International Banking Regulation and Basel Modifications - Essay Example

International Banking Regulation Name xxxxxxxx Course xxxxxxxx Lecturer xxxxxxxx Date xxxxxxxx Question 1: Basel Modifications In 2009, following the Global Financial Crisis of 200b that started in the US and quickly spread to Europe and the rest of the international economy, the Basel Committee on Banking Supervision proposed improvements to Basel II. They were intended to strengthen the Basel framework for banking and to respond to the crisis effects and lessons. These amendments have culminated into the development of a new regulatory system based on Basel III. Essentially, these amendments revolve around the need for securitization and enhanced risk management with regard to Pillar 1 (minimum capital requirement), Pillar 2 (supervisory) and Pillar 3 (market discipline) (Basel Commitee on Banking Supervision 2009). With reference to minimum capital requirements, the amendments make reference to risk weights entrenching a need to enhance resecuritization. The changes require that banks which use internal ratings-based approaches for securitization do effect application of higher risk weights in the analysis of resecuritization exposures. It is also proposed that risk weights should be changed in effect. Pursuant to higher risk weights the changes effected, securitization on liquidity facilities requires that banks apply a 50% credit conversion factor without regard to maturity time of the facility according to the standardized approach. This removes the alternative ratings and maturity times differences. As per the IRB approach, there are changes to effect clarifications on seniority of liquidity facilities. Market disruption lines, in the new dispensation, will not accorded any favourable treatment The changes on pillar 2 are emphatic on risk management and keener supervisory responsibility. Essentially, they are not amendments to the pillar, but rather serve to enhance it. This is in response to the discovery that financial institutions were oblivious of the risks related to credit products and businesses they dealt with. The institutions are cited as having overlooked vital risk management and financial judgement principles. As such, Basel indicates a need for adequate on- and off-balance sheet risk provision and long-term capital maintenance. The enhancements are commensurate to the core principles for banking supervision, also known as “The Basel Core Principles” (Basel Commitee on Banking Supervision 2006). They point out the need to have firmwide risk oversight systems comprising set policies, procedures and limits, active oversight teams, risk monitoring and reporting, internal controls and focused management information systems. In addition and closely related to the latter, the changes focus on pillar 3 intended to promote financial discipline. This pillar is perhaps the main element featured in the crisis. According to Meyer Brown (2009), the Committee seeks to address market risk capital requirements by seeking to improve the trading book exposures. There is more emphasis on the risks related to risks. With regard to this, the Committee proposes the market risk rule, a risk-based capital requirement. The rule empowers banks to use a value-at-risk approach with internal models for the purpose of addressing general risks. Essentially, the proposed ammendments seek to enshrine stricter market discipline by promoting sustainable disclosure practices. Specifically, the Committee addresses trading book securitization exposures, off-balance sheet vehicles sponsorship, resecuritization exposures, securitization exposures valuation, asset-based commercial papers (ABCP) liquidity facilities, and pipeline and warehousing risks (Basel Commitee on Banking Supervision, 2009; Mayer Brown, 2009). Implementation of the changes The changes to Basel II in response to the global economic crisis:improved risk sensitivity and mitigation importance, flexibility, supervisory review and market discipline provide a platform for growth of global modern banking regulatory framework. Firstly, it is essential to note that the changes are getting effected and implemented in economic situations in which markets still remain with shreds of turmoil. As such, the expected changes in securitization and market stability may not be immediate. However, economies have made significant progress in implementing these changes, that are new substantially manifested in the succeeding Basel III. This notwithstanding, the progress would make more gains for if there was increased transparency with regard to the question and concerns of effecting the changes in individual systems. For instance, Chris (2012) and FSB (2011) cite differences in implementation of the changes with respect to the shadow banking industry. This is attributed to Basel’s failure to stipulate with clarity the definition of banking implying that proposed prudential and capital buffers would have limited impact on the industry as the banks were non-deposit taking. As a result, the interpretation and implementation was at the discretion of national authorities which determined the extent of implementing Basel Capital Accords. This is where the transparency has been faulted resulting in discriminatory application of regulatory supervision across levels of institutions and with reference to individual financial institutions. For instance, implementation was more speedy and enhanced in the EU than the US market (Chris 2012). The implementation has also been hampered by the concerns that Basel II is increasingly becoming an expensive compliance, especially