Basel III Proposal To Strengthen The International Banking Industry

by Jason Shaw
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Introduction

Basel III Proposal To Strengthen The international banking industry has long recognised its inter-relationship with each other, even though it is split between different jurisdictions, distance and the economic system. Indeed, their supposed effect on the economic prosperity of the global economic system is embedded in their sensitivity and fragility. Yet, in general, the role of the banking sector in the economy of a country or even in the world determines the basis for any financial activity within each country and between parties across the world. The Basel III Consultative Paper lays out the Basel Committee’s proposal to strengthen global capital and liquidity regulations with a view to promoting a more resilient banking system. The aim of the Basel Committee policy package is to strengthen the ability of the banking system to with stand shocks from financial and economic stress, whatever the cause, this eliminates the risk of spillovers from the finance sector to the real economy (Basel Committee on Banking Supervision, 2009).

            This paper provides a critical review of the proposals and ultimately determines their feasibility, practicality and enforcement among the banking industry around the world. The repeated and continuing onslaught of economic stressors starting from the past decade has left the banking industry more fragile. The Basel Committee on Banking Supervision has long recognized its role in providing guidance not only to banks but also to regulators to ensure that the banking system remains not only resilient in the face of economic slowdown or down turn but also to be more prudent in their fiscal management. The viability of the Basel Committee’s previous recommendations and proposal was regarded as the cure for the ailing global banking industry however, Basel III’s round of proposal are too complex (Allen, Chan, Milne, & Thomas, 2010)

Basel III Proposal To Strengthen The International Banking Industry

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Basel III Proposals

                Emerging from the three pillars of Basel II that would include (1) risk management; (2) regulatory governance; and (3) corporate governance that aims to ensure the risk sensitivity of capital allocation, quantification and separation of operational risk and credit risk, and lastly to align regulatory arbitrage. Basel III has the following proposal that aim to strengthen the international Banking industry further.

1. Capital Base

Learning from its experiences in the past, the banking industry which have faced several global financial crisis have determined that the capital base of some banks are of insufficient quality. Normally these are the banks that are considered as the ground zero of the financial crisis. These banks are then forced to rebuild their capital base at a time when it is hard to do so. Governments are then forced to intervene that may save the situation temporarily however the domino effect of the whole financial industry will just make matters worse (Basel Committee on Banking Supervision, 2009).

A key element and rationale of this proposal is that common equity is still regarded as the highest quality component of capital due to its peculiar nature of absorbing losses when they occur, full flexibility of dividend payments and lastly it has no maturity date. It makes sense to use it as an instrument to ensure a bank’s liquidity. The proposal also emphasize that the creative way of firming up capital with non-common equity to meet regulatory requirement should be limited. However, regulators should also take into consideration another form of high quality equity that can be converted into common equity these are equity coming from mutual funds and cooperatives. Responding to the growing concern on security the proposal also stressed the need for full disclosure of the nature of capitalization.

Capitalization

                Tier 1 capitalization refers to the actual common equity of a bank. In the current practice equity can be in a form of bond, stocks, tradable financial paper and other similar instruments. The very nature of the tradable instruments is the variability of its value. BASEL III has discouraged this practice to ensure that common equity capitalization is resilient to market forces and will return a constant value even in the face of a financial crisis. As an added result to this, if let us say the market value of a tradable equity fluctuates this will translate to a dip in the common equity value of the bank. The process in which this will be implemented should include regulatory and governance changes across the banking industry within a particular jurisdictions.

Forward Looking Provisions

The groundbreaking provision of this initiative is that it encourages a transition in accounting practises towards a “expected loss” approach to replace the existing “incurred loss” approach. Mainly viewed as an initiative of the International Accounting Standards Boards (IASB), the Committee has laid out guiding principles that will include a basis for the final standard. The primary objective of the plan is to increase the usefulness of decision making and the importance of financial statements to stakeholders (Basel Committee on Banking Supervision, 2009).

2. Risk Coverage

The business models of banks make them exposed to a lot of factors that affect not only their short term revenues but also their recurring/long term revenues. Over exposure to loans without proper risk assessment being conducted on the loan may result to losses or bad assets that have the tendency to lose its value over time. Over investment in derivatives can lead to monumental losses if the market collapses. To illustrate: hedging on foreign exchange to mitigate fluctuation losses may lead to further losses if the value of the foreign exchange shifts its direction.

