Banking Regulatory Reforms - Report Example

?Banking and Insurance Law Spring Dr Ifzal Akhtar Section XXX IDs: Majors: Assignment Basel III (30 Banking Regulatory Reforms Introduction The origination of Basel accord can be traced back to the exchange rate crisis occurred in 1974 due to breakdown of the Bretton Woods system. The Federal Banking Supervisory Office of West Germany cancelled the banking license of Bankhaus Herstatt when they discovered that the bank had foreign exchange exposures that were three times to its capital. Due to this act of the central bank, many banks had to suffer huge losses on their pending trades with Herstatt triggering a cascading effect in the banking sector. A few months later, the Franklin National Bank of New York had to shut their operations due to substantial foreign exchange losses. The turmoil in the financial sector prompted the governors of the central banks of G10 countries to decide upon measures on Banking Regulations and Supervisory Practices. Later, this came to be known as the Basel Committee on Banking Supervision with a purpose to extend cooperation among its member countries in the matters related to banking supervision. Initial objectives were to set minimum supervisory standards; exchange information on supervisory practices and improve the techniques of supervision on their banking system. The Central banks of the each member country represent their countries in the committee. It must be noted that the committee's decision has no legal bearing. The committee formulates standards and recommends them to their member countries for its implementation. The committee's sole aim is to have common standards for regulatory and adequacy measures. The 1988 accord among the member countries, with regard to the regulation and supervision of banking sector, continued until 1999 when the Committee decided to further improve the capital adequacy framework. Current Regime under Basel II The revised capital framework came into force in 2004 called Basel II. The Basel II was aimed at creating an international standard for regulators to decide upon how much capital the banks must have to safeguard themselves in the event of any financial crisis. Sufficient consistency of regulations was focused at to ensure that this does not become a reason of competitive inequality for some of them. Their advocates believed that such a regulatory framework is needed to prevent failure of banking system should such crisis emerge in the future (Basel Committee on Banking Supervision, 2013). Basel II, in theory at least, attempted to set up capital and risk management requirements so that banking failures could be avoided. For this, Basel II created disclosure requirements so that all market participants could know about the capital adequacy of a financial institution. They also ensured that market risk, credit risk, and operational risk are articulated based on available data. Basel II focused on minimum capital requirements, market discipline and adequate supervision (Basel Committee on Banking Supervision, 2013). Though Basel II regulatory measures were in force yet it could not prevent 2008 international financial crisis. Post 2008 crisis, the Central banks came out pointing various reasons of financial failures and about the weaknesses that existed in Basel II accord. An urgent need was felt by all concerned to address weaknesses in Basel II. That is why the Basal committee on banking supervision decided to create a new comprehensive accord that could further reform and address the issues that were instrumental in causing the 2008 financial crisis (Basel Committee on Banking Supervision, 2013). It will be interesting to see how Islamic banks, in the context of Basel II manage the capital adequacy and risk exposures. Islamic banks do not use money markets and that is why they are susceptible to liquidity risks. Their inability to borrow for short-term fund needs make them vulnerable to market fallouts. The situation necessitates that Islamic banks must maintain higher liquidity than any conventional banks. Basel II also expects from Islamic banks to meet regulatory and legal measures as applicable to others; however, the following could be prominent issues in Islamic banking (Hassan & Dicle, 2009). Deposit Insurance In convention banking system, most of the regulatory framework aims at creating deposit insurance schemes to protect interest of deposit holders. Islamic banking system does not have such insurance protection schemes and therefore deposit holders are exposed to risk. Current Accounts Current account holders create deposits with the Islamic banks for the safety of their funds. Islamic banks make investment of this fund and they do this without the consent of current account holders to make profits; however, profits are not distributed to the account holders. Deposit holders get their share of profit, only if the funds are invested along with other deposit pools. In view of the risk involved on the part of the deposit holders, it becomes important that regulatory authority makes it mandatory to seek insurance for