with regard to economic times hardships. This problem can be alleviated if the Committee focuses on removing ambiguities in areas such as determination criteria for average level of aggregate capital and what to do with cyclical variation in regulatory capital (U.S Government Accountability Office (GAO) 2007). In implementation, there have been efforts to explore installation of risk indicators in various aspects that concern the banking sector. The Committee has evaluated the extent to which economies have enacted regulatory indicators. This characterizes economies into four categories depending on the status: draft regulation not published, draft published, a final rule published but yet in force and final rule in force (Basel Committee on Banking Supervision 2011). According to the report, European Union economies have taken a lead with the EU expecting that member states would have a full transposition effective by December 2011. As such, there are economies which will have to run and are running parallel implementation programs for both the amendments and the succeeding Basel III. Basel III framework In view of delivering safer banking and ensuring enhanced local and global economic conditions, the Committee has developed the Basel III framework which replaces Basel II. Basel III has been refered to as the global regulatory framework which will help improve resilient banking (Basel Commitee on Banking Supervision 2011). This framework sets to expressly deal with the outcomes of the economic crisis in a more firm approach than its predecessor. It has express reforms focused on strengthening capital and liquidity regulations, as well as improve the banking sector and individual banks rating of resilience and stability. Firstly, the model, as advancement of the Basel regime, requires the maintenance of a minimum capital ratio. The ratio must be maintained at 8 % constantly with 6% making up the Tier 1 capital and the rest being Tier 2 capital. This presents a stronger system than Basel II requirements based on emphasis on a higher percentage of Tier 1 capital- common equity. As such, the reforms raise the threshold on the quality and quantity of regulatory capital base. By using the leverage ratio, the framework intends to constrain leverage excesses that have characterized the previous banking systems. In a similar token, there is a focus on capital conservation buffer requiring maintenance of 2.5% of common equity without which banks are prohibited from paying dividends or bonuses (Morrison 2012). According to Chris (2012), the new framework emphasis on capital based safety is demonstrated by a shift from risk-weighting to capital requirements. This, in my view, presents a safer tenet of operation given that the foundation is on the numerator. It is now mandatory for banks to hold at least three times as much capital on reserve drawing them to more conservative market positions with improved buffer against losses. This requirement on the numerator is enhanced by stricter denominator (risk weights) requirements. This covers risk exposures Basel II is accused of overlooking and consequently precipitating the crisis. As such, there are additional capital charges for different risks to take care of trading book aspects such as off-balance sheet risks and derivatives exposures. Closely related to this are changes in liquidity management to ensure that banks have adequate short-, medium- and long-term liquidity. This reforms entail the introduction of two additional ratios: Liquidity Coverage Ratio and Net Stable Funding Ratio. The former requires that institutions should maintain adequate convertible assets that can serve the institution’s needs in severe liquidity stress for a month. The latter is intended for a longer term, one year, and requires that there be a minimum amount of funds sources that are stable with relativity to assets liquidity profiles. It is also based on the potential for contingent needs that emanate from off-balance sheet commitments (Basel Commitee on Banking Supervision 2011). Essentially, this ratio aims to promote better liquid risk assessment and reduce overreliance on short-term whole sale funding. The preceding section has attempted to shed light into the reforms proposed by the framework. In my opinion, Basel III provides an opportunity for safety and resilience in the banking sector. It has provisions and requirements that address the weaknesses of the preceding frameworks in the regime. In spite of indications that its implementation is an expensive engagement, risk mitigation is considerably well covered. On the cost side, it is expected that there will be increases in the lending costs for lenders causing a pressure increases on loan prices. This results from the emphasis on eventually quadrupling common equity assets. In risk mitigation, this framework is serious on alleviating systemic risk. A group report to the G20 by the Finacial Stability Board (FSB), the IMF and Bank for International Settlements indicated the role of Basel III model in establishing macroprudential instruments. This address the systemic risk concerns from the dimension of time and crosssection. In response to procyclicality, a time-dimension of the risk, the model establishes a maximum leverage ratio, and capital conservation and countercyclical capital buffers. In addition, this model enhances the development of fall-back plans that are stable. The G20 leaders have admitted that the global economy has become bigger in volume and size, and more significantly in volatility. This volatility contributed to the crisis instability affecting even