Relationship between the Capital Base of Banks and the 2007-2010 Global Financial Crisis - Assignment Example

BASEL III Name: Institution: Professor: Date: Table of Contents Table of Contents 2 Introduction 2 Discuss the need to include the leverage ratio and off-balance sheet assets in Basel III. 10 Tahyar, M.E., 2011. New Standards in Counterparty Credit Risk Management 13 European Banking Authority. 2014. Supervisory Review and Evaluation Process (SREP) and Pillar 2 16 Introduction Basel III is part of the G-20s’ agenda1 on financial reforms (Chouinard & Graydon 2014). It builds on the previous Basel II requirements that regulated how financial institutions conducted business. Basel III requires banks to build a capital base by holding capital/ funding such that it matches the level of their medium to long term lending. It is aimed at curbing the reliance on short term credits during booms and encourages a closer analysis of risks. In addition, Basel III calls for additional measures of leveraging risk-based capital requirements in addition to requiring banks to reveal their off-balance sheet risks. The leverage ratio requirement will prevent build-ups of leverage and subsequent deleveraging processes that destabilize financial markets. Discuss the relationship between the capital base of banks and the 2007-2010 global financial crisis. Using your own research, cite at least two examples of real world financial institutions. The financial crisis of 2007-2010 originated from the US and European markets and had its effects being felt all over the world (Gambacorta & Marques-Ibanez 2011). It was characterized by massive withdrawal of investors from markets as a result of reduced confidence, volatile world stock markets and reduced liquidity for banks which were unable to offer or obtain credits. Some financial institutions were facing the risk of collapse, while others e.g. the Lehman Brothers actually collapsed. In the article The Balance of Payments Crisis in the Euro Area Periphery, Higgins and Klitgaard (2014) identified heavy foreign borrowing to finance excessive domestic consumption and housing investment as the main cause of the economic crisis. When the crisis hit, foreign investors started withdrawing, causing deficits in the balance of payments. The financial crisis was as a result of over-optimissim trade errors. Such errors usually result in losses since traders mistakenly forecast gains for unprofitable ventures. This level of optimism is so high that the pessimism levels are below the market equilibrium at which transactions avoid losses. These levels of pessimism that are below the equilibrium are characterized by numerous transactions. Due to the availability of low interest rated loans, many people had access to funds which they invested mainly in the housing and stock markets. The increased demand for real estate properties definitely increased prices. Many investors were speculative and estimated that their investments would generate high returns that would be enough to settle the loans. This estimation was wrong and created a trader error. There was high spending on fixed asset investments and reduced income generation (Provopoulos, 2013). This created a balance of trade deficit, leading to the financial crisis. The crisis exposed the fragilities of the then financial system. Majority of banks relied on funding from investors to finance loans and failed to build their liquid capital base. In the years preceding the crisis, foreign investors, especially from Asian economies were channeling a lot of money into the US and European markets. Banks, therefore, had the privilege of offering cheap, adjustable mortgage loans. The low initial interest rates for these loans encouraged speculators to increase borrowing so as to fund their investment in real estate. This was done under the assumption that real estate prices would always rise. For that reason, investors thought that they would be able to offset their mortgages. The situation was made worse by the shadow financial system comprising of hedge funds and investment banks. These faced less strict financial regulation compared to commercial banks hence contributed the most to the unregulated lending and the subsequent crisis. When the investment bubble burst, the prices of assets started falling, in some cases falling below the mortgage value. Foreign investors then started losing confidence in the markets, hence resulting in the mass liquidation of stock market investments as well as other fixed assets (Berne 2014). The approach in that case was the conversion of assets into liquid capital, generally into currencies that were thought to be well cushioned from the looming depreciation of the dollar. This move by investors depleted the foreign currency reserves available to most financial institutions. As the value of assets depreciated, loan defaults increased alongside a decrease in bank deposits. This created a disruption of the lending channel due to the decreasing capital base. In addition, the mass liquidation of assets coupled with the depreciation of the real estate investments increased the dollar’s vulnerability to depreciation. To protect the dollar against the looming depreciation, banks started to look at ways of building their capital base. This prompted banks to revise loan rates by increasing the interest rates of the adjustable mortgage loans, while freezing credits. The freezing of credit markets during the crisis led to the collapse of investment banks since they could not obtain funding. Running these institutions became impossible, leading to some