Bank Regulators and Basel Accords

Subject: Business
Type: Exploratory Essay
Pages: 12
Word count: 3070
Topics: Accounting, Capitalism, Finance, Macroeconomics, Microeconomics


Banking regulation is a form of control, whereby, a regulator mandated by the government imposes a number of restrictions, regulations, and standards for financial institutions. The design of banking regulations inculcates a level of trust and confidence in the financial sector for all stakeholders including customers, investors, and the government. The banking regulations create a fair playing field for financial institutions by promoting healthy competition, deterring and penalizing unethical practices (Mills & Haines, 2015, pp.33). The banking regulations help to develop safe financial infrastructure and a stable environment for business through risk management (KPMG, 2012, pp.8-9). Banking regulations create transparency in the financial market and hold the banks accountable for their conduct. Furthermore, banking regulations help to protect the welfare of consumers and create a means of legal redress. Therefore, banking regulations are important and necessary aspects of the financial system. As the financial and economic environment has evolved over time, regulators have changed the regulations to address emerging issues in the sector. The paper will examine the Basel Accord on Banking Supervision, the connection between banks and the economy, regulations relating to loans, and recommendations for addressing changes in the Basel regulations. 

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Basel Accord on Banking and Supervision

The Basel Accord on Banking and Supervision refers to a three banking regulations that the Basel Committee passed on the Banking Supervision (BCBS). The regulations provided are Basel I, Basel II and Basel III. The BCBS was launched in 1974 as a collaboration between the central banks and financial regulators from 12 countries from Europe, North America and Asia (Hopton, 2006, pp.8). These entities formed the committee to act as an authority for handling banking supervisory issues across the member countries (Barth, et al., 2006, 178). The 12 countries hoped that creating cooperation in banking regulation would improve supervision of banks and instil a degree of stability in the financial market. BCBS acts by collecting and disseminating information about global financial markets with the intent of identifying existing and emergent risks for the banking sector (BIS, 2016). BCBS develops and promotes standards and sound practices for banks. It monitors the behaviour of banks globally to identify any breaches in the implementation of Basel Accords. Finally, BCBS coordinates and cooperates with other regulators in the financial sector to cultivate stability and share supervisory approaches to enhance cross-border regulation efforts. 

Basel I

Basel I was the first accord instituted by BCBS. Basel I was launched in 1988, and it became effective in 1992. The core objective of the accord was to create soundness in the global banking system. BCBS hoped that the accord would create stability and an equitable platform for competition among banks across the world (IPOL-EGOV, 2016, pp.1). Even though Basel I was established as a way of regulating banks that operated internally, the accord was implemented by most banking institutions worldwide. The framework evaluated capital and its connection with credit risk while also developing approaches that would implicitly address other risks. Therefore, all capital requirement regulations were grounded on assessments of credit risk. The capital restrictions in Basel I managed to prevent cases of banks growing business volumes without the requisite capital backing. In 1996, the committee amended the Accord to take into consideration the market risk that arose from trading accounts such as fluctuations in market prices and interest rates. 

Basel I required banks to have a regulatory capital that was not less than 8% of the value of the risk-weighted assets of the bank. The capital could be a mixture of loan-loss reserves, equity and subordinated debt. The process of calculating the bank’s assets were undertaken by evaluating the perceived risk was tied to the different types of assets possessed by the bank. The risk was classified into figures of 100%, 50%, 20%, 10% and 0% (FRB, 2003, pp.395-396). More risky loans such as commercial loans were weighted at higher percentages than less risky loans. The total of the risk-weighted assets was then multiplied by 8% to establish the minimum capital requirement of that particular bank. Over the years, a banking institution’s capital ratio has grown to become an integral indication of any bank’s financial capacity. The framework allowed regulatory bodies to have a higher level of discretion in regards to implementing the regulations in Basel I to their specific markets. Basel I managed to create an equitable environment in the international banking sector, and banks grew more disciplined on matters of managing capital. However, Basel I had notable shortcomings such as disregard for market values and inadequate focus on emerging practices, and policies in the financial sector (NBS, 2017). 

Basel II

Basel II was the second set of regulatory standards provided by BCBS. The accords were published in 2004 thus superseding the Basel I accords that were in operation since 1992. Basel II was developed to create an approach that would reflect the transformations in the financial market because the Basel I accords became effective. The restrictions reinforced the regulatory capital framework for banks that operated internationally (BCBS, 2004, pp.7). The new capital requirements were more attuned to the risk profile of each bank. The Basel II accords also provided incentives to banks that employed strong risk management policies.  The changes in Basel II created a new more methodical way of calculating risk based on risk-reward characteristics of new financial instruments. Basel II created a capital requirements framework that connected the capital as much as possible to the risk taken. 

Basel II operated on three pillars. The first pillar focused on the capital requirements of international banks. The formula for computing capital ratio was unchanged from Basel I. The minimum capital ratio was still 8% while the definitions of capital were unchanged. However, the understanding of risk-weighted assets. The Basel calculated the amount of risk associated with each loan by introducing the concept of securitization (FRB, 2003, pp. 398). The second pillar of Basel II was supervisor oversight. Under the supervisory pillar, Basel II created a framework that enabled regulatory bodies to handle different types of risks in the market. The Basel II accords required banks to ensure that they possessed enough capital to satisfy their risk profile. Basel II also required the regulators to provide feedback to banks based on internal evaluations. The third and final pillar of Basel II was to create discipline in the financial market. The accord required banks to provide the public with timely and comprehensive information about key operations. The disclosed data would enable the stakeholders in the financial sector to evaluate the capitalization of the bank and the risk profile of the institution. 

