The Basel Committee on Banking Supervision Issues - Essay Example

Take Home Exam Student’s Name Professor Course Date Answer One Basel II refers to the second of the three Basel records, which are commendations on banking regulations and laws that, the Basel Committee on Banking Supervision (BCBS) issues. It was initially published in June 2004, and it was established for the purposes of creating an international standard for banking regulators to be in charge of the capital, banks require to set aside to safeguard against the type of operational and financial risks the banks as well as the entire economy faces. Base II focus is to maintain adequate stability of regulations in a bid to ensure this does not develop into a source of competitive inequality amid the globally active banks. Its advocates believe that such a worldwide standard can assist the global financial system from problems, which may emerge in case a major banks or a series of banks go under. Base II has attempted to accomplish this by introducing capital and risk management requirements, which are crafted to make sure that a bank has enough capital for the risks that the banks expose themselves through investing and lending practices. Baseline II articulates three different forms of supervision: “Minimum capital requirements (Pillar One), supervisory review (Pillar Two), and transparency discipline (Pillar Three)” (Brummer 2012, p. 215). Baseline II is in the process of being substantially modified. One of the key principles under development is minimum capital requirements (Pillar 1) in the area of resecuritisations (Basell Committee on Banking Supervision (BCBS 2009, p. 1). One of the changes that the Basel Committee is making changes to under resecuritisations is resecuritisations risk weights where banks employing IRB “Internal ratings-based” strategy to securitization will be needed to use increased risk weight to resecuritisations contacts (BCBS 2009, p. 1). The standardized risk weights will also be changed for the same exposures. The third area refers to the “Use of Ratings Subject to Self-guarantee” where banks will not be allowed to apply ratings for exposure guaranteed or comparable support offered by the bank itself (BCBS 2009, p. 1). The fourth area to be changed entails “Operational requirement for credit analysis” where the banks will have to meet a particular operation criterion to employ the risk weights laid out in the securitization framework of Base II (BCBS 2009, p. 1).). The criterion is meant to facilitate the banks to undertake their individual appropriate attentiveness and not depend merely on rating agency credit ratings. The fifth change is on “Liquidity facilities in the standardized approach where the credit conversion factor (CCF) for every appropriate liquidity facilities (LFs) in the SA securitization framework will be standardized in spite of the LF maturity” (BCBS 2009, p. 1).. The sixth change on “liquidities Facilities in the IRB Approach” articulates that revised language shed light on when the liquid facilities may be taken as senior securitization exposures. The last change on “General market disruption LFs in the standardized & IRB approaches has to do with the favorable treatment of capital by general market disruption LFs under the SA as well as under the Supervisory Formula Approach (SFA) in the IRB as it has been done away with” (BCBS 2009, p. 1). The key developments also entails strengthening of Base II risk culture; especially for the off balance-sheet contacts and the trading book, develop the superiority of tier-one capital as well as build extra shock absorbers into the framework, which can be put into practice during stress periods to moderate procyclicality (Brummer 2012). The other key development entails evaluating the need to supplement risk-based measures of exposures in both risk management and prudential frameworks, which will allow the regulators to have increased freedom to take precedence over the models. The Basel committee also seeks to strengthen supervisory framework to evaluate the funding liquidity dependability as cross border financial institutions and leverage the framework to strengthen governance practices and risk management in banks. It also seeks to strengthen the counterparty credit risk capital, risk disclosure, and management in banks as well as advancing internationally synchronized supervisory follow up exercises to facilitate implementation of industry and supervisory sound principles. These key developments are meant to strengthen the framework as well as respond to lessons learnt from the financial crisis. These key developments followed the financial crisis, which led many countries to be motivated to reform their domestic regulatory systems as well as the international regulatory system (BCBS 2009). The developments are meant to address the fundamental weaknesses in supervision, regulation, as well as risk management practices, which were highlighted during the financial crisis. The devastation brought upon the financial institution amounted to loss of much money and led to the suggestions that Basel II is not adequate as a risk management framework in the form it was at the time. According to Brummer (2012), the Basel Committee efforts have been focussed on creating a new generation of capital requirements under a Basel III regime, on identifying systematically important financial institutions in the global context and determining the bank-compensation and corporate governance practices, which would strengthen financial stability (p. 77). After the financial crisis, the Basel Committee