of them declaring bankruptcy. Bankrupt firms had to liquidate their fixed assets through acquisitions while some were placed under government takeovers. Examples of such include the Lehman Brothers, Bear Stearns and Countrywide Financial. Bear Stearns and Lehman Brothers were some of the largest investment banks in the United States. In March, 2008 when Bear Stearns was facing bankruptcy, the Federal government facilitated its acquisition by JP Morgan Chase. Lehman Brothers on the other hand declared bankruptcy in September, 2008 and their assets in America and Europe were bought by Barclays, while those in the Asia-Pacific were bought by Nomura Holdings. Countrywide Financial was acquired by the Bank of America (Buehler, Samandari & Mazingo 2009). The collapse of these investment banks was fuelled by the over-reliance on credit funding from foreign investors on a short term basis to finance long term loans with little potential for returns, and the failure to build a capital base through deposits. When the funding was cut, amid loan defaults, running these institutions became impossible, hence their subsequent collapse. Why is there a perceived need of counter-cyclical buffers? Define and discuss how counter-cyclical buffers might best be structured. (a) Why is there a perceived need of counter-cyclical buffers? The countercyclical capital buffer, an integral part of the Basel III framework, is a policy put in place with the aim of preventing the occurrence of another financial crisis. It requires financial institutions to build up a capital base over time to counter developing imbalances in credit markets. The measure thus protects banks from the repercussions of increased credit by building their ability to absorb losses. The policy is to be implemented when accumulating credit is understood to be as a result of increasing system-wide risks. In that case, the policy would help increase the interest rates of loans, or else the cost of credit, hence making them un-attractive. Therefore, the credit cycle would be stopped in its initial stages. The 2007-2009 financial crisis was characterised with capital flight from markets as a result of investors losing confidence in local assets and resulting to a mass exit by converting portfolio assets into liquid foreign currencies (Basel Committee on Banking Supervision 2010). This outflow created massive deficits in the periphery. The conversion of portfolio assets into liquid foreign currencies perceived to be more stable created an increased demand for foreign currencies and reduced demand for local currencies. This exposed local currencies to the risk of depreciation. The first measure that governments took in fighting the recession was to cushion their currencies against depreciation. Governments came up with economic stimulus programs to finance the capital flight deficit (Justine 2014). In the United States and Australia, for example, the economic stimulus programs were affected. Currency inflows from the Target 2 system and from the IMF in the case of Greece helped in adjusting the balance of trade created by capital flight (Gibson, Hall & Tavlas 2012). The financing of central banks through the Target 2 program helped maintain their lending capacities and meet their ability to make payments for outflows. In addition, the response from the European Central Bank and the reassurance by the Outright Money Transactions program that the euro’s value would be cushioned against value depreciation restored investor confidence hence the sale of portfolios subsided with some investors returning to the periphery markets in 2013. Experts have blamed the delay in implementing these reactionary measures for the extended adverse effects of the financial crisis where some financial institutions collapsed. The crisis was as a result of banks having very shallow capital bases as well as accumulating heavy credits. When the crisis hit, the credit channel was disrupted, leading to banks making huge losses as they tried to implement makeshift measures of building a capital base. Where the government and other international monetary institutions intervened to replenish the funds reserves for banks, such banks did not collapse. However, in those banks where such interventions were not made, the institutions ended up collapsing. Even though interventions were made, the moves were made very late, at a point where losses could not be avoided (Price Waterhouse Coopers 2011). Such observations having been made during the crises, experts saw the need to come up with monitoring and response strategies. The countercyclical capital buffer policy seeks to avert such scenarios by putting in measures for early detection of looming financial crises and providing measures to stop the crises in their initial stages. This way, the crises would be averted. (b) Discuss how counter-cyclical buffers might best be structured. To be effective, counter-cyclical buffers need to be properly structured and implemented. The most important part of the policy is being able to detect increasing credit accumulation in the initial phase of the credit cycle (Liang 2011). This should enable financial institutions to come up with the best response measures. The following are the most common indicators of accumulating credits and potential financial instability; Mortgage Volume Prolonged phases of thriving bank lending are usually followed by financial crises. Prices of real estate Increased bank lending coupled with increasing property prices is usually an indicator of looming disaster since when the market stabilizes, financial instability