A3 Individual Assignment Research Paper How financial stability is enhanced when banks adopt Basel III accord? PDF

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INDIVIDUAL ASSESSMENTSubject Code BAFISubject Name Financial MarketTitle Of Assignment Research PaperTitle of Research Paper How financial stability is enhanced when banksadopt Basel III accord?Student Name Tran Thi Yen Nhi - sLecture Name Huy PhamWords count 2420Date of submission 14 th January 201...

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INDIVIDUAL ASSESSMENT Subject Code

BAFI3182

Subject Name

Financial Market

Title Of Assignment

Research Paper

Title of Research Paper

How financial stability is enhanced when banks adopt Basel III accord?

Student Name

Tran Thi Yen Nhi - s3651583

Lecture Name

Huy Pham

Words count

2420

Date of submission

14th January 2019

I.

Abstract

Basel III is considered as a spotlight after years when it has solved many shortcomings of the first two Basel Accord published in 1988 and 2004, respectively such as the ability to cover many financial risks. Basel 3 - a global regulatory framework has been developed by Basel Committee on Banking Supervision to respond with the financial crises in 2007 -2009. This framework objectives is to promote “a better balance between banking sector stability and sustainable credit growth” (Vestergaard & Wade 2012).

The purpose of this report is to investigate how financial stability can be enhanced when banks adopt Basel III regulation into their operations. Throughout the paper, the definition of financial stability will be provided to prove the role of Basel III in reinforcing financial stability. Next, there will be an analysis on how Basel III helps bank strengthen its system to manage liquidity, supervision and risk as well as its function to facilitate the funds’ flow. Some Basel III’s limitations are also figured out later in this paper. II.

Introduction

What is Basel 3 and why Basel Committee on Banking Supervision develops it? Basel III is a global administrative accord that presented a lot of changes intended to enhance the control, supervision and risk management for the banks. The Basel Committee on Banking Supervision was introduced based on the first version of Basel III in late 2009, allowing banks around three years to fulfill all prerequisites. To a great extent in light of the credit crisis, banks are required to keep up appropriate use proportions and meet certain base of capital requirement. Basel III was designed to strengthen banking regulatory systems which is the expansion of the Basel I and Basel II archives, and a tool to improve the bank's capacity to manage monetary pressure, as well as hazard the executives, and reinforce the banks's transparency. A remarkable point of Basel III is to encourage more prominent strength at the individual bank level so as to diminish the danger of system-wide shocks. Stakeholder risk, securitization and missing danger factors are covered by Basel 3. It not only enhances the control and hazard the board of monetary administrations industry but also gives the transparency to the framework (Kushwaha et al 2013). The Basel 3 package can be viewed as an incomplete conservation to a more straightforward way to deal with banking

supervision. Though Basel 1 to a great extent was established on an order and-control based methodology (Blom 2009), Basel 2 depended on more market-based strategies for supervision.

III.

Analysis:

What is financial stability? Financial stability has not had its own definition until now as in his paper, Freedman & Goodlet (2007) states that “There is currently no good way to define financial stability” and it’s still way off to be controversially accepted. However, it is asserted that “financial stability is a condition where the financial system is able to withstand shocks without giving way to cumulative processes, which impair the allocation of savings to investment opportunities and the processing of payments in the economy” (Padoa-Schioppa 2002). It emphasizes the ability to absorb sudden shock in market or the resilience of financial system so that its main function is still normally and smoothly carried out through crises. Those activities includes payments transmission, financing instruments price setting risk management and playing the role as financing intermediaries (Alawode & Sadek 2008). Different financial services perform as a facilitator to manage the fund flow from surplus to deficit units by implementing intermediate payment among financial markets, which helps to enforce the financial stability by minimizing systematic risks. Nevertheless, as Garry J. Schinasi (2004) states, the stability of financial system fluctuates from time to time and is consistent with various combinations of fundamental financial elements. Applied for the financial crisis 2007, the circumstance that United States, European countries and Japan set the interest rate incredibly low leads to the low cost of funds contributed to an increasing demand for debt. Consequently, it blew up a financial bubble and it is impossible for banks to obtain funding through financial market at that time and thus, causes a financial crisis globally (Edey 2009). By adopting Basel 3, the stability of financial system is strengthen regarding to the 2 main functions “intermediation of fund” and “allocation of risk”. It can also help to minimize the financial crisis impacts.

