The Key Elements Of Basel III - Case Study Example

THE KEY ELEMENTS OF BASEL III THE KEY ELEMENTS OF BASEL III Insert name Insert grade course Insert instructor’s name September 27, 2011. Introduction The main elements of Basel III were set out so as to Strengthen the resilience of the banking sector (December 2009), but many more focused documents issued over the past two years also contain relevant proposals. Following the consultation process in the first half of 2010 as well as the wide spreading testing (QIS 6), several vital changes were agreed and these were announced on 26 July, 2010 by the Basel Committee’s (BCBS’s) main group of 27 central bank Governors and Heads of Supervision, which approved a seven-page summary of decisions taken at the BCBS’s meeting in mid July. The majority of them involve concessions to the powerful banking lobby but in a few cases some tightening or extra protections were proposed. On 12 September 2010, another paper was released that set out the proposed calibration of the new standards and instituted an all-inclusive timeline for their phased introduction over period that runs up to 2019. Nevertheless, most of details are not clear and it will only be after the release of a comprehensive paper that has been promised for the end of 2010 that the full package will become clear (Freeland, 2010). The package has five most important elements, three of which are wholly new. Pillar 1 is significantly tightened up, both in the definition of capital (the numerator of the 8% ratio) and in a number of elements of the denominator (the measure of risk). The new elements include extra capital ‘buffers’, a leverage ration as well as measures concerning liquidity. It is as well crucial to recall that earlier papers tightened up the market risk structure, along with Pillars 2 and 3 of Basel II that handle the supervisory review process as well as market discipline. A number of media have criticized the sluggishness of the timetable, but there are two main reasons for this, first, uncertainty concerning the health of some parts of the global economy and second the fact that a number of banks in Europe is particular have log operated with capital that will not be recognized under the new arrangements and will require time to restructure their business models (Freeland, 2010). This paper discusses the key elements of Basel III and its impact on Australian banking especially in the area of credit risk management. The key elements of the Basel III reform package Since banks are at the centre of the credit intermediation process, both directly and indirectly through their role as lenders, market markers, suppliers of backstop liquidity, as well as payment services, it s obvious that banking crises are associated with much deeper monetary and fiscal recessions. There are a number of factors that contribute to the build up of the crisis, including excess liquidity, leading to too much credit and weak countersigning principles. The vulnerability of the banking sector to this risk in the framework primarily resulted from excess leverage, too little capital of poor quality, as well as too little liquidity protections. Lastly, there were a lot of inadequacies surrounding risk management, company governance, and market intelligibility, as well as the quality of management. The Basel Committee reforms (the Basel III key elements) deal with these weaknesses both through micro prudential and macro prudential measures (Al-Darwish, et al. 2011). 1. Strengthening the global capital framework I. The quality of the regulatory capital base will be improved by: Introducing a more rigorous definition of, and qualifying criteria for, Tier 1 and Tier 2 capital. This comprises of the removal of incentives to trade in as well as the inclusion of a provision that the contractual terms of any non-common equity capital instruments ought to permit them to be disregarded (or transformed into ordinary shares) in the event that a bank is determined by a pertinent power to be non-viable or receives a public sector booster of capital (or corresponding support) without which it would have become non-viable; and Balancing regulatory adjustments (that is, deductions) to the capital base and providing that in most cases these have to be subtracted from the ordinary equity element of the capital base. II. The minimum regulatory capital provisions in relation to risk-weighted possessions will be increased, with: The ordinary equity provision rising from 2% (before application of regulatory alterations) to 4.5% (after the application of firmer regulatory adjustments); and The Tier 1 capital requirement will be raised from 4% to 6%. The total minimum capital requirement will remain unchanged at 8%. III. The transparency of the capital base will be enhanced, with all components of capital being required to be released along with a comprehensive reconciliation to the reported accounts (Walter, 2010). 2. Reducing procyclicality In normal times outside of periods of monetary and economic strain, banks ought to hold buffers of capital above the regulatory minimum capital prerequisite. For this reason, Basel III institutes a ‘capital conservation buffer’ of 2.5% of risk weighted assets including common equity (after the application of regulatory alterations). Restraints will be forced on allocations by a bank when its capital level falls into the conservation buffer range. In an effort to deal with the cyclicality of the capital structure and neutralize any predisposition towards procyclicality, Basel III offers for the assortment of the capital protection buffer to be enlarged in periods of unnecessary cumulative credit growth by the add-on of a ‘countercyclical capital buffer’. This countercyclical capital buffer may vary from 0% in normal times up to 2.5% of risk-weighted assets at some stage in periods of too much credit growth linked with the increase of system-wide threat (Brown, M. 2011b). 3. Supplementing the risk-based capital provision with a leverage ratio Basel III offers for the introduction of an uncomplicated leverage ratio intended to limit the increase of too much leverage in the banking segment. The leverage ratio will offer an extra protection against model risk and measurement error in the risk-based sufficiency computation. 