Basel III

Basel III is a set of regulations provided by BCBS to supersede the Basel II accords. The committee passed the third set of regulations in 2010 and became effective in 2013. They developed the regulations partly as a response to the economic downturn of 2008. Basel III guidelines were established with the goal of improving the capacity of the financial services sector to tackle any challenges that would arise from economic downtimes. Basel III would improve the management of risks across the banking sector by raising liquidity standards (KPMG, 2012, pp.5). Additionally, the third set of accords would create more transparency among banks through disclosure requirements. 

Basel III developed more stringent capital requirements as compared to Basel II. The accord divided the regulatory capital into two divisions: Tiers 1 and 2. Under Tier 1, there is common equity Tier 1, which is equity that has discretionary dividends but lacks maturity. Another category is additional Tier 1 capital, which refers to securities that retain subordinated debt. Additionally, Tier I capital lacks maturity, and the dividends are subject to abrupt cancellation. On the other hand, Tier 2 capital comprises of unsecured debt with a maturity period of five years minimum. The regulations for identifying and evaluating risk remained as defined in Basel II. As such, high-risk credit is still weighted with higher risk scores. Under Basel III regulations, the capital ratio was raised from 2% to 4.5% (FT, 2017). Basel II has faced criticism for its framework that weighs risk by assuming that securities that were risky in the past or risky in the present will hold the same risk in future (Salmon, 2010)

Basel IV

Basel IV refers to the set of banking regulations that are currently under consideration to replace and improve on the requirements in Basel III. Basel IV will provide considerable revisions to the capital requirements and funding for banks. Furthermore, the liquidity requirements will cover the areas of counterparty credit, funding, and market risks (PWC, 2016a, pp.1). The consideration in Basel IV will have an impact on trading and banking books of financial services institutions. Basel IV would introduce streamlined approaches to assess market-risk capital especially for smaller banks. Basel IV will create a shift from internal model-based calculations of minimum capital requirements that are cited as a shortcoming of Basel III (Amorello, 2016, pp. 24). Basel IV proposes the creation of floors, which will effectively limit the practice of risk-weighting assets at lower levels (Bennet, 2016). 

Another risk management consideration proposed in Basel IV is the introduction of total loss absorbing capacity (TLAC) for Globally Systematically Important Institutions (GSIIs) (Amorello, 2016, pp.30). The TLAC requirements are intended to improve the capacity of the banking institutions to recapitalize during periods of economic downturn or economic stress. Another regulation proposed in Basel IV will require banks to maintain quantitatively and qualitatively recommended set of debt instruments that it would convert into equity or written down in case the bank collapses. Basel IV proposes that the minimum leverage ratio should be set at 3% of the total assets held by the bank (IPOL-EGOV, 2016, pp.6). Furthermore, Basel IV will set a binding net stable funding ratio that will be set at 100%. Basel IV will also help to promote lending to economy especially in regards to development banks and centralized regulated savings (PWC, 2016a, pp.1). 

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Bank and the Real Economy

Banks channel money to the economy through loans. The loans provide financing for various projects that contribute to the growth of the economy. The financing options available to firms catalyse growth in their respective sectors, which in turn spurs growth in the economy (Canton, 2014, pp.4). The finances provided by banks provide capital for market entry by new companies. Deposits enable the banks to act as financial mediators who provide funds to people who are lacking but in need of financing (Petkovskia & Kjosevskib, 2014, pp.62, 64). Banks channel money into the economy through the process of liquidity provision. The liquidity provides funding to businesses in the economy during economic downtimes. Moreover, as key players in the financial sector, banks buy securities in large quantities (Gabor & Ban, 2015, pp1). Development banks provide financing to private business units as well as the public sector for projects that ignite development and economic growth. Banks channel funds to important economic sectors such as the industrial and agricultural sector through credit provision. 

Basel IV raised the capital requirements for banks meaning that some banks will need to increase their capitalization by as much as 800% (Noonan, 2016). As the minimum capital requirements increase, it will affect banks that carry out large securities operations. As such, the Basel IV proposals will increase the cost of trading which will reduce the activities of banks; thus, reducing the contribution of banks to the real economy. The proposals in Basel IV will increase the capital requirements as a ratio of the weighted average in regards to market risk (Oudéa, 2016). The increase will means that banks will have to reduce lending because of the exponential capital requirements needed to secure risky loans. The rise will reduce the amount of lending that banks provide the most crucial sectors of the economy. 

The increased capital requirements in Basel IV will have an effect on new businesses. Since new businesses are a risky undertaking, banks will be required to have more capital in order to fund new businesses. Thereby, banks may be force to reduce lending to new businesses hence, negatively influencing the real economy. The new capital requirements will have a direct impact on the ability of banks to finance public projects. Banks will have to reduce funding towards public infrastructure projects because the capital required for such projects will increase fivefold (Brassac, 2016). The new requirements will threaten the ability of banks in countries with fixed rates to provide loans to consumers since the capacity of the borrower to pay is calculated based