Finance - BIS Capital Adequacy - Essay Example

BIS Capital Adequacy 29 July 2009 Bank for International Settlements The BIS or Bank for International Settlements is the “mother of all central banks” that maintains one office located in Basel, Switzerland with only two representative offices (Hong Kong and Mexico City). Despite this seeming low-key profile, the BIS plays a very big role in maintaining global monetary and financial stability. It renders services exclusively to central bank authorities and international organizations only by providing a forum for discussions and doing both economics and monetary research.

Additionally, and more importantly, it serves as the prime counter-party among central banks transactions and as trustee or escrow agent for major international financial operations. Among its more important committees is the Basel Committee which is responsible for the promulgation of banking regulation guidelines concerning supervisory issues. In this regard, Basel I (1988 Accord) was a landmark in the banking industry in that banks having an international presence are required to hold as a minimum 8% of their capital equal to the risk weighted assets (there are five risk weightings).

Basel II, which came in June 2004, addressed some of the weaknesses from Basel I. Both accords, however, are designed to strengthen the financial banking system by requiring a more rigorous set of capital requirements for banks to meet their credit and capital risks. Furthermore, Basel II is more forward-looking by requiring banks to identify those risks now and in the future especially with the sudden surge in hedge funds and esoteric investment instruments such as credit default swaps and other derivatives.

Basel II attempts to avoid systemic risks such as what happened in the US subprime mortgage crisis which engulfed the entire banking system with spectacular collapses such as AIG. Basel II is also more comprehensive by requiring banks to maintain enough capital to certain risks by quantifying credit and operational risks. A bank that engages in more risky investments is required to maintain a higher capital adequacy ratio to remain solvent in case of a crisis. Other considerations are a banks residual risks and the mandatory disclosures to comply with international accounting rules and standards.

This last provision is crucial as it gives counter-parties an idea of the risks they face when dealing with a certain international bank. This way, there are no ticking time bombs like CDS which Mr. Warren Buffett likens to weapons of mass destruction (Graham & Dodd 2008, p. 622) due to unregulated credit default swaps that reached an astounding $45,000 billion! (Soros 2008). An increasing sophistication and complexity of financial markets requires close regulation to determine the capacity of a counter-party to honor its obligations and Basel II thankfully requires this.

Before the housing crisis turned into a financial crisis, banks were of the view that more is always better. It can be said that banks may fail based on three reasons: poor lending practices, fraud and mismanagement. The lending frenzy prior to the mortgage crisis showed banks abandoned good credit practices and were guilty of the aforementioned reasons. Bank management wanted fast growth to capture a bigger slice of the supposedly growing housing industry pie and caution was thrown entirely out of the window.

They indiscriminately lent to unqualified borrowers and not overly concerned with risks because they employed agents that originated the loans and then repackaged these loans in the derivatives markets through asset backed securities (ABS) which were given investment grade ratings. End result was a major distortion in the risk-reward equation. The Basel accords forced banks to take a conservative approach by diverting capital to improve solvency instead of funding new unbridled growth. A net effect was slow down growth to sustainable levels appropriate to a banks capitalization.

But techniques like SGR cannot substitute for good strategic thinking (Higgins 1984, p. 2). ReferencesGraham, B & Dodd, D 2008, Security Analysis (6th edition, illustrated), McGraw-Hill Professional, Dubuque, Iowa.Higgins, RC 1984, Analysis for Financial Management, R.D. Irwin, Homewood, IL.Soros, G (April 03, 2008), The False Belief at the Heart of the Financial Turmoil, The Financial Times Ltd., London, United Kingdom. Available from: www.FT.com http://www.ft.com/cms/s/0/ca1fac78-0116-11dd-a0c5-000077b07658.html?nclick_check=1 (Accessed on 24 July 2009) or alternatively athttp://www.opednews.com/maxwrite/linkframe.php?linkid=56186