4. Enhancing risk coverage The capital provisions for counterparty credit risk (CCR) disclosures in banks’ derivatives, repo as well as securities financing actions will be made stronger. This will be attained through a range of actions comprising of: the imposition of capital charges for market-to-market losses; and the use in the capital computation of strained inputs and of an asset value association multiplier for disclosures to large regulated, financial firms. Risk management principles for model legalization, stress-testing, security supervision as well as margining provisions will as well be made stronger. The BCBS handed in a consultative paper, on 20 December 2010, concerning the Capitalization of bank exposures to central counterparties, setting out proposals for the capital treatment of banks’ exposures to central counterparties (CCPs). While offering motivations for banks to build-up their use of CCPs to clear OTC derivatives trades, the suggestions intend to make sure that the risk arising from banks’ exposures to CCPs is sufficiently capitalized. The BCBS anticipates finalizing the proposals before the end of this year for realization by January 2013, as part of the improved capital handling for CCR exposures (Brown, 2011a). 5. Introducing global liquidity standards and monitoring metrics Basel III has introduced two minimum principles for funding liquidity: 1) The Liquidity Coverage Ratio (LCR) – to make sure that banks have an adequate stock of high-quality liquid possessions to cater for conditional liquidity requirements and endure for at least 30 days under a supervisor-defined situation uniting an distinctive and market-wide shock; and 2) The Net Stable Funding Ratio (NSFR) – to encourage banks’ use of more steady and longer term financial support sources to maintain their actions. Under this ratio, banks are demanded to make sure that their approximation of ‘necessary steady funding’ over a one-year time horizon under circumstances of extensive strain is met by their approximation of ‘available stable funding’ from dependable funding sources. Transitional arrangements The BCBS has stipulated a set of transitional arrangements for the realization of the new Basel III principles with a view to making sure that the banking sector can handle the higher capital and liquidity principles through reasonable earnings retention, capital or fund raising, as well as additional balance sheet alterations, while still supporting lending to the economy. Accomplishment will thus begin on 1 January 2013 with full realization by 1 January 2019 (even though the phase-out of capital instruments issued before 12 September 2010 that no longer qualify as Tier 1 or Tier 2 capital will continue until 2023). Reporting during observation periods Provided that the leverage and liquidity ratios are new, the BCBS has offered observation periods, within its transitional phase-in arrangements, to permit the ratios’ operation and effects to be monitored before they are formally executed as minimum principles. Strong data reporting and evaluation procedures will be instituted for the duration of these observation periods, involving extra QIS-type exercises commencing later this year, followed by the introduction of a more formal regulatory reporting structure. To give banks time to develop their reporting systems, it is expected that the initial formal reporting will be needed to be submitted in or around January 2012 (BCBS, 2011). Impact of Basel III reforms on Australian banking in the area of credit risk management Basel III is anticipated to be applied consistently around the globe in order to minimize the risk that financial institutions will move their operations to jurisdictions with more lenient regulatory regimes. Nevertheless, the timing of execution will not be the same and Australian banks with operations in several other countries might be forced to comply with the tightest national timeline to which they are subject. These banks may also find it difficult to comply with Basel III new requirements for countercyclical capital buffers. Australia is required to consider whether to increase their national capital requirements when there is an unsafe build-up of credit (Bhimalingam, & Burns, 2011). The implementation Basel III will modify the standardized measurement method for market risk by adding the concept of correlation trading. The correlation trading portfolio integrates securitization exposure and nth – to- default credit derivatives with certain criteria. It will also provide alternative strategies to measure the price risk of options, depending on the significance of a bank’s trading portfolio. The impact of the Basel III requirements in general may encourage certain activities to migrate to the shadow banking or unregulated sectors. Full compliance with Basel III is likely to result in small dip in real GDP growth (Sherman &Sterling, 2011). Conclusion This paper has discussed the key elements of the Basel III reforms. The paper started with a brief introduction of the Basel III report and how it was reached at and a short framework of the five key elements. The paper has also discussed the transitional arrangements for the implementation of the Basel III standards. Moreover, I have discussed briefly how reporting will be done during observation periods. Finally, I have discussed the impact of Basel III reforms on the Australian banking system and especially the credit risk management. References: Al-Darwish, A. et al. 2011. Possible Unintended Consequences of Basel III and Solvency II. International Monetary Fund. Available at http://www.imf.org/external/pubs/ft/wp/2011/wp11187.pdf (accessed September 27, 2011) BCBS 2011. Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems. Revised Version 2011. Bank for International Settlements. Available at http://www.bis.org/list/basel3/index.htm (accessed September 27, 2011) Bhimalingam, M. and N. Burns 2011. Basel III and Solvency II - Impact on Credit Markets. Deutsche Bank Special Report. Brown, M. 2011a. Basel Committee Releases Final Text of Basel III Framework. Legal update, 7 January, 2011. Available at http://www.mayerbrown.com/publications/article.asp?id=10235 (accessed September 27, 2011) Brown, M. 2011b. 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Financial institutions advisory & financial regulatory. Available at http://www.shearman.com/files/Publication/f4e80b99-f0a1-4e3a-90f0-3bf21c7d0ce0/Presentation/PublicationAttachment/8d4e19cc-1ba3-4501-8fe6-63a6633d5b6b/FIA-033011-The_new_Basel_III_framework__Implications_for_banking_organizations.pdf (accessed September 27, 2011) Walter, S. 2010. Speech on Financial Stability Institute, Bank for International Settlements, Basel, 3-4 November 2010. Basel Committee on Banking Supervision, at the 5th Biennial Conference on Risk Management and Supervision. Available at http://www.bis.org/speeches/sp101109a.htm (accessed September 27, 2011) Read More