economies with solid fundamentals. The global systemic nature is significantly responsible for this. In addition, it has been indicated that globalization is characterized sophistication of financial institutions and products, and deregulation of markets that paints the picture of the increasingly interdependent financial systems. This implies a higher susceptibility to operational risk which is multidimensional in time and crosssection. This requires a solid fall back plan that is relative to banks asset based and that least requires state assistance. In this view, Basel III entrenches the need for solid short- medium-, and long-term common capital equity providing a buffer to individual banks, and banking systems locally and internationally. Additionally, the model proposes enhancements in risk weights so that systems are buffered. As indicated in the previous section, this framework has had its share of criticism. Its effect on loan prices leading to a credit crunch has been linked to possible declines of much sought-after economic recovery and growth. It is expected that there will be increase price pressure due to the higher equity buffers expected. In addition, Chris (2012) points out three key areas. Firstly, it is argued that tier 1 capital ratios recommended are not adequate to leverage institutions in crises commensurate to the recent one. As such, it is recommended that economies would benefit from ratios that are as high as 50% of weighted risks. In the same token, Wolf (2010) argues that the risk-weighting in ineffective as a regulatory tool. Secondly, there are issues with the 2019 time limit given for full implementation of the model. As such, majority of institutions are still in Basel II regime. It is possible that Basel III may have outlived its use given the ultra-dynamism of the globalized systems. Finally, Chris (2012) cites fault in the flexibility and discretion in risk-weighting over various jurisdictions. There is also substantial ambiguity in the calculation of risk weights. Essentially, the critics of the model are emphatic that given the impacts and lessons related to the previous crisis, any established regulatory framework should be adequately equipped to take care of loopholes that have been previously overlooked. The G20 leaders refer to this as strengthening of global finacial safety nets’. It is also vital that international systems should not focus only on regulations, but also on transformation of financial systems. Question 2: International Banking Regulation When international trade rather than domestic trade takes place there is a crucial difference. If a French resident, for example, purchases a product made by France factors of production in France, only one currency, the franc, will be involved. If, however, a French resident buys a good which has been produced abroad and imported into France, currency exchange must take place. This is because the French resident will use franc to buy the product in the shop but the foreign factors of production will require payment in their own currencies. Over the last 30- years or so, international trade in the world economy has grown more quickly than GDP growth. This trend is expected to persist, as the various economies of the world become more dependent upon each other through global market. Markets across the world are becoming more integrated, with developed and developing countries becoming much more economically dependent upon each other. For developing countries, trade is the main way in which they can realize the benefits of globalization. Strategies used by a number of European banks are: Consumers in European countries have an increasing variety of products to choose from as European banks simulate financial products offered in other countries into these countries very cheaply and efficiently (Block & Hirt 2008). Foreign banks provide additional competition especially for domestic banks. It also exposes them to the practices of such foreign banks. In turn, investing in other European countries enlarge the markets for the products of these countries, benefiting the banks and their employees. Trade gives banks in European countries access to improved capital inputs, so improving their own productivity. There has been substantial re-allocation of resources in the world economy. This can be seen through the ongoing shift in manufacturing activity from an industrial tourism growth has also benefited many European countries. The World Trade Organization (WTO) set up in 1995, has sought to create an environment in the world economy conducive to unrestricted multilateral trade. The most sensitive task it has faced to date has been to reduce trade barriers on international trade and ensure there is an equitable treatment of various regulations (Verdier 2009). These products provide genuine opportunities for many countries to trade in world markets. Despite the work of WTO, the structure of international trade in the twenty first century is such that the benefits are being realized, not so much on a global scale, but through the increasing role of regional trading blocs, although the WTO continues to press greater exchange between blocs and developing countries. Financial institutions help in money creation in any country. When individuals or firms deposit cash in bank the deposited cash become a liability to the bank and an asset to the depositor. The bank converts this liability into an asset in form of reserves and loans given out to borrowers. The process of money creation continues indefinitely subject to three limitations: the cash ratio, lack of demand for loans, and