is realized. Other indicators like credit condition indicators, cost of credit and leverage should also be considered. Counter-cyclical buffers should not be implemented at all times. Instead, when indicators of accumulating credits are noted, a study of indicators in previous crises should be studied and from that, the seriousness of the existing imbalances determined. From that, the decision whether or not to activate a buffer should be made. The level of the buffer should always be determined by the degree of imbalances existing in the system. According to the proposal in the Basel III, buffers should be built within a period of three to twelve months depending on the urgency (Persson 2012). The structuring of a counter-cyclical buffers can be approached from two different perspectives, namely: the funding and investment perspectives (Drehmann, Borio & Tsatsaronis 2011). From the funding perspective capital and liquidity buffers can be made while from the investment perspective, an asset buffer can be made. A capital buffer can be made by having banks increase the capital buffer ratio in times of economic booms to prevent credit accumulation or expansion. During recessions, the capital buffer ratio should be reduced. The liquidity buffer would allow banks to hold high-value liquid assets where there is a possibility of massive fund outflows in an existing short-term acute shortage. During the economic boom, the liquidity coverage should be set above 100% and below that during the recession (Repullo & Saurina 2011). An asset reserve requirement ratio should also be set to control assets by regulating capital and liquidity ratios in cases where markets fluctuate sharply. Discuss the need to include the leverage ratio and off-balance sheet assets in Basel III. Excessive on-and-off leveraging of balance sheets in the financial system has been identified as one of the causes of the 2007-2009 financial crisis. These leverages were built on the background of strong capital ratios that were risk based. During the crisis, financial institutions were forced to reduce leverage so as to reduce pressure on asset prices. This worsened the existing situation where banks facing reduced capital base and decreasing credit availability. To prevent such an occurrence in the future, the Basel III agreement called for a non-risk based ratio that is simple and transparent. This would provide a reliable additional measure of leveraging risk-based capital requirements. The Basel framework also requires banks to reveal their off-balance sheet risks. It was common practice for Lehman Brothers to hide assets by not including them on its financial reports with the aim of giving investors a false impression of reduced leverage (Repullo & Saurina 2011). The leverage ratio requirement will prevent build-ups of leverage and subsequent deleveraging processes that destabilize financial markets. It will also ensure the detailed description of off-balance sheet leverages and their inclusion in financial statements. With the new requirements, banks will be required to hold leverage for all assets including minimal risk assets and off-balance sheet assets. Most importantly, the requirements will set common accounting standards, especially in financial reporting. What measures should limit counterparty credit risk? Counterparty credit risk refers to the risk of a party failing to fulfill obligations, thereby causing other party's replacement losses (Nowak 2011). This mostly affects financial institutions that engage in over-the-counter securities. This type of risk can be compared to credit risks where losses are incurred due to defaults, though it varies in terms of the level of exposure at default. In addition, depending on the existing market conditions at a particular time, exposure after settlement may be positive or negative. Measuring the counterparty credit is important for determining the cost bearing a counterparty credit risk. This cost is calculated as a difference between the default risk and the market risk. The default risk in that case is the cost of covering losses in case a counterparty default while the counterparty credit risk charge is the amount of capital needed to settle losses arising from the market value volatility of the initial counterparty risk. While the default charge was a requirement of Basel II, Basel III saw the need to introduce the market capital charge after the 2007-2009 financial crisis (Beier et al. 2010). Basel II requires the estimation of losses due to default by looking at a combination of three elements, namely; Probability of default (PD) This is the probability of a counterparty failing to meet the agreements in an over the counter agreement. According to Basel II, this should be a one-year calculation. The probability of default increases with the decrease in the counterparty credit rating. Exposure of default (EAD) This refers to the expected sum, in monetary form, of exposure or cost of default by the counterparty. This is usually a maximum of a one-year-period calculation Loss given default (LGD) This refers to the extent of the loss on the exposure suffered by a company as a result of counterparty default. According to the Basel II requirements, this calculation should only be made for the un-collateralized facilities. In some market segments, the loss given default is assumed to remain constant. Basel III proposed the introduction of the non-internal model method in measuring the exposure at default. This would substitute the current exposure method as well as the standardized method used in calculating counterparty