Basel 3 helps bank cover three potential risk: market risk, credit risk and operational risk. Uncertainty is a typical characteristic of the contemporary world (Dimitriu et al 2011). Regarding to banking sectors, banks are considered to be the risk management institutions

because regardless international or domestic transaction, it is subjected to different risk factors (Dimitriu 2011). Safari et al (2016) mention that “risk management is an area that is experiencing rapid growth and it entails many and various perspectives and views of factors that are involved, how they are conducted and their uses”. Limited risk management makes banks or banks holding companies, companies and even households more vulnerable when there is a financial shock, this limitation is also considered to be the critical elements in financial crisis globally in the past (Rampini et al 2017). Consequently, governs and financial industry leaders are all agree to have the comprehensive strategy towards risk management in financial field (Safari et al 2016). And Basel 3 is believed to cover the three main potential risks namely market risk, credit risk, and operational risk (Dimitriu 2011).

Market risk: It is crucial that a good quality capital base support banks' risk exposures. The economic downturn illustrated that part of banks' tangible common equity base are credit losses and write downs come out of retained earnings (BCBS 2011). It seems hard to avoid major on- and off-balance sheet risks, as well as derivative related exposures (ibid). During the crisis, this was a main destabilising factor. A Leverage Ratio, recommended by the Basel 3 package, can limit the number of assets (on- and off-balance sheet) that a bank can hold given its amount of capital. Therefore, Bengtsson (2013) asserts that the risk-based capital requirements can be enhanced by a clear and simple leverage ratio. According to Basel 3 Accord, it is suggested that the banks total asset should only be equal or lower to its own capital 33 times (KPMG 2011). Asset prices devaluation will be more worsen with the high leverage ratio, therefore, the new leverage ratio under Basel 3 will slow down the growth of the excessive leverage, reduce lending and fortify the bank’s capital which enable them to hold adequate assets for normal functions in case economic distress. Thus, can reduce systemic risk and reinforce financial stability among banking sectors. Furthermore, Basel 3 also mentions the new two rule for capital buffers so as to reduce market risk. Basel 3 requires banks to raise up the conservation buffer to 2.5%, leads to an increase in total common equity requirement to 7% (IBM n.d). This rate can be adjusted later to absorb losses during financial instability period.

Credit risk: through normal operations, banks enclose with various activities that contribute to their own capital and liability profile. Credit risk or basis risk or asset quality risk is

considered as “a risk of insolvency of the debtor's failure manifested by customers under the bank credit agreements in terms of repayment to the bank” (Dimitriu et al2011). Through the financial crises, several limitations of Basel 2 has been realized. There are some critical problems such as: an inappropriate of average capital requirements which leads to the collapse of many banks recently, “capital requirements under Basel II regulations are cyclical and therefore tend to reinforce the business cycle fluctuations”. Furthermore, the thing that credit risk evaluation is assigned to those non-bank sectors under Basel 2, rating agencies for example potentially lead to the conflicts of interest among financial institutions (Dimitriu et al 2011). Therefore, the application of CET1 ratio is proposed by the BCBS under Basel 3 since it is believed when not only using the most robust and loss-absorbing form of capital but also have ability to reduce the credit risk (Fender & Lewrick 2015). According to Basel 3 new framework , group 1 banks always have to achieve the minimum capital of 4.5% and 7% (plus 2.5% of capital conservation buffer) in regard to CET1 ratio and CET1 target level, respectively (BIS 2015). This standardized approach may help to reinforce financial stability since the possibility of credit risk can mainly minimize.

Operational risk capital will also be strengthened. Operational risk is defined as the potential loss caused by not only inadequacy and failure in internal processes, but also by people, systems or from external events” (Wilson 1997). Adopting Basel 3 can help to minimize this risk, as stated in BCBS (2017), operational risk capital has decreased by an average of 25% among group 1 banks. Under Basel 3, this risk is improved by adjusting operational risk capital (ORC) calculation and controlling internal loss data. Following Basel 3 regulations, it is a must for banks to calculate ORC using the standardized measurement approach. This approach will help to minimize the effect over ORC in the internal loss multiplier (ILM) variable (Deloitte 2017). Thus, help to enhance the resilience of financial institutions and decrease the shocks widespread among financial banking system (BCBS 2009).