cash drain. These limitations are cause of the severe difficulties being experienced by a number of European banks, particularly those in Spain. There are three categories of financial institutions: central banks, commercial banks, and non-bank financial institutions. Commercial banks have a duty to: facilitate transactions or exchange; provide facilities for saving and borrowing, and help to distribute credit among business enterprises and individuals. They face various types of risks which include; credit risk, market risk, insurance risk, liquidity risk, operational risk, legal and regulatory risk, strategic risk, and related party risk. Banks can use stress testing tool to identify anticipated negative results in many risks. The tool helps in providing prior assessments of risk; defeating models’ limitations and limitations of historical data; supporting internal as well as external communication; feeding into liquidity and capital planning procedures; helps in setting the levels of risk tolerance by banks, and facilitates the development of mitigation of risk across many stressed conditions. Creating a new regulator in Europe which supervises directly the biggest banks would alleviate the existing difficulties since the regulator will: act as a financial advisor of the Euro zone governance; supervise European banks as well as the non-bank financial institutions; it will act as a bankers’ bank through extending credit to the European banks, and according to International Monetary Fund (2010), will represent the trading block in international monetary meetings. The process by which trading blocs have been established is referred to as economic integration. It refers to deliberate ways in which national economies of developing nations agree to merge their economic affairs into a single economic organization. Consequently, there is a blurring of their boundaries as their economies become more closely linked to each other. The three main forms of organization are described below: Free Trade Zone- the loosest form of organization involving the systematic removal of trade restrictions between members. In practice, this may be for just a selected range of products. Customs Union- The crucial feature is that members agree to erect a common external tariff on trade on trade with non-members. This tariff may be may be on all trade with non-members. This tariff may be on all trade or, as is the case with the EU, mainly on imported services which member states are able to adequately provide themselves. Economic Union- This involves the removal of restrictions on the movement of factors of production (labor, capital and enterprise) between members. The most important issue is whether these regional trading blocs actually enhance, or detract from global economic welfare. There are two effects: Trade creation- consistent with absolute and comparative advantage, trade is generated between members over and above what might otherwise have happened. Greater specialization occurs and less efficient producers lose markets as imports from within the group replace their production. Trade Diversion – more difficult to explain and only occurs when external trade restrictions are imposed. Trade from outside the group is replaced by trade from within; this is not consistent with an efficient allocation of resources as the prices paid for such goods will be higher than if purchased on the open world market. Price is an important factor in determining purchasing decisions, but it is not the only consideration. Other factors include design, quality, reliability or availability. Over long periods of time, European banks can become uncompetitive internationally in one or more of these factors. Indeed it is often argued that the Spain has suffered this fate over the past century. What then happens is that the economy finds it more and more difficult to export whilst imports increase. There is therefore continual downward pressure on the exchange rate. The debate about what makes a multinational company is internationally uncompetitive is the same as the debate about why a country grows at a slower rate than other countries. In services, access to markets was the key issue. In many service markets, non tariff barriers, such limiting the ability of foreign companies to bid for government contracts, were key to restricting trade. Forcing open markets would increase trade. First world countries are particularly concerned to tighten up intellectual property rights in the face of widespread piracy, whilst third world countries wants their rights over plant derived compounds and traditional knowledge and folklore protected. Agreements to tighten up the role of the WTO in settling trade disputes are being negotiated. The immediate causes of high levels of inflation in a country are complex. However, one fundamental reason why economies can become fewer prices competitive over time is labor productivity (i.e. output for each worker). If output for each worker, for instance increases at a rate of 2% per annum in the Spain and 5% per annum in Germany, then it is likely that Spain is less competitive internationally than Germany over time. Wage costs are the single most important element on average in the final value of a product. World Capital flows (international trade financing) have been growing over time. This has been one aspect of globalization. International trade financing occur for a number of reasons: Speculators are looking for quick profits. Shifting capital round the world, buying and selling debt and shares, trying to spot which currency will appreciate in value and which will