released numerous consultative documents to tackle the financial sector weaknesses. The documents have included proposed revisions to the market risk framework. The main aim of the strategy by the committee is to strengthen capital buffers and assist contain financial leverage in the banking system, which might arise from both on as well as off balance sheet activities. The final objective is to assist the banking sector to serve its long-established function as the financial system shock absorber as opposed to a risk amplifier involving the financial sector as well as the real economy (BCBS 2009). The Financial Stability Board (FSB) is responsible for surveillance of the reform agenda. The FSB succeeded Financial Stability Forum (FSF), which is an organization, which had been established in 1999 to boost exchange of information and collaboration between the regulators of various countries with important multilateral financial institutions and financial markets. The agenda of FSB is motivated mainly by the weaknesses in the financial regulation framework as well as cross border cooperation in developed countries shown by the financial crisis. To deal with the weaknesses of Basel 2, there has been an increased emphasis on links between solvency or capital on one hand and liquidity on the other hand. The connection was highly evidenced by the 2008 case of Bear Stearns and Lehman Brothers solvency, which showed that solvency relies on continued access to short-term finances (Brummer 2012). Secondly, there are currently increased clear acknowledgements that the risks allied to banks exposures to derivative are usually more in the care of non-standard products, which do not have a central counterparty. The quality of risk management by banks depends on the manner in which the banks employee is remunerated. The credit ratings also enters several points into the setting of Basel 2’s credit risk weight, for instance, the weights under the approaches which have been standardized and for securitization exposures. The manner in which the banks position values are measured as well as their estimated reported profits determine the international accounting rules. As a result, these rules have a significant bearing on the risk management of banks through the staff remuneration as well as their incentive structures and on the approvals of financial reporting in accordance with the third pillar of Basel 2 (Brummer 2012). The subject of crucial relations between the micro prudential regulations of macro prudential regulation and individual financial institutions is also intended to counteract systemic risks. The relations are important to the proposed addition of countercyclical provisions and buffers in Basel 2 revised version. Concerning securitization exposures, the banks are expected to carry out their individual diligence regarding the securitized assets. This serves to reduce failures on the front observed in relation with originate-to-distribute process during the credit crisis. For the aims of ascertaining capital charges, the securitization exposures calibration has been made more thorough to account for the risks in a better manner. Under the market risk heading, the capital charge was increased by the “Basel Committee on Banking Supervision” to account for default risks to position banks trading books underscored by the 2008 financial crisis (BCBS 2009). The other reform by Basel Committee entails improving regulatory capital countercyclical capital provisions and buffers as well as an overall leverage ratio. Concerning liquidity risk, the Basel Committee published principles of management and supervision of liquidity in 2008. The principles focus on individual banks practices, which is their requirement for enough liquidity cushions. Nonetheless, the Basel Committee oversight body decided that liquidity risk micro prudential principles should be supplemented by principles, which address the link between the systemic financial risk and the liquidity risk of institutions (Brummer 2012). These principles comprises of a framework for assessing system wide liquidity risk which serves as a basis for internalizing in individual financial institutions, the externalities which their activities generate. Concerning central counterparties and OTC derivatives, special emphasis has been focussed on broadening the use of central counterparties (CCPs) for clearing and settlement arrangements. Clearing and settlement are arrangements for completing security transactions whereby clearing covers confirmation of quantity and identity of the contract of financial instrument being sold or bought, the buyer and seller identities and the date and price. It may also cover trades netting. On the other hand, settlement netting refers to payment to the seller and transfer or delivery of ownership of the financial instrument to the buyer. CCPs serve the function on information repository and reduce the risk of credit through interposing themselves amid the transaction counterparties becoming the seller to each buyer and the buyer to each seller (Brummer 2012). This eliminates the risk of domino defaults arising from the failure of one party to a number of bilateral derivatives contract. Basel 2 has been revised such that the least regulatory capital requirements show more correctly the risk related to the other choice. Markets served by CCPs will have reduced capital requirements for derivatives. The Basel Committee is currently establishing minimum regulatory charges for credit risks. Basel III can change the framework under which large banks must operate as it has