The Development of Basel III in Comparison to Basel II - Assignment Example

Letter of Transmittal Please type the address here Dear (type your professor name here) In compliance with the requirements of the project “The development of Basel III in comparison to Basel II” has been compiled according to the instructions provided by you. The main purpose of this paper is to present the reason for the development of Basel III which looks at improving the capital adequacy ratio so that liquidity can be improved and the required capital requirements of the business can be maintained. This will help to ensure proper business development and ensure proper liquidity in the system. We hope that the paper meets the requirements provided by you Yours Truly Type your name here Executive Summary The financial crisis in 2007-2008 highlighted the gap that existed in the Basel II norms as the financial crisis showed that the requirements of the capital adequacy ratio were inadequate. The crisis also highlighted that securitization resulted in removing some assets being written of the balance sheet which resulted in both a liquidity crunch and capital adequacy. This developed the Basel III norms which look towards strengthening the capital requirements for the banking sector. The Basel III requires that the capital adequacy ratio be increased to 6% and the increasing the risk weight age asset to 4.5%. This will thereby result in altering the manner in which banks work as they will have to bring changes in the their balance sheet structuring and will affect the lending capability of the banks as the capital adequacy ratio will be altered and will result in affecting their business. This will thereby help to strengthen the functioning of the banking reforms and will ensure better opportunities of growth. Table of Contents Introduction 4 Objective of the Report 4 Basel System Historically 5 Factors that evolved Basel III norms 5 Features of Basel III in comparison to Basel II 8 Implications for bank 11 Conclusion 13 References 14 Introduction The financial crisis in 2008-2009 affected the banking sector tremendously as there were bank failures and the incapability of the banks to deliver quality service and maintain transparency. The number of bank failures especially due to liquidity has made the world governing bodies to look towards revising the capital adequacy requirements. This led to a change in capital requirements which has been provided in Basel III and the G20 summit increased pressure on banks to accept it. The different core issues pertaining to Basel III are still being discusses but it looks mainly towards improving the attention towards implementation by making policies and strategies that ensures better compliance. The fact that the deadline to incorporate the changes pertaining to compliance has been kept at 2019 it is imperative that world bodies looks towards achieving the capital and liquidity requirements before that for better compliance and monitoring of the activities. Objective of the Report This report looks to analyze the factors which have resulted in the development of Basel III and the differences it has in comparison to Basel II. The paper further looks into different reasons which have made the banking regulations to undergo changes and the changes and implications it will have for banks. This will thereby help to understand the manner in which the banking sector has evolved and the manner in which transparency, compliances and liquidity will be looked into. This will thereby help to understand the manner in which the working of the banking sector will improve and help to strengthen the banking regulations. Basel System Historically The Basel system started in 1992 after discussions which went on from 1988. The Basel I came into operation in 1992 which required that banks ensure sufficient capital so that the losses could be absorbed and to develop a field where they competed internationally but avoided conflicts. This was corrected by developing Basel II norms which looked towards filling the regulatory arbitrage gap that existed. According to the Basel I requirements banks controlled their capital requirements by shifting balance sheet items and securitizing assets by shifting them off the balance sheet which affected the capital requirements and risk taking ability of the banks. This resulted in the simplification of Basel II norms where banks were allowed mortgages to 30% so that risk weight age reduces from 50% to 30% (Gordy, 2003). Despite developing different pillars which looked towards ensuring that the capital adequacy requirements improved and banks were able to maintain more liquidity the actual situation didn’t turn out the same. This resulted in the development of Basel III norms which would help to boost the capital that banks hold and will allow increase trading there ensuring better liquidity and maintenance of capital adequacy. Factors that evolved Basel III norms The financial crisis witnessed in the year 2007 was one of the prime reasons which led towards the development of the Basel III norms. The financial crisis clearly highlighted that the several gaps which existed in the banking sector resulted in many countries have excess on and off the balance sheet leverage which resulted in bank failures and created a crisis. This brought forward the need to revise the regulations of the banking sector and the Central bank and the government had their role to be played. A special emphasis which also required urgent development of the banking sector reforms was that the crisis resulted in the decline in the value of mortgage based securities, which led towards defaults leading to a problem associated with liquidity and solvency of the banking sector. This resulted in a downward spiral of asset prices creating problems of liquidity and solvency. Banks to maintain their capital requirements and in situation of falling assets prices it created a liquidity crunch and highlighted the gaps that existed in the Basel II norms which had to be fixed for ensuring better banking sectors reforms (Kane, 2006). The other reason which had led towards the development of Basel III and moved away from Basel II is the fact that the confidence of the banking sector declined which affected the liquidity position due to the fact that counterparty risk increased which automatically transferred into reduced trade finance. The gap that existed between the demand for trade credit and the supply for trade credit was slowly growing which made it difficult for the banking sector to ensure that they were able to provide the same liquidity. This made the government intervene and look into the matter as it would otherwise result in even wider loss to the economy. This increased the role of regional development banks and export credit agencies as they had to finance the gap so that liquidity could be ensured. This resulted in highlighting the fact that the Basel II norms were inadequate in ensuring liquidity in all situations and required further developments so that the gap which existed can be removed and liquidity can be ensured in the system through the development of Basel III norms The financial crisis and liquidity problem in addition to capital requirements made the Basel Committee look into the whole spectrum and develop new regulatory and supervisory standards which would look into liquidity, credit, operation, and market risk. The crisis helped to understand the fact that the Basel II norms were inadequate and required certain changes due to the additional following reasons (Adrian, 2009) The financial crisis showed that the capital requirement ratio which was maintained at 4% was insufficient in situations when there was a huge loss as witnessed during the crisis Making the third party assign the rating agencies to parties looking for loan increased the counterparty risk as it resulted