credit risk. The non-internal model method will be more risk sensitive since it is cognizant of the advantages provided by collateral and better outlines legal netting requirements in addition to being standardized to a stress period. The non-internal model method will also achieve other important policy objectives and provide a framework that; Is simple, easy and applies to a wide range of derivatives transactions Borrows from prudent approaches that are already contained in the Basel framework Minimizes the need for excessive discretion by institutions, while helping them better understand counterparty risk profiles. To best manage counterparty credit risks, the following Basel III approaches should be used; Formalization of counterparty credit risk limits Monitoring of credit risk exposures against established limits Maintenance of appropriate risk control to reduce limit exceptions Counterparty credit risk concentrations should be measured, monitored and controlled by legal entities. Basel III proposes that banks should set counterparty credit exposure risk limits, monitor the exposure against set thresholds and keep adequate information systems in addition to setting risk controls to measure counterparty credit risks and reduce limit exceptions. Large bank-holding firms will be required to aggregate credit exposures to a major company within the institution. In addition, Basel III proposal places some counterparty risk management roles on the top management of respective banks. Senior managers and directors have the responsibility to set counter party credit risk tolerance, measure, monitor and regulate counterparty credit exposures, as well as come up with effective policies which they should also implement. They should also make sure that counterparty credit risks are covered in internal audits2. Finally, they have a duty to receive and analyze counterparty credit risk reports on a monthly basis. Financial institutions have the duty to control netting and the access to legal documents as well as collateral terms by using automated systems. They should also review collateral and netting terms and their validity on an annual basis. Banks should also review counterparties on an annual basis to determine the extents of exposure risks and the effectiveness of risk management frameworks put in place by the counterparties. Discuss the use of liquidity ratios as a focus for international regulations As stated earlier, the 2007-2009 crisis was as a result of banks failing to build a strong capital base. Their inability to roll over short-term credit caused a mass exit of investors, which resulted in reduced liquidity. The liquidity ratios proposed by the Basel committee are aimed at cushioning banks against market shocks, remove structural disparities between bank assets and liabilities as well as discourage short-term funding/credits (Global Regulatory Network 2013). The proposal introduced two new liquidity requirements, namely: Liquidity coverage ratio and net stable funding ratio. Liquidity coverage ratio This requirement is aimed at protecting banks from market shocks. According to the proposal, banks will be expected to hold quality liquid assets e.g. currency and government bonds to meet intense capital outflows for a period of 30 days and above during crises (Bair & Herring 2013). High quality assets are appealing in that case because they can be easily liquidated during crises. Net stable funding ratio Basel III requires banks to build a capital base by holding capital/ funding such that it matches the level of their medium to long term lending. It is aimed at curbing the reliance on short term credits during booms and encourages a closer analysis of risks. Implications Under the new requirements, banks will have to revise their balance sheets such that they cover for shortfalls against these liquidity ratios. This could be done by holding high quality assets while shortening the maturity of loans. Alternatively, they could hold on deposits and seek long term funding instead of short term funding. It has been noted that most internationally active banks do not meet the required threshold. Excess liquidity will also not be recognized for cross-border banking by foreign banks in its consolidated liquid coverage ratio where doubt exists over the availability of the liquidity. Generally, the requirements will regulate cross-border cash flows to avert the scenarios that led to the 2007-2009 crisis. During this time, leveraging (driven by speculation) at an international level was common. Cross border transactions were made where funds acquired on a short term basis were used to acquire properties in the hope that the investments will yield returns, higher than the cost of the credits. This inclination towards leveraging available funds with little regard for building a capital base contributed to the widespread nature of the recession effects. With the new regulations, cross-border capital outflows will now be more regulated as banks seek to balance between building an asset base and lending. Discuss the need for various domestic regulations to supplement Basel III, explaining why some countries have chosen not to implement Basel III. Basel III is an agreement made by all the G20 nations. The set deadline for the transition into the Basel III regulations is 2018 (Chang 2010). The agreement sets an international standard that should act as a guideline to regulate bank lending and funding. The proposal requires financial institutions to build a capital buffer by accumulating high quality assets during economic booms so that they match