Flow of funds is managed and banks’ intermediary role is strengthened under Basel 3. As emphasized in IBM (n.d), “the global capital framework and new capital buffers require financial institutions to hold more capital and higher quality of capital than under current Basel II rules”. Under Financial Institutions and Markets direction, Basel 3 suggests that banks support their capital immediately at the ideal economic period to prevent the capital

during the time when financial conditions debilitate (Kohn 2003). The bank is required to maintain higher capital proportions in order to protect the financial system under recession. This ratio helps to maintain the sufficient funding during economic stress.this requirement also prevent the bank from shortage of liquid assets and work regularly under monetary downturn. The role of this factor is to ensure the bank's performance as intermediaries since “macro-financial instability can seriously impair the lending of funds from ultimate savers to ultimate borrowers, resulting in a sharp reduction in the ability of the financial system to allocate credit” (Freedman & Goodlet 2007). The more elevated amount of capital is required, the more cheap capital the bank can call for to remain the loaning level. Additionally, the issue introduces now is "borrowers are obliged in the proportion they can borrow while banks are compelled in the proportion they can loan" (Gallegoy 2014). Furthermore, as mentioned above, Basel 3 aims to promote “a better balance between banking sector stability and sustainable credit growth” (Vestergaard & Wade 2012). Along these lines, this "capital-to-risk-weighted-assets ratio" advances money related security and proficiency in economic system around the world. Basel 3 required the base capital necessity stays at a total 8% of risk weighted assets (Vestergaard & Wade 2012). Banks are required to have the minimum capital adequacy ratio (the capital conservation buffer included) at 10.5% (BCBS 2011). Capital Conservation Buffer is designed for banks accumulate capital buffers during normal times to ingest misfortunes during financial crisis or economic stress happening (Bengtsson 2013). Financial institutions will be asked to maintain a capital conservation buffer of 2.5% to handle future times of pressure, adding the total equity requirement up to 7% (4.5% common equity requirement and the 2.5% conservation buffer. In case the bank cannot maintain the required capital conservation, it will be limited in its capacity to repurchase shares and pay profits or optional rewards. In this way, the buffer forces banks to preserve capital instead of cutting down lending (Bengtsson 2013). In addition, development change performed by banks is a basic piece of monetary intermediation that adds to effective asset assignment and credit creation. Yet private incentives to restrict the exceeded dependence on funding of core resources are weak (Bank for International Settlements 2014). Numerous banks might raise up the leverage level in private way, and they likewise have motivating forces to expand the balance sheet owning because of low-level and short-term funds. By increasing the balance sheet, it contrarily influences banks' capacity to respond to liquidity shocks when they occur and if banks

cannot disguise numerous costs related to huge funding gaps, systemic implications may be happened, and consequently leads to financial instability. Thus, Basel III managed the suitable required stable financing adds up to take care of this issue, where the strong credit creation is carefully considered – the NSFR requires stable fundings for some extent of loaning to the genuine economy so as to guarantee the coherence of this kind of intermediation (Bank for International Settlements 2014).

IV.

Conclusion

Although there are still some limitations that Basel 3 has not yet solved such as creating many challenges for small scale banks because of an increase in capital levels and interest rate risk in financial market, it can be clearly seen that Basel 3 Accord has come out with new comprehensive strategy to address the remain issues of the first 2 versions (Basel 1 and Basel 2) and settle down the financial crisis while reinforce financial stability. Basel 3 not only helps to facilitate the fund’s flow and consolidate the bank intermediation role but also helps to manage the risks - credit risk, market risk as well as operational risks better. Specifically, through the new requirement in minimum capital for banks, common equity tier 1, operational risk capital, leverage ratio so as to improve the financial stability. As cited in BCBS (2010), the probability of future crises in banking sectors will remarkably reduced thanks to the combination of higher levels of capital and global liquidity framework. Furthermore, by adopting Basel 3, the resilience among banks and banking systems as well as economic growth is improved, exposure of the public sector and tax payers is reduced. To conclude, despite some limitations, the advantages of Basel 3 is believed to outweigh the drawbacks and thus, when updating to Basel 4, there will be solutions to those.

V.

Limitations of research paper

Basel 3 limitation Although having solved the current financial crisis, the new regulatory framework still has some limitations. By requiring banks and bank holding companies to have higher minimum capital requirements levels, the Basel 3 regulation will be more preferable for large scale banks than the small ones since they do not have financial capability to follow this (Kupiec 2013). Consequently, in order to adjust with the circumstance, small banks need to increase the interest rate to attract savers which may help them to increase the capital base. In

contrast, large banks - having advantages when continually hold a large amount of capital create difficulties for small banks that lead to an increase in interbank market’ s interest rate. Regarding to large banks, according to Kupiec (2013), it is also expensive to enforce the new rule because of “new unproven macro prudential capital buffers” which can be the cost burden filled with uncertainty stability benefits. Therefore, it is recommended that the next version should be flexible when determine the required capital level for banks. Furthermore, it may be a shortage when not including requirements for capital levels to manage the interest rate risk in Basel 3. As stated in Kupiec (2013), under Basel 3, it is still allowed national regulators treat its sovereign bonds as if there is no risky when holding that bonds which is very strange if noticing recent experience of banks in Greece, Cyprus and Argentina. Thus, Basel 4 should mention about that.

VI.

Reference List

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