additional supervision and regulatory frameworks. The banks have to meet their capital ratios by 2019 while the liquidity assets to avert a Lehman-like collapse have to be achieved by 2015. To achieve these liquidity assets, large banks have to shed their risky portfolios and the capital satisfactoriness has to attain through adding profits to reserves and raising new capital. Basel III is a step in the right direction as it builds on Basel II three pillars and addresses the weaknesses of Basel II, which failed to cushion financial institutions against the effects of the financial crisis (BCBS 2010). Basel III will raise the banking sector resilience through fortifying the regulatory capital framework; developing Basel II 3 pillars. The reforms will enhance the quantity as well as the quality of the “regulatory capital base” and improve risk coverage structure. The leverage ratio will constrict surplus advantage in the banking system and offer an added safety level against measurement error and model risk (BCBS 2010). In Basel III, there are also various macro prudential constituents in the capital framework to assist control systemic risks, which come about from the financial institutions interconnectedness and procyclicality. Basel III will make international financial safer as it has introduced harmonized worldwide liquidity standards which lays down the minimum requirements similar to the global capital standards. This will promote international level grounds to facilitate prevention of competitive race to the bottom. Although most of its aspects are good, Base III can be improved by addressing the issue of risk weighting. Base III has inherited some of the problems of Base II in the whole concept of risk weighting (Brummer 2012); the notion that various assets are riskier compared to other and the fact that banks should hold more capital when it comes to risky assets that they hold against assets, which are much safer. This idea supposes that securities that have been risky in the past are similar to securities that will be risky in the future, which obviously is untrue. Since the committee did not alter risk weighting, Basel III efficiently doubles Basel II shortcoming on risk weighting; financial institutions will be required to hold added common equity than ever-against their risk-weighted assets (Brummer 2012). National securities regulators and various financial institutions, use ratings as the basis for making determinations regarding the suitability of various investments, the institutions riskiness, and provision of credit, and the access that some companies have to various investors classes (Brummer 2012). Base III extremely increase the inducement to look for weight assets with low risk to get some profit as these assets can be leveraged increasingly higher relative to the risky assets. Base III should thus address the issue of risk weighting. According to Brummer (2012), Basel III continues to rely on credit ratings, though, it supplements risk weightings with stress testing, which itself remains suspect. The Basel approach for the most part addresses the causes and consequences of the global financial crisis however, it is lacking in various aspects, which limit its effectiveness. For instance, Pillar one of Base II collapsed under the weight of the 2008 financial crisis even though the framework has just been established (Brummer 2012). Nevertheless, Base III has tackled the most of the weaknesses of Base II by establishing better quality capital and liquidity. The regulatory tools and rules will have unequivocally macro-prudential focus. Answer Three The system of international financial regulation has been criticized as illegitimate, obscure, and unaccountable. This is not true. The system is not illegal, as most of the governments have embraced the international financial regulation and have chosen to embrace international financial regulation through approaches such as Basel. The governments realized the need to do so because over the last twenty years, they have chosen to eliminate obstacles to cross border flow of capital and opened their domestic to foreign financial institutions. These changes have led to a progressively more integrated world in the international finance arena. Various policymakers have pointed to recent financial woes in Russia, Latin America, and Asia to conclude that the integration calls for increased international regulation of financial institutions. Nevertheless, international financial regulation has been effective in establishing practices and oversight for financial activities to guarantee the strength of the global financial systems (Brummer 2012) The international financial regulation is designed to avoid or at least mitigate the risks inherent in business, especially insolvency risks which encompass the risks in bank loans (credit risk) and market or investment risks, and systemic risks, which cause social costs to be imposed on an economy because of a transmittable breakdown of a financial intermediary. As a result, international financial regulation supports the reliability as well as the safety of the financial systems. The international financial regulation reduces information asymmetry, which increases the risks to which financial institutions such as banks are exposed. By its fundamental nature, banking involves the credit risk, which borrowers may fail to repay their loans to banks (Brummer 2012). One important aspect of risk is that banks are usually not knowledgeable enough about the market conditions, borrowers’ revenue stream, as well as the organizational integrity than the