fall, they are inevitable part of the world capitalist system. Capital flows are an essential part of finance of trade. A Germany resident may take out a Germany loan to buy a car. A Germany firm may take out a Germany loan from Spain to finance the purchase of a machine from Spain. Banks in one country are finding it increasingly profitable to lend to economic agents in another on short term basis. A Spanish bank, for example, may decide to expand its operation in the French loan market. Individuals transfer funds abroad for a number of reasons. One is that they might have a house in another country. Foreign direct investment occurs because a firm in one country can see that it can make a profit by investing in a longer term in a firm in another country. Portfolio investment occurs for the same reasons as FDI or it may be more speculative in motivations. Part of portfolio is investment in government bonds, a form of long term loan to governments. It should be noted that any economic shock from one of the country in a trading block is experienced in other trading partners since they share the same currency (Pratt, 2010). This creates the need of establishing a regulator who will oversee the financial deliberations in Euro zone countries. The regulator will help to strengthen the financial institutional basis of one currency in order to avoid financial crisis within the region (Brummer, 2011). When one country grows more than another, it will experience a boom which will transform its shocks into the entire public finance since there is no federal budget and thus cause shocks of financial stability. Therefore European countries need a regulator who disciplines both the private and the public sector so that all countries exercise their fiscal policies at the same level, which includes avoidance of excessive deficits. The regulator should be guided by a set of principles if it is to be effective in supervising directly the biggest banks. These principles of regulation are discussed below. The power to set the licensing criteria and reject applications for setting up a bank should be left to the licensing authority. The regulator should review all mergers and acquisitions and also operations in other economic countries in order to prevent introduction of risk exposure to European banks. The regulator should set the minimum capital requirements for the banks. This will help the banks to avoid assuming too much risk than they can afford. The regulator must ensure the banks adhere to comprehensive process of risk management. The banks should consider their risk profile that prudently identifies, measures and controls its credit risk (Pritchard and Kemshall, 1995). The regulator should set limits of exposure by banks. This should be guided by the level of concentration in a portfolio and extend to related parties on arm’s length. All European banks should maintain sufficient reserves and transfer risks to related parties so that at no one time should the bank retain so much risk than it can afford to mitigate. The regulator should ensure that the banks efficient internal control measures and audit of accounts. Each European bank should keep sufficient records in line with international accounting practices and policies. This will eliminate cases of duty overlap and a single individual committing the bank which might afterwards cause it to be in financial distress. References Basel Commitee on Banking Supervision, 2006. Core Principles for Effective Banking Supervision, Basel : Bank for International Settlements. Basel Commitee on Banking Supervision, 2009. Enhancements to the Basel II Framework, Basel: Bank for Intenational Settlements. Basel Commitee on Banking Supervision, 2011. Basel III: A global regulatory framework for more resilient banks and banking systems, Basel : Bank for international settlements. Basel Committee on Banking Supervision, 2011. Progress report on Basel III Implementation, Basel: Bank for International Settlements. Block, S. B., & Hirt, G. A. 2008. Foundations of financial management (12th ed.). Boston, MA: McGraw-Hill/Irwin. Brummer, C., 2011. Soft Law and the Global Financial System: Rule Making in the 21st Century. Cambridge: Cambridge University Press. Chris, B., 2012. Soft Law and the Global Financial System : Rule Making in the 21st Century. Cambridge: Cambridge University Press. FSB, 2011. Shadow Banking: Strengthening Oversight and Regulation, FSB. International Monetary Fund, 2010. Australia: Report on the Observance of Standards and Codes-Data Module. Sydney: International Monetary Fund. Mayer Brown, 2009. Base II Modified in Responses to Market Crisis. Securitization Update, 23 July, pp. 1-11. Meyer Brown, 2009. Securitization. Financial services regulatory & enforcement update: Basel Committee Issues Risk-Based Capital Proposals Responding to Market Crisis. Meyer Brown, 18 February, pp. 1-8. Morrison, R., 2012. The principles of project finance. Farnham: Gower. Pratt, J., 2010. Financial Accounting in an Economic Context. New York: John Wiley and Sons. Pritchard, J. and Kemshall, H., 1995. Good Practice in Risk Assessment and Risk Management. London: Jessica Kingsley. The G20 Seoul Summit Leaders’ Declaration, November 11-12, 2010. Available at https://store.tdjakes.org/p-2727-in-between-miracles-3-dvds.aspx U.S Government Accountability Office (GAO), 2007. Risk-based capital: Bank regulators need to improve transparency to finalizing the proposed Basel II Framework. Washington, D.C: GAO. Verdier, P., 2009. Transnational Regulatory Networks and Their Limits. The Yale Journal of International Law, 34(113), pp. 114-171. Read More