b, “How Can the Invisible Hand Strengthen Prudential Supervision?” in Market Discipline: Evidence across Countries and Industries, edited by Curt Hunter, George Kaufman, Claudio Borio, and Kostas Tsatsaronis, Cambridge: MIT Press, pp. 363-379. Herring, Richard J. and Jacopo Carmassi, 2007, “The Structure of Cross-Sector Financial Supervision,” Financial Markets, Institutions & Instruments, forthcoming. Kane, Edward J., 2007a, “Basel II: A Contracting Perspective,” Journal of Financial Services Research, forthcoming. Kane, Edward J., 2007b, “Connecting National Safety Nets: The Dialectics of the Basel II Contracting Process,” working paper, August 1. Read More