borrower. In a similar manner, the insurance company risks (over and above insurance claims spate) entails possible insurance claims customers being more well informed about their propensities to generate insurance claims compared to their issues. Even the securities transactions involve considerable risk insofar as traders and investors of securities are likely to have considerable limited information about a company prospects for future success that the security issuers. Following this, it is evident that financial institutions are put through a number of capital reserve requirements in case the investments go bad hence financial regulations are mostly focused on the systemic risks generated by financial institutions. The interconnectedness of financial institution, which has resulted from increase in cross border capital, has necessitated the need for financial regulation. For instance, the 2008 financial crisis showed the interconnectedness of financial institutions across the globe (Brummer 2012). Most countries have as a result moved to embrace international financial regulation to safeguard their financial institutions, which are interconnected to other institutions in other countries. The international financial regulation is not obscure or incomprehensible. It relies on soft law standards and network of regulators in offering effective cooperation while enabling the benefits of flexibility, speed, as well as expertise in regulation of international financial markets. Some people have called for a formal international organization in regulation of finance. Nevertheless, the international finance regulation system in its current state has been largely successful in enabling basic cross border supervision as well as enforcement assistance among regulators’ and getting rid of barriers to international finance through harmonizing various national rules (Brummer 2012). Nonetheless, it has faced various setbacks in its attempts to increase regulatory standards in states where dominant domestic constituencies oppose changes. Secondly, it has struggled to secure resilient collective action among main jurisdiction to increase prudential standards such as capital adequacy regulations. It has also been unsuccessful in creating plausible means of addressing situations whereby unilateral action is counterproductive. The absence of a binding international legal commitment to implement regulations such as Basel and other international financial standards has taken these standards to be considered as outside the scope of customary international treaties and law. Nevertheless, numerous countries have so far implemented the 1988 Capital Accord and are undertaking arrangements to implement Basel framework (Brummer 2012). For instance, the European Community has implemented the Capital Accord into EU law and has committed itself to implementing Basel (Brummer 2012). The growing consistency of state practice with the Basel Accord as well as other international financial standards point to the fact that it is possible to have a uniform practice of states without a general practice of states, which does not have as its motive the formation of customary rules of international law. In this sense, the subject element of state practice does not contain the belief that it has a legal obligation. This absence of a legal obligation offers standard setters and regulators with the needed flexibility to act rapidly to financial markets developments and to set up non-binding standards in a manner, which suits their jurisdictions needs. This is the reason why international soft law remains viable as an instrument for reforming international financial regulation (Brummer 2012). Numerous international rules and standards for banking supervision and regulation have evolved from a purely voluntary and nonbinding role to an increasing obligatory and precise status backed by both market and official incentives and sanctions. This is evident in the voluntary financial standard-setting process in Basel, which was initially meant to apply only to the G10 countries, however has currently been extended by the World Bank and IMF to most of their member countries through conditionality and surveillance programs (BCBS 2009). Most of the international guidelines, rules, standards as well as other arrangements, which govern financial regulation, are not of a legally binding nature and was as a result referred to as “international soft law.” The theoretical framework of international soft law embraces both legally binding and nonbinding rules as well as standards of international financial regulation. Unlike the traditional international organizations, most international regulatory organizations depend on “soft” administrative structures. This is the reason why it is vulnerable to the criticism that it is illegitimate, unaccountable, and obscure. For instance, the Basel Accord, which was initially meant for G10 countries, has extended the extent of coverage of its global principles as well as standard to every country whereby international banks is in operation (BCBS 2009). The Basel Committee endeavors to generate uniform and common regulations which would be relevant all through the international financial system have been met with opposition from most large developing countries as well as emerging companies as they suppose that they should not be forced to take up standard which they took limited role in establishing. Most recently, in response to serious defects n G10 country regulation, the Basel Committee expanded its committee membership to 20 countries in March 2009 (Brummer 