Key Elements of the Basel III as well as Its Impact on Australian Banking - Coursework Example

CREDIT AND LENDING DECISIONS CREDIT AND LENDING DECISIONS Insert name Insert grade course Insert instructor’s name September 6, 2011. Introduction On July 26, 2010, the Group of Governors and Heads of Supervision (Governors), the supervision group of the Basel Committee on Banking Supervision (Committee) (BCBS), pronounced ‘wide-ranging agreement’ on the ultimate stipulations of the Committee’s extensive ‘Base III’ package of wealth and liquidity transformations projected in December 2009. Despite the fact that the general composition and the majority of the main elements of the Base III reforms remain integral, the Governors’ review of the accord reflects transformations in a number of major areas, including the description of capital, the handling of counterparty credit risk, essentials of the new worldwide power ratio, new regulatory capital safeguards, alleviation of general risk as well as the new international liquidity principles. Basel III attempts to increase the general quantum of capital as well as its quality as a means of protecting against bank failures, together with enhanced quantification of risks that were poorly catered for under Basel II. Basel III has been developed by the BCBS in reaction to the recent financial crisis. It is aimed at applying to globally- active banks, on a fully-consolidated basis. It evolved from Basel II and now includes liquidity requirements and offers increased attention to dealing with system-wide issues, like the interaction of prudential requirements as well as economic conditions. This paper is going to discuss the key elements of the Basel III as well as its impact on Australian banking and in particular the credit risk management (Brown, 2011). The fundamental elements of Basel III Since banks are at the centre of the credit intermediation procedure, both directly and indirectly through their function as lenders, market markers, providers of backstop liquidity, as well as payment services, it s evident that banking crises are linked with much deeper economic and financial downturns. There are several factors that contribute to the build up of the crisis, including excess liquidity, leading to too much credit and weak underwriting standards. The susceptibility of the banking sector to this jeopardy in the structure mainly resulted from surplus leverage, too little capital of poor quality, as well as too little liquidity safeguards. The crisis was propelled by a pro-cyclical deleveraging procedure in addition to the interconnectedness of universally significant, too-big-to fail monetary institutions. Lastly, there were a lot of shortcomings surrounding risk management, corporate governance, and market transparency, as well as the quality of supervision. 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). The micro, institution-specific reforms (key elements) and how they promote enhanced monetary system flexibility First, the quality of capital has been greatly raised, with major focus on common equity to absorb losses. This is because credit and market value losses come directly out of retained earnings and thus common equity. For the duration of the emergency, it was the substantial common equity ratio that market members focused on to evaluate bank flexibility. This is as well the reason why regulatory presumptions are taken from this general equity element of capital. All the aspects of the definition of capital have fully been harmonized and they ought to be fully disclosed in the financial statements (Walter, 2010). Second, the coverage of the risks have been greatly improved, particularly in relation to capital markets activities. Trading book exposures will be subject to a strained value at risk prerequisite. Banks ought to hold suitable capital for fewer liquid, credit responsive possessions with much longer investment periods. Securitization exposures will be subject to capital charges more dependable with those for the banking book. The capital requirements for counterparty credit risk are also being strengthened by demanding that these exposures be measured by the use of stressed inputs. Banks as well ought to hold capital for market-to-market losses linked with the worsening of the counterparty’s credit excellence. Third, much higher levels of capital are demanded so as to absorb the kinds of losses linked with crises such as the previous one. This involves an increase in the minimum common equity requirement from 2% to 4.5% as well as a capital conservation safeguard of 2.5%, bringing the total common equity requirement to 7%. This is a seven-fold increase in the common equity requirement (Moody’s analytics). Forth, an international liquidity standard has been introduced to supplement the capital regulation. Even though capital is an indispensable provision for bank flexibility, it is of course not adequate. Banks are therefore required to be able to withstand a 30 day system-wide liquidity distress in addition to maintaining a more strong structural liquidity profile. This will by all means raise the cost of funding in normal times and have an impact on business models. Banks will also be required to do more to self ensure against times of stressed liquidity, just as they are required to hold capital to absorb unanticipated losses. Henceforth, liquidity requires being priced suitably and not seen as a free good. Finally, risk management, stronger supervision as well as disclosure standards are being introduced. The Committee has as well reinforced the Pillar 2 administrative evaluation procedure of the Basel capital structure, including the areas of company control, risk appetite, threat aggregation, as well as stress testing. The Pillar 3 transparency has also been increased for additional multifaceted capital markets actions (Al-Darwish, et al. 2011). Macro prudential elements that deal with the shortcomings emanating from crisis First, a leverage ratio has been introduced with an aim of assisting to control the compression of the risk based requirement. A recent research of the Basel Committee’s Top-down Capital Calibration Group demonstrated that the leverage ratio did the most excellent work in discriminating between banks that ultimately needed official sector support and those that did not. The macro prudential role of the leverage ratio is in preventing the build up of excess leverage in good times and therefore reducing the deleveraging dynamic in times of stress. Furthermore, the leverage ratio protects the system against unintentional outcomes of the risk weighting management. The leverage ratio will assist in making sure that there is concern