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STUDENT NUMBER

Business Report

12015699

BASEL III – IMPLICATIONS OF IMPLEMENTATION

Word Count: 1,896

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Table of ContentsExecutive Summary...............................................................................................................................2

Introduction...........................................................................................................................................3

Basel III..................................................................................................................................................4

Background........................................................................................................................................5

Previous Basel Accords - Shortcomings.............................................................................................5

New Capital Requirements....................................................................................................................7

Description........................................................................................................................................8

Impact on Banks Global Lending Activity...........................................................................................8

Countercyclical Capital........................................................................................................................10

The Concept.....................................................................................................................................11

Effects on Banking System...............................................................................................................11

Summary.............................................................................................................................................13

References...........................................................................................................................................14

Executive Summary

This report has been commissioned to give an investigative insight into the implementation of Basel III; the implications of implementing, previous accords and also the impact this has on various systems and activities. It will explore the previous shortcomings of the accords, aswel as the new requirements. There will be a brief description on each topic as well as a sound,

but critical analysis of the impact upon each of these, caused by Basel III. Topics include: Basel III, previous accords, Global Bank Lending and the Bank System.It incorporates a variety of information sources to gain a broader understanding of viewpoints and effects, but will focus largely on Bank Behaviour in Response to Basel III: A Cross-Country Analysis by Thomas F. Cosimano and Dalia S. Hakura (2011).

The analysis and information found herein have been commissioned by the Chief Financial Officer (CFO) of this Banking Institution.

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Introduction

Basel III is the latest Basel Accord established by the Basel Committee on Banking Supervision. Its aim is to strengthen global capital standards by applying universal regulations to banks. Basel III was a response to the financial crisis of 2008 and hopes to prevent a similar collapse from happening again.

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Basel III

Background

Previous Basel Accords – Shortcomings

IN THIS SECTION

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Background

In August 2007 BNP Paribas; ones of the world’s largest banks, became the first global bank to acknowledge the risk of exposure to sub-prime mortgage markets (Kingsley, 2012). This is event is widely accepted as the first sign of the forthcoming recession, which would become the worst in over 80 years (The Economist, 2013).

Little than a month later British bank Northern Rock applied for a bailout loan from the Bank of England as it found it difficult to find a cash lender to fund its day to day operations (BBC, 2007), leading to the first ‘bank run’ in 150 years (Globalisation and Health, 2008).

This financial crisis sparked the Basel Committee on Bank Supervision (BCBS) to establish the Basel III reforms and put in place systems that would aid in the prevention of a similar situation reoccurring in the future.

Basel III was, as the name suggests, the third accord established by the BCBS, with each previous accord also being a response to some form of financial crisis. However, each accord has had its shortcomings, creating the need for a newer and better ‘versions’.

Previous Basel Accords - Shortcomings

Basel I was established in similar situations almost 40 years ago when a German bank had its license revoked due to foreign exchange exposures three times that of its capital. This had a domino effect which meant many German banks incurred huge foreign exchange losses, with one New York bank closing its doors the same year due to the same problem (BIS,

2014).

The main focus on Basel I was to strengthen the stability of the international banking system and diminish existing sources of competitive inequality among international banks. Basel I was the first attempt at incorporating (credit) risk into capital requirement calculations.

A downfall of Basel I was its lack of differentiation of credit risk within commercial loan classifications. This meant that the required capital was always set at 8%, disregarding the credit rating and collateral offered by borrowers.

This lead to commercial lending risk being mispriced which encouraged banks to push forward under-priced portfolios, ultimately leading to a degraded the quality of portfolio credit.

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The shortcomings of Basel I encouraged a more considered approach within Basel II rather than focusing solely on credit risk. Basel II introduced the concept of risk-based capital requirements – the minimum capital a bank must set aside according to its risk, a clear improvement from the “one size fits all” approach of Basel I (Hanson, Kashyap and Stein, 2003).

Basel II also tackled the fixed risk weighting that each risk category carried in Basel I by introducing risk weights determined by the borrower’s external credit rating (Council of Mortgage Lenders, 2013). This gave a more accurate and borrower specific risk weighting than Basel I, which had a tendency with most of its procedures to go with one rate for everyone, regardless rule.

However, Basel II was not without fault, one of the many problems noted in Basel II was its method of measuring financial risk – “Value at Risk” (VaR). It is proposed by the LSE Financial Markets Group (2001) that VaR can destabilise an economy, inducing crashes which otherwise would not occur. Further, they state that risk is endogenous and this is ignored completely by Basel II’s use of VaR.