in defaults and wrong ratings making the banks bear an increase burden of loss The crisis also showed that when the economy is growing the country and counterparty risk for a borrower reduces because the value of the assets increases in that period which allows the bank to lend more and still ensure sufficient liquidity. On the other the reveres happens in case recession as the value of the assets decreases and results in increasing the risk for the borrower because decrease in the value of assets automatically transfers into high capital requirements which reduces the lending ability leading to a liquidity crunch as the financial crisis highlighted. The Basel II norms allowed the process of securitization which ensured that banks were given the freedom of removing certain risk weight assets from their balance sheet. This thereby increased the ability of the banks to lend more which affected their capital leverage and affected the capital adequacy ratio thereby highlighting the importance of taking corrective steps Thus, there are various reasons which culminated towards the development of Basel III norms which was strengthening the Basel II norms and would help to improve capital adequacy, monitoring, liquidity, and compliances within the banking sector. Features of Basel III in comparison to Basel II The Basel III norms looks to build on the Basel II norms and looks towards filling the gaps which existed in the banking sector reforms as highlighted from the recent economic debacle. The changes in the Basel III norms in comparison to Basel II has been done after discussion and consultation with central bankers, experts, journalists, and other person related to this field so that strong legislation can be developed. This has ensured that the newly formed Basel III will differ from Basel II as it looks to include the followings (Jackson, 2009) The Basel III looks towards narrowing the term capital by ensuring that only capital and retained earnings are included in it which was not the case in Basel II as it included mortgages and security based assets as well Along with the narrowing of capital the Basel III will increase the capital adequacy ratio to 6% in comparison to the 4% stated in Basel II so that better capital adequacy can be maintained The ratio of equity in comparison to risk weighted assets will increase to 4.5% in comparison to 2% under Basel II. This would mean that the Basel III, will also look towards having a different benchmark for Tier 1 capital which will be calculated as equity over the risk weighted assets which is missing in case of Basel II The Basel III will also require that a capital conservation of 2.5% of the capital has to be maintained in case of stressful situations and can be met only through equity. This also allows the financial institution to withdraw the additional capital by curtailing the distribution of bonuses. This will act as a major force in ensuring that the capital requirements which under Basel II were not so strong is properly maintained thereby ensuring proper capital management in the banking sector In addition to it Basel III proposes that financial institutions will also have to maintain an additional buffer of 0% to 2.5% in period when there is excessive credit growth. This will help to improve the pr-cyclicality which was missing in Basel II and ensure proper capital requirements above the threshold limits. Banks under the Basel III will also have to ensure that they maintain higher capital requirements so that a financial crisis can be averted. The Basel III recommendations thereby looks to work on the different aspect of capital requirements and liquidity which was previously missing in case of Basel II. This has also being demonstrated in the chart below The above chart demonstrates the manner in which Basel II looks towards improving the capital adequacy requirements, leverage requirements and liquidity requirements so that the reforms reduces the chances of another banking or financial crisis. This will help to improve the aspect of monitoring and complying with the different regulations prescribed by the Basel Committee and improving the overall banking sector. Implications for bank The banking sector has to undergo tremendous changes due to the changes made through the Basel III requirements. It will require that banks look towards changes in almost every area like funding, credit, capital, assets, and liability management. Banks while looking to make the changes and adjusting to the Basel III requirements have to ensure that flexibility and resilience is maintained for the growth of the business. The different changes in the Basel III requirements will thereby transform into making changes in the balance sheet structure; improvements in different areas so that the additional cost in relation to funding and capital can be maintained; and restructuring of the different aspect of business which has been affected under the Basel II requirements. The changes will thereby have the following affect on the banks which they will have to comply with (Jackson, 2009) The new capital requirements will have little effect on the banking institutions over a longer period of time as the new rule will help to ease the problem of credit associated with borrowers and will improve the capital adequacy maintenance The small and medium size firms will be impacted as their lending will decrease due to increase in the minimum capital requirements which will have an effect on their business outcome The new regulation might result in the credit tool like “Letter of Credit” to become expensive as compared to other financial tools due to the fact that there is more reliability associated with the conventional credit tools Since Basel III doesn’t bring changes for the non-banking financial institutions it will increase their role at the cost of traditional banks which will lead towards the benefit of non financial banks It might also result that some countries apart from the tight legislation prescribed in Basel III might result in additional rules for the banking sector like increasing the capital requirements which will make it difficult for the banks Thus, there are widespread implications for the banks which has further been presented in the table below The above table also highlights the important areas for banks which needs to be considered and based on it policies have to be developed for their successful implementation and achievement of the objectives due to which it has been designed and planned. Conclusion The economic crisis highlighted the gaps in the Basel II which has led towards the development of Basel III which looks towards strengthening the Basel II. The Basel III looks towards improving the capital requirements, liquidity and leverage aspect so that financial crisis can be prevented. Basel III looks towards improving the capital adequacy by raising the capital requirements and working in different directions so that the overall condition of the banks can be improved. This also provides different implications for the banking sector as they will be affected in a different manner and will have to make changes in the manner which they work so that better regulations are developed. This will thereby help to improve the manner in which banks work and will help to ensure that the financial crisis in the banking sector doesn’t happen again. References Adrian, B. 2009. The Elephant in the Room: The Need to Deal with What Banks Do. OECD Journal: Financial Market Trends, vol. 2009/2 Gordy, M.B. 2003. A Risk-Factor Model Foundation For Ratings-Based Bank Capital Rules. Journal of Financial Intermediation, vol. 12 Jackson, P. 2009. Capital Requirements and Bank Behaviour: The Impact of the Basle Accord. Basle Committee on Banking Supervision Working Papers, No. 1 Kane, E.J. 2006. Basel II: a Contracting Perspective NBER Working Papers, 12705 Read More