2012). Although the expansion of the Basel Committee’s membership to 20 countries (including China, Russia, Brazil, and India) improves its political legitimacy and accountability, there remain serious concerns. These concerns have to do with the committee mandate legitimacy, as there are a large number of developing countries as well as emerging market countries, which are not on the Committee and have little influence in the standard setting (Brummer 2012). This shows that the decision making structure is criticized on the grounds of procedural accountability as well as the broader issue of political legitimacy. Nevertheless, most non-G10 countries have incorporated the Basel standards into the regulatory framework for various reasons such as strengthening the soundness of their commercial banks, to raise their credit rating in international financial markets and to attain a universally recognized international standard (Brummer 2012). In addition the adherence requirement made by the IMF and World Bank have necessitates most countries to adopt the Basel Accord to qualify for financial assistance (BCBS 2009). The accountability of the Committee arises from lack of clear procedures on the way decisions are reached among the members of the Basel Committee. In addition, the decision-making procedure repeatedly entails the exchange of confidential and insightful reports and hence the regulators require the discretion as well as flexibility to offer frank and sincere evaluations of state regulatory rules exclusive releasing this information to the public. Complete revelation of every one of discussions may possibly dissuade regulators from making honest evaluations of restructuring suggestions and hence undercut the effectiveness of the standard setting procedure (Verdier 2009). Furthermore, crisis durations, successful decision-making may often necessitate officials and regulators to convene within short notice and in private for purposes of making emergency resolutions, which can have considerable impacts in preventing a full-scale catastrophe. There is need for safeguards to guarantee against needless revelation of insightful and confidential financial market reports during regulatory proceedings and negotiations. Successful standard setting necessitates a particular discretion and secrecy level for regulators to formulate complicated resolutions, particularly in the time of emergency. Nonetheless, responsibility necessitates that the procedure for such decision making be clarified beforehand and the line of authority for decision making are also apparent and point toward the number of countries that can take part in placing standards , save for comprehension of the way their task may be reduced in period of crisis or emergencies. The other approaches to system of international financial regulation are incentive based financial regulation and rule-based regulation. The incentive-based regulation supports an added “hands off” directive and offers financial institutions more freedom to choose the level and amount of risk they wish to accept (Brummer 2012). The rule-based approach adopts the structure of exogenous design for capital for a given risk level and some form of inspection. This approach avoids the agency distortion; however, it fails to take into account the diversification benefits of holding different types of risks. The rule-based regulation makes inefficient use of managerial expertise. As a result, the best alternative approach to financial regulation system is the incentive-based approaches as it uses the insight of market participants and managers to acquire an informational advantage when setting regulatory standards. However, the incentive-based regulation also faces issues such as strategic interactions among the different decision-making agents within financial institutions (Brummer 2012). Compared to the rule-based regulation, the incentive –based regulation is more flexible and this come from the actuality that it is not openly regulatory however, it generates incentives via other means such as penalties. The system attempts to solve mechanical design problem through specifying a framework, for instance, a penalty device, that financial institutions can considerer when choosing a risk and committing regulatory capital. The effectiveness of such a program relies on how well the regulator foresees the tactical opportunities that such a method might generate. The incentive-based approach is realistic as in as the effectiveness of international financial organizations depends on regulators complying with the rules that have been agreed on (Brummer 2012). In incentive-based approach, the regulators would not have any reason to lack confidence in that others will do what they say. The incentive –based regulation is more flexible and this contributes to its effectiveness. Reference List Basel Committee on Banking Supervision (BCBS) 2010, Basel III: a global regulatory framework for more resilient banks and banking systems, Bank for International Settlements, Switzerland. Basel Committee on Banking Supervision (BCBS) 2009, Enhancements to the Basel II Framework, Bank for International Settlements, Switzerland. Basel Committee on Banking Supervision (BCBS) 2006, Core principles for effective banking supervision, Bank for International Settlements, Switzerland. Brummer, C 2012, Soft law, and the global financial system: rule making in the 21st century, Cambridge University Press. Verdier, P 2009, Transnational regulatory networks and their limits, The Yale Journal of International Law, vol. 34, iss 113, p. 117-130 Read More