current accounts. Profit and Loss Sharing Accounts Islamic banks' earnings come from their share of returns. It is up to them how they share the returns with the deposit holders for the share of funds provided by them; however, regulatory issues are involved here when rights of certain deposit holders are violated. Regulatory authority needs to impose a mechanism to regulate profit sharing that is acceptable to deposit holders. Islamic banks tend to match deposits with credits; however, they carry maturity related liquidity risks with regard to profit and loss accounts and regulatory authorities must find ways to regulate such risks. BASEL III The financial crisis of 2008 created a need to develop more stringent measures to control and regulate banking activities. The Basal Committee of Banking Supervision (BCBS) revised the capital adequacy measures and the framework came to be known as Basel III. Basel III norms were endorsed by G20 countries when they met in 2010 Summit in Seoul, Korea. The key recommendations of the Basel III can be summarized as per the following (Basel Committee on Banking Supervision, 2013). Basel III initiates three major reforms that are aimed at improving banking sector's ability to face financial shocks that may arise due to financial crisis; improving banks disclosures and transparency; and enhancing governance with respect to risk management. Basel III enforces on banks to maintain 4.5% of common equity against current norms of 2% in Basel II. Tier 1 capital requirements have been revised upwards to 6% of risk-weighted assets from the existing 4% in Basel II. Additional capital buffers need to be maintained in Basal III during high credit growth. Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are two important standards that have become a part of the Basel III. As per the LCR, banks will need to keep high-quality liquid assets in sufficient amount to ward off a 30-day stressed funding scenario. The NSFR, a long-term structural ratio, is aimed at meeting liquidity crisis. It will take into account the entire balance sheet providing incentives to banks to harness more stable sources of funding. Implementation of Basel III reforms has been earmarked such that it does not hamper the economic recovery adversely; accordingly, implementation has been phased out in 5 years. For example, the Tier 1 requirements and the minimum common equity norms revised from 4% and 2% levels respectively to 4.5% and 3.5% will be implemented by early 2013. They will be further boosted to 5.5% and 4% in the beginning of 2014 respectively; the last phase will finish in beginning of 2015 when Tier 1 capital and common equity will be raised to 6% and 4.5% respectively. Capital conservation buffer of 2.5%, in addition to the 4.5% minimum requirement, will come into effect from January 1, 2016 and will become fully effective only by January 1, 2019. Similarly, the liquidity coverage ratio (LCR) will get effective from January 1 2015 at 60% rate to become fully effective only on January 1, 2019 with equal annual increments of 10 percent. NCFR denoting minimum liquidity standard, as introduced in Basel III, will begin phasing in January 1, 2018 to address funding mismatches. Kafsa Kara argues that Islamic banks are adequately capitalized and many of them already exceed norms set by the Basel III. Islamic banks were least involved during last financial crisis. In fact, they fared reasonably well after the crisis; nevertheless, they aim at improving further. Islamic bank's structure is not only simpler but also more tangible to understand. As per Islamic Financial Service Board (IFSB), they have already initiated the regulations as per Basel III such as capital adequacy and the forms of additional capital needed. Islamic banking due to their high levels of Tier 1 capital, they are less impacted than many high-leveraged conventional banks (Kara, 2011). Conclusion Basel III is an extension to the Basel II imposing more stringent parameters on banking industry post 2008 financial crisis. It is need of an hour to safe guard the banking industry from the future shocks in the benefit of all stakeholders and Basel III is a right step in that direction. Basel III will certainly provide required cushioning to the industry and international economy by imposing norms on capital adequacy norms related to Tier 1 capital and common equity. The LCR and NSFR will provide more strength to banking industry and will help avoid any future financial crisis. Furthermore, Basel III provides enough time to banks to meet with the regulatory norms such as minimum capital requirements by 2015; conservation buffer by 2019; disclosing the leverage ratio by 2018; introducing the liquidity coverage ratio (LCR) by 2015 and the Net Stable Funding Ratio (NSFR) by 2018. Works-Cited Basel Committee on Banking Supervision (2013). “A Brief History of the Basel Committee”. Web. 30 Oct. 2013 Hassan, Kabir; Dicle, Mehmet. Basel II and Regulatory Framework for Islamic Banks. Web. 30 Oct. 2013 Kara, Hafsa. Islamic banks hold Basel III advantage. The Banker. Web. 2011. 31 Oct. 2013 Read More