the liabilities. In that case, banks would be able to survive the stress caused by interrupted capital channels during financial crises. This approach is based on a study on banks, which had such structures in place prior to and during the 2007-2009 financial crises. For example, it was observed that banks in Canada, which had a strong banking system, were not adversely affected by the financial crisis. Among the proposed requirements is the establishment of counter-cyclical buffers by financial institutions. This would help in building up a capital base over time to counter developing imbalances in credit markets. This measure would protect banks from the repercussions of increased credit by building their ability to absorb losses. Another requirement is that financial institutions include leverage ratio and off-balance sheet assets in the implementation of Basel III. The leverage ratio requirement will prevent build-ups of leverage and subsequent de-leveraging processes that destabilize financial markets. It will also ensure the detailed description of off-balance sheet leverages and their inclusion in financial statements to prevent financial institutions giving investors a false impression of their exposure risk levels. Additionally, Basel III proposes that banks secure themselves against counterparty credit risk. This will help prevent losses arising from the market value volatility of initial counterparty risks. Finally, the proposal requires that banks regulate their liquidity ratios, such that they balance between liabilities and assets. This will help in building a capital base to cushion them from future market shocks. However, the Basel requirements neither apply to all markets, nor are they enough measures as they are. There is a need for various jurisdictions to implement additional regulations, using the Basel III requirements as a benchmark. Individual nations and banks have the option of adding extra measures or raising the standards set by Basel III. For example, where a bank’s liquidity risks are not properly addressed by Basel III’s proposed Net stable funding ratio and Liquidity coverage ratio, such banks can decide to hold additional liquidity (KPMG.com 2012). The need to hold more assets will be informed by the banks self risk assessment and the decision to implement the Pillar 23 requirements in addition to the Basel III requirements. Additionally, where a bank has to meet more that the proposed ratios at group levels in the case that transferring liquidity around the group is deemed difficult, a capital base that surpasses the Basel requirements may be necessary. Another factor is the fact that banks in some countries may not have access to adequate high quality liquid assets. This could be due to reduced government debt or else, the capital markets in such countries may be under-developed. A case example is the Middle East and Asia Pacific regions. In some cases where funding and lending are done in multiple currencies, banks will obviously get difficulties in achieving the required Basel III liquidity coverage ratio for each of those currencies. Such challenges are affecting the rate at which Basel III regulations are being implemented. Currently, there are varied views on the advantages that Basel III presents. For example, in countries like the US where the Federal Reserve Bank considers effecting the Basel III requirements, financial institutions are still apprehensive. In such cases, only parts of the Basel III framework are being considered. The banking industry in the US has stated that implementing Basel III requirements in full would have a negative impact on the economy. The US’ Institute of International Finance estimated that the economy would shrink by 3% in five years if the requirements were implemented (Elliot 2010). Other banks have stated that Basel III requirements are too restrictive on the amount of cash inflows for the stated 30 days in a financial crisis where the proposed requirement is that inflows should not exceed 75% of the total outflows (KPMG.com 2012). The Basel III requirements have been seen by many as the only way through which the adverse effects of a financial crisis can be avoided. However, the proposal contains numerous issues which need to be addressed so as to increase its implementation rate. It is encouraging that the committee responsible for addressing these challenges is considering proposals from the banking industry. This way, financial institutions, and world economies at large, will be able to fully enjoy the provisions of the Basel III framework. 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Chouinard, E & Graydon, P 2014, 'Making Banks Safer: Implementing Basel III', Financial System Review, pp. 53-59. Drehmann, M, Borio, C & Tsatsaronis, K 2011, 'Anchoring Countercyclical Capital Buffers:The Role of Credit Aggregates', Monetary and Economic Department, Bank for International Settlements, Bank for International Settlements., Basel. Elliot, DJ 2010, 'Basel III, the Banks, and the Economy', The Brookings Institution, Washington DC. Gambacorta, L & Marques-Ibanez, D 2011, 'The bank lending channel:Lessons from the crisis', BIS Working Papers, May 2011, p. Lessons from the crisis. Gibson, HD, Hall, SG & Tavlas, GS 2012, 'Fundamentally Wrong: Market Pricing of Sovereigns and the Greek Financial Crisis', Journal of Microeconomics, pp. 498-516. Global Regulatory Network 2013, 'Basel Committee tightens leverage ratio requirements', Global Regulatory Network Executive Briefing, Ernst & Young Global Limited. 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