Strengthening Capital Requirements Ratio Vis A Vis Bank Operation

                In order to resolve this exposure, BASEL III has proposed that mitigation processes should not include hedging the investment with another investment on derivatives. But rather the mitigation process should include firming up common equity of the organization. Or on the opposite end of the table, Banks are directed to loan only what their capital equity can support.

3. Leverage Ratio

Leverage or leveraging is a technique often used by banks to multiply gains or to maximize its existing asset for better returns. To maximize this opportunity while being prudent, banks often use leverage ratio to put a cap on its exposure. However, leveraging asset that are already exposed in the derivatives market or leveraging assets that are technically not there anymore because it has been betted to another market while technically sound is dangerous. Most especially in an environment that tend to exhibit a cascading effect during a collapse. The Basel proposal calls for strict governance supervision to stop this practice.

Build-Up Cap

                Banks are enjoined to practice prudence and good financing practice to build the capital first that will support the operation and then build the capitalization further in order for any potential losses to be absorbed. Through the implementation of this vehicle to protect the base capital of the bank, banks and stakeholders alike, including its depositors are assured of the stability resilience of the bank.

Simpler Risk Metrics

                Risks that are often associated with leveraging are the potential loss or variance in the projected revenue against what has been invested. Other factors that are considered as contributory stimulus that can either increase potential revenue are often used to soften the risk thereby decreasing the cushion that should have softened the landing of any potential crash. The Basel proposal supports a simpler risk determination by simply relating the amount of investment made for leveraging as allowed by its capitalization. Bank supervisory authority are enjoined to legislate if not provide a framework on how to monitor these kinds of bank activities.

4. Capital Buffers

In simpler terms do not use money that is not there. Basel III encourages banks to build its capital base with enough buffers to cover potential loss from its operation that would include asset maximizing and revenue generating processes. Banks by nature of its business engages in derivatives, trading and other asset maximizing schemes in order to earn decent revenues. It is therefore prudent to ensure that investments and its attendant risk and exposure are covered at the onset.

Capitalizing The Excessive Credit Growth

                Instead of providing instruments that has a floating value as collateral for loans banks are enjoined to guarantee loans using its stable capital buffers. By doing this, the liquidity position of the bank is assured and its assets are not stressed to the point of losing its actual value. The framework will preserve the values of the asset that is used as guarantees for the loan. This proposal specifically addresses the theoretical reason for the real estate collapse in the western hemisphere.

5. Global Minimum Liquidity Standards

Basel III has recognized the importance of constant monitoring and supervision to ensure that banks under a specific jurisdiction comply with what the other banks are doing. A harmony of the efforts of all the banks should therefore be addressed at the local level where it is more practical to monitor the compliance and operation of the banks. To give more teeth to the Basel accord, the bank supervisory authority of each country are enjoined to pass if not issue directives under its jurisdiction that will address the requirements of the proposals.

Consultation that will lead to a decision impacting the minimum required parameters that will address the liquidity of banks around the world is under way. The minimum liquidity requirements will also harmonize and limit the financial transactions of each bank.

Other Supervisory Measures

                Other supervisory measures were also recommended by Basel III. Using basic financial indicators and economic indicators supervisory processes have become pro-active in dealing with potential indicators running in disarray. Under the proposal, banks should regularly report specific information that will help paint a dashboard of economic indicators to bank supervisory authorities. The reports in whatever form be it online or manual should be mandatorily regularized.

Conclusion

                The common theme of the responses to the BASEL III proposal was that of cautious anticipation and at the same time guarded reservation due to the revenue restriction that will result therefrom. The cautious anticipation was due to the series of financial crisis that have been a constant in the global financial landscape that need to be arrested. Pundits are hoping that this round of proposals when fully implemented in 2019 would stabilize the global banking industry in terms of governance and profitability. Strong opposition to the Basel III proposal also dominated the request for comments due in fact to the deficiency of the proposal to take into consideration other financial services that are not involved in retail banking. However, these institutions are considered part and parcel of the financial sector due to their economic activity that primarily use negotiable financial instruments.

272 Responses To The Basel III Proposals

                Risk taking for profit is an inherent mission of the banking system (Sieveking, 2010). If banks are prevented from efficiently redistributing and taking adequate liquidity risk in form of liquidity gaps, this will result to liquidity saturation that may worsen the situation. It is therefore suggested that the liquidity risk and exposure of banks be reported to the local jurisdiction to monitor and arrest possible reckless over exposure of errant banks. Harmonizing the intent of Basel to monitor, govern and supervise bank activities worldwide with that of local jurisdiction should be expedited (Onorato & Battaglia, 2010).