Basel II also created a problem by giving banks the option to use their own models for assessing risk and determining required capital, which leaves banks open to manipulate this option. Banks may be overoptimistic about their exposure so to minimise regulatory capital and maximise the return on equity (Benink, 2015).

It’s clear to see that from each new Basel accord, problems arise, maybe due to a flaw in the accord, or maybe due to institutions looking to make the most of the accords give, i.e. Basel II freedom of internal models.

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New Capital Requirements

Descriptions

Impact on Banks Global Lending Activity

IN THIS SECTION

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Description

The introduction of Basel III brings with it a higher equity-asset ratio, so the largest banks would have to increase their ration from 5.7% to 7% (Cosimano, 2011). These largest have to maintain significantly above the minimum levels of required capital against all assets, even those deemed non-risky (Armour and Tracy, 2015).

The aim of new capital requirements is to strengthen the risk coverage of the capital framework. By doing this BCBS hopes to negate on and off balance sheet risks to avoid a future destabilising banking situation which could lead to another crisis.

The increased capital requirements are a prudential step to act as a safety to fall back on should another crisis occur. Not only that, but by simply building the buffers, the likelihood of another crisis is lessened, as capital is the most expensive form of funding and so credit will not build as quickly.

The Bank of England (2011) reports that the Capital Requirements Directive IV (CRD IV) is a legislative package that intends to implement Basel III agreement through the EU. Enhanced quality and quantity of capital and new rules for counterparty risk are both included in the package.

Impact on Banks Global Lending Activity

The new higher capital requirements would mean that banks will have to marginally increase their cost of loans. This in turn could decrease loan growth as fewer parties are willing to take out loans at this higher cost, in turn holding back economic recovery (Thomas Cosimano, 2011).

The cost of raising the equity-asset ratio varies considerably between countries; with non-crisis countries feeling the greatest impact. These non-crisis countries, such as Japan and Denmark are likely to have low elasticity of loan demands with regards to loan rates, hence why they would feel the greatest impact. This is demonstrated by the net cost of raising equity by 1.3% in Japan of 26 basis points. Hence, Japan would have to increase its loan rates by 26 basis points to achieve the Basel III 7% equity to risk-weighted asset ratio (Cosimano, 2011).

Countries that are most effected will then have the opportunity to explore why the impact of increasing equity is so large, is it due to the cost of equity, if so why? This also gives banks

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the opportunity to manipulate their lending rates elasticity or cost of equity to meet the requirements of Basel III.

Under Basel III banks must maintain equilibrium of loans and deposits, so when equilibrium is not reached they must engage in cross-selling and make deposits/take out loans with other banks. This encourages a more intimate relationship with clients, which will benefit both banks by establishing themselves as having an operational relationship, meaning during periods of distress, their losses are decreased. This will also encourage a more traditional banking system, another objective of Basel III.

Thomas Cosimano (2011) also finds that even though the change in lending rate is not substantial, it may encourage banks to move from traditional banking activities to ‘shadow banking sector’. If this occurs then BSBC will also have to include regulations/reforms for the shadow sector, otherwise banks will have found a way out of avoiding the increase in loan rates.

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Countercyclical Capital

The Concept

Effects on Banking System

IN THIS SECTION

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The Concept

The aim of Countercyclical Capital is to provide a buffer of capital to achieve broad protection of the banking sector from periods of excess aggregate credit growth – strongly linked to system wide shocks i.e. recessions (BCBS, 2010).

One of the key objectives of Basel III is to reduce pro-cyclicality; this is achieved through the use of the countercyclical buffer. Ensuring that if the economy were to crash again, banks and their lending would not also coming to a halt, as this worsens the problem, but instead continues to lend by maintaining the before mentioned buffer.

In periods of growing system wide distress a capital ‘defence’ buffer should be built up. The building up of these buffers should also benefit the economy by helping moderate excessive credit growth, as capital is a more expensive form of funding. These periods can also lead to a 2.5% increase in capital ratios.

If these buffers were not in place and the lending of banks was left to be procyclical; financial stress/recessions are more likely to occur, and when they do, because of the procyclical nature, borrow from banks will be though/ more expensive. This could potentially lead to defaults and closures of many businesses, which would in turn affect the banks again. Countercyclical capital not only helps to prevent recessions, but also ensures that if one does occur, the situation is not worsened.

Effects on Banking System

Banks must always have enough capital to comply with the stress tests and meeting the minimum capital requirement of stress periods. Basel III insists that banks limit the size of their activities in relation to their capital. This will help prevent excessive capital credit growth, rather than a bank lending/depositing too much.

This buffer ensures that credit growth is reduced during times on economic growth and attenuate credit contraction once it is released; lessening procyclicality when capital levels are high, increasing the banking sectors resistance to shock (Drehmann, 2011).