on the fact that there are wider system broad risks that require to be underpinned by capital (Walter, 2010). Second, measures to raise capital levels in good times have been introduced so that they can be drawn down in times of stress to minimize pro-cyclicality. In the event that the bank’s capital reduces below the 2.5% conservation safeguard, managers will limit allocations and additional benefits, in order to deal with the collective action problem that existed before the crisis, that is, the market strain to keep paying out dividends. This will make sure that capital is preserved in a recession and recreated in the period of upswing. Moreover, a countercyclical capital safeguard has been introduced to shield the structure against surplus credit intensification. It has been observed that nearly all harsh crises are preceded by credit bubbles. Whenever these bubbles burst, the banking sectors are the first victims. Since these bubbles may not always be preventable, banks can be made more flexible to the inevitable fall-out (Walter, 2010). Third, internationally universal banks will be required to have extra loss absorbency capital beyond the Basel III necessities. The Committee’s Cross-Border Resolution Group noted that there is no global liquidation structure for monetary firms and a restricted hope of one being formed in the near future. Thus if the impact of the problems at a global bank cannot be eliminated, efforts must be put reduce the likelihood. The Basel Committee together with the Financial Stability Board is building up a methodology involving both quantitative and qualitative indicators to evaluate the universal significance of international monetary institutions. It is as well evaluating the magnitude of loss absorbency that global banks ought to have. It is also expected that this extra loss absorbing capacity will be achieved through some combination of common equity, contingent capital and bail-in debt (Al-Darwish, et al. 2011). Higher levels of capital, together with an international liquidity structure, may greatly minimize the probability and severity of banking crises in the future. This will protect financial stability as well as economic growth, in addition to reducing the exposure of public sector and tax payers. For instance, studies have shown that an increase in the banking sector’s common equity ratio from 7% to 8% can reduce the annual likelihood of banking crisis by at least one percentage point. A one percentage point reduction in the probability of a crisis in turn generates an anticipated annual output benefit of between 0.2% and 0.6%. Thus, there are significant economic benefits linked with an improved capitalized banking sector. Furthermore, the introduction of the new standards is anticipated to have only a modest impact on financial growth during the transition period. The transition period will make sure that higher standards can be attained through earnings retention, de-risking of certain capital markets exposures, as well as suitable capital rising (Walter, 2010). The impact of Basel III key elements on Australian banking and in particular the credit risk management Basel III is planned to be put into practice consistently around the world so as to minimize the risk that financial organizations will move their operations to jurisdictions with more moderate regulatory management. However, the timing of implementation 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 II new requirements for countercyclical capital buffers. This is because the Basel III demands that individual countries consider whether to raise their national capital requirements when there is an unsafe build-up of credit. The new liquidity demands may prove more difficult for mid-size and smaller banks in Australia than for larger banks, and this may cause these smaller banks to exit lines of business that tie up liquid assets, such as possessing cash payments. 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. Summary In conclusion, the paper has discussed the key elements of Basel III as summarized below. Capital ratios: The core solvency ratio will be retained at 8% of risk weighted assets (RWAs). Minimum common equity component will be increased from the current 2% to 4.5% when fully implemented by 2015. The overall Tier 1 element of the capital base will be increased from the current 4% minimum to 6% when fully implemented by 2015. There may be also a ‘capital conservation buffer’ composed of common equity and amounting to 2.5% of RWAs when fully implemented by 2019. A further ‘countercyclical capital buffer (made up of common equity of up to extra 2.5% of RWAs) will be imposed at a national level only in times of excessive credit growth, and will be released during times of credit contraction (Sherman &Sterling, 2011). Constituents of capital The ordinary equity of Tier 1 will include the ordinary share capital as well as retained profits. Non-common equity Tier 1 (extra tier1) will be mainly made up of perpetual non-cumulative preference shares as well as other qualifying instruments. Tier 2 capitals will no longer be divided into lower Tier 2 and upper Tier 2. Leverage ratio: A backstop 3% ratio of Tier 1 capital as against all of a bank’s assets along with certain off-balance sheet exposures will be introduced. Liquidity ratios: Short term liquidity – Liquidity Coverage Ratio (LCR) - banks will be needed from 2015 to maintain a liquid assets safeguard regulated by reference to net cash outflow over a month stressed period. Longer term liquidity – net stable Funding Ratio (NSFR) – banks will be needed to generate stable funding address funding requirements over a stressed one year period (Sherman &Sterling, 2011). References: Al-Darwish, A. et al. (2011). Possible Unintended Consequences of Basel III and Solvency II. International Monetary Fund. Retrieved on September 6, 2011 from http://www.imf.org/external/pubs/ft/wp/2011/wp11187.pdf Brown, M. (2011). Basel III Capital and Liquidity Reforms Modified but Remain Largely Intact. The Mayer Brown Practices. Retrieved on September 6, 2011 from http://www.mayerbrown.com/publications/article.asp?id=9420&nid=6 Moody’s analytics. Basel III New Capital and Liquidity Standards – FAQs. Retrieved on September 6, 2011 from http://www.moodyskmv.com/download/Basel-III-FAQ.pdf Sherman &Sterling (2011). The New Basel III Framework: Implications for Banking Organizations. Financial institutions advisory & financial regulatory. Retrieved on September 6, 2011 from 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 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. Retrieved on September 6, 2011 from http://www.bis.org/speeches/sp101109a.htm Read More