            In retrospect the Basel III accord’s proposal may have a potential adverse impact at the macroeconomic level at its present form, the cumulative impact of Basel II then to Basel III initiatives should be given more emphasis and study (Monroe, 2010). Basel III while addressing the financial sector in general not only affects banks, credit card companies are also affected. The “broad brush” approach may have unintended consequences to consumers. The treatment of unconditionally cancellable commitments provides an example where the Capital Proposal’s goal is oversimplified since it is not congruent with economic realities (Henry, 201).

            The proposals that would directly or indirectly impact the short-term global capital markets, much of which is currently funded through the issuance of highly rated short-term securitized instruments and corporate securities that benefit from unfunded liquidity commitments provided by banks. These short-term markets play an essential role in the financial system and the global economy and provide many benefits, including efficiency of financing, incremental credit creation, credit cost reduction, liquidity and risk transfer (Deutsch, 2010). These rounds of proposal while pro-active in nature still fail to address the after effect of the just concluded economic slowdown in specific regional economy. To note faster than expected, global economic recovery remains largely driven by massive fiscal stimulus undertaken by major economies. This should not continue mismanagement of highly paid bank executives and this should not be paid for by the consumers and tax payers. Full recovery should be driven by the public sector through financial intermediation. Impaired assets due to oversupply and uncertainty of the market are still a growing concern that will impair the recovery efforts of banks with an asset base that is projecting a lower value than what it should be (Aihara & Watanabe, 2010).

            “A capital standard premised on a worst case scenario is not meaningful. Likewise, a capital standard that makes adjustments for selected items needs to have a very high degree of assurance backed by data of the financial relevance of such adjustments. Otherwise the capital measure is distorted leading to the inevitable misallocations of capital which would be counter-productive to economic growth and stability” (Kelly, 2010).

“As discussed the financial servicing industry is not a sector that is purely dominated by banks, there are other financial management firms not involved in retail banking and yet provide service that impacts the stability of the financial sector and in particular the economy. The Basel III’s proposal will in effect mandate the European Commission and other European Nations to significantly increase regulatory capital and decrease the risk while increasing the amount of credit. This according to some pundits will result to another round of credit crunch and an increase in credit cost. The proposed measure such as building high quality capitals, strengthening of risk coverage, mitigating pro-cyclicality, discouraging leverage as well as strengthening liquidity risk requirements and forward looking provisioning for credit losses will have crucial impacts on the financing of the economy for specialized institutions” (PALLE-GUILLABERT, 2010).

“By institutionally reducing the value of negotiable instruments by treating them as an unstable asset not worthy to be used as common equity by banks and other financial institution would result to the collapse of the sector that uses these bonds in negotiations. The dismissive and rigid view of mortgage bonds as suggested by the Basel Proposal would put in jeopardy the entire Danish mortgage bond industry. The size and impact of a mere suggestion that would reverberate to the entire financial servicing world would marginalize not only the value of the industry but also the real assets that support those bonds (Jensen & Beltoft, 2010). Denmark and Sweden both trade in the mortgage bond market heavily, in these countries the liquidity of their banks is actually supported by bonds. These two countries regard bond as a liquid asset” (Tetzel, 2010).

“Credits and Loans are basically the lifeblood and revenue lines of banks and financial institution, the over-calibration of the capital changes, when combined with the changes to liquidity, will give rise to a significant slowdown in the availability of credit, and an increase in its cost. The cost of money in acquiring and owning credit or loan instrument shall invariably make or money unavailable to regular consumers. Banks or any financial institution, as a result of the Basel III accord shall first comply with the requirement of a strong capital base before it can provide any kind of credit line” (Australian Banker’s Association, 2010).

“This dynamic propelled deleveraging that has been used further during the economic crisis which caused more concern than intended. Given the global economic contraction, banks have had a heightened sensitivity in their exposures to trade clients and have experienced decrease access to private-sector risk mitigation providers, as a result of retrenchments due to the economic impact of their non-trade related business. Trade underpins the prospect of global economic recovery and any measures that potentially restrict the willingness or ability of banks to support trade has the potential to disrupt or slow global economic growth. Trade finance instruments are pivotal in supporting international commerce and contributing to the growth of the world economy. During the economic crisis, world trade fell by more than 12% in 2009, in part due to some global banks stopping the flow of credit to cut losses. While some banks in fact raised their lines of available trade credit during the crisis, the fall in overall demand for trade in goods and services mitigated that rise and largely cause the fall in trade volume. Restricting the flow if credit to this area, by increasing the risk weight of trade finance instruments disproportional with their nature and value, means essential goods cannot be traded, posing a threat to importers in emerging countries, with smaller banks and small to medium sized enterprises disproportionately” (BAFT-IFSA, 2010).