BIS (2011) also found that in Brazil, during an economic downturn, the amount of capital buffer will rise whilst the growth of loans simultaneously decreases.

Evidence also suggests that periods of excessive credit growth should be co-ordinated with decisions regarding monetary policy. Thus this will differ from country to country as each country has its own monetary policy and regulations.

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Basel III accord aims to fundamentally strengthen global capital standards by emphasising focus on banks’ ability to cope in financial stress by regular ‘stress testing’.

It aims to reduce the reliance on banks internal models, as this is what was previously manipulated in Basel II to achieve more attractive financial results for the banks.

Further, it would also like to reduce reliance of external ratings and so has indicated that risk-weighted assets will increase due to an enhanced risk coverage with relation to capital market activities (Whitecase, 2011) also incorporating elements of IOSCO that require banks to conduct their own internal assessments of external rates.

Basel III would also like banks to reduce the size of their balance sheets, so they do not become ‘too big’ in relation to their capital, as this is more risky for the economy. Chami and Cosimano (2010) identified the optimal holding equity of banks at 1.3%

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Summary

Past Basel Accords have all had minor downfalls, but each has been significantly better at ensuring a stable market than the last. Basel III has many benefits compared to the most recent Basel accord but and seems to be going the right way to ensuring the economy is protected, or at least prepared for any sudden downturns. In theory it appears to be a technically sound system, with a few areas that could be modified slightly – and am sure they will be in future updates. However, only time will tell if it can be truly effective in the real world.

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References

Armour, S. and Tracy, R. (2015). Big Banks to Get Higher Capital Requirement. [online] WSJ. Available at: http://www.wsj.com/articles/SB10001424052702303456104579489643124383708 [Accessed 8 Jan. 2015].

Benink, H. (2015). Turmoil Reveals the Inadequacy of Basel II. [online] Financial Times. Available at: http://www.ft.com/cms/s/0/0e8404a2-e54e-11dc-9334-0000779fd2ac.html#axzz3OC9wTYjO [Accessed 8 Jan. 2015].

Brasliņš, Ģ. and Arefjevs, I. (2014). Basel III: Countercyclical Capital Buffer Proposal-the Case of Baltics. Procedia - Social and Behavioral Sciences, 110, pp.986-996.

Chami, R. and Cosimano, T. (2010). Monetary policy with a touch of Basel. Journal of Economics and Business, 62(3), pp.161-175.

Clementi, D. (2001). Financial markets: implications for financial stability. Balance Sheet, 9(3), pp.7-12.

Cml.org.uk, (2015). Basel II - a guide to capital adequacy standards for lenders. [online] Available at: http://www.cml.org.uk/cml/policy/issues/748 [Accessed 8 Jan. 2015].

Cosimano, T. and Hakura, D. (n.d.). Bank Behavior in Response to Basel III: A Cross-Country Analysis. SSRN Journal.

Drehmann, M. and Juselius, M. (2014). Evaluating early warning indicators of banking crises: Satisfying policy requirements. International Journal of Forecasting, 30(3), pp.759-780.

Hanson, S., Kashyap, A. and Stein, J. (n.d.). A Macroprudential Approach to Financial Regulation.SSRN Journal.

Kingsley, P. (2012). Financial crisis: timeline. [online] the Guardian. Available at: http://www.theguardian.com/business/2012/aug/07/credit-crunch-boom-bust-timeline [Accessed 8 Jan. 2015].

Maes, I. (2012). Goodhart, The Basel Committee on Banking Supervision: The History of the Early Years, 1974–1997 (Cambridge: Cambridge University Press, 2011, 624 pp., £95, ISBN 9781107007239). Financial History Review, 19(03), pp.365-368.

News.bbc.co.uk, (2015). BBC NEWS | Business | Rush on Northern Rock continues. [online] Available at: http://news.bbc.co.uk/1/hi/business/6996136.stm [Accessed 8 Jan. 2015].

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Ojo, M. (n.d.). Basel III and Responding to the Recent Financial Crisis: Progress Made by the Basel Committee in Relation to the Need for Increased Bank Capital and Increased Quality of Loss Absorbing Capital. SSRN Journal.

Risk Transfer Mechanisms and Financial Stability Bank for International Settlements Basel, Switzerland, 29–30 May 2008. (2007). Journal of Financial Intermediation, 16(4), pp.621-622.

Sarkany, Z. (n.d.). The New Basel III Rules and Recent Market Developments. SSRN Journal.

Stuckler, D., Meissner, C. and King, L. (2008). Can a bank crisis break your heart?. Globalization and Health, 4(1), p.1.