There were a total of two hundred seventy two responses to the Basel III request for comments most of which provided adverse assessment and comments that are legitimate in nature. The comment mostly concerned itself with the re-evaluation and re-assessment of the Capital Requirements and Bank supervisory strategy. The far reaching impact of the Basel III when implemented could result to the collapse of some economy that relies mostly on floating instruments to capitalize their operation. Other concern includes the fear of making the provisions of the recommendation used for political gains.

While some economies are struggling to stay afloat, some economies are trying their best to maintain the status quo to ensure their recovery. Everybody wants a more resilient and pre-dominantly strong banking institution. However, the framework proposed by Basel can potentially do more harm than good. As indicated earlier, the banking sector is akin to an intricate web that any ripple experienced in one side can be felt at the other side. Despite the individual resiliency of the banks, there will still be recidivist strugglers that can throw a monkey wrench in the dynamics of the banking industry. Such situation may be averted through the continuous monitoring of bank supervisors however monitoring activity by its very nature is already after the fact. The potential damage has already created havoc and mayhem to the fragile state of the banking and financial sector.

Critical Analysis

                The BASEL conference only produce proposals and banks worldwide cannot be made to comply within a finite period to ensure that its effects reverberate within the banking and financial industry. Another visible challenge that could slow down the implementation of the details and provisions of each and every proposal is that the gap analysis between the predominant system and the proposed system has not been carried out in detail. As it is, this is the second round of proposal coming from the banking industry meeting in BASEL, visible results has yet to be seen and felt across the financial and banking industry worldwide. What is worst is that there is no published statistics with regards to the compliance of the banks worldwide to the previous proposals. No attempt to monitor the compliance and effort of the banks to be in symmetry with the BASEL accord is ever recorded. The lack of information with regards to compliance therefore put into question the efficacy of the measures and proposals of the BASEL accord.  

            Another primary important factor that needs to be considered is the outliers when it comes to the unique business models that rely on the negotiable instruments as basis for the value of their trade. As indicated in the response of Sweden and Denmark markets, reliance on bond exists. Another point that is worth considering is that banks are predominantly linked to each other either directly or through a third party. The fragile relationship structure therefore makes the whole system vulnerable to collapse. The resulting domino effect can happen if one organization in the structure does not comply with the proposal of BASEL III.  

Procyclicality

            The Basel accord as seen by many to be procyclical to illustrate: one of the critical proposals of the Basel accord is the suspension of any operation in the derivatives market that is not supported by the capital of the organization. Reducing the operation of any risk mitigating devices such as operation in the derivatives market is like putting the cap on what the bank can do to recover during an economic slowdown. This will effectively prolong the recovery period of the bank that may cause it to collapse onto itself further. On the other hand, the Basel accord is only promoting responsible banking during economic slowdown so as not to exacerbate the situation. In Basel III, it has been recommended to make this part of what the government can regulate and ensure through the imposition of laws that may prosecute organization including banks that is engaged in this activity. As indicated by many the proposals hinder the freedom of trade.

            In closing, the increased visibility of the local banking supervisory council may politicized the implementation of the Basel III accord. That would further weaken if not increase the risk of banks not following or complying with the provisions of the proposals in detail. Anaemic implementation to haphazard implementation could also lead to another round of economic slowdown. Greater visibility of the Basel committee or a formal organization in charge of banks worldwide should be created if not augment the current Basel rounds to monitor the performance and compliance of all the banks worldwide including their banking supervisors.

            It should be emphasized however that increased regulation may foster the creation or spawning of another evil which is the shadow banking economy. Simply put the shadow banks are the unregulated banks while the regulated banks are the official and considered legitimate banks. There has to be a mechanism or incentives to consumers that will use the regulated banks as opposed to the use of an unregulated bank. Although this is a growing concern, existence of such banks can be regulated through the use of legislated controls that are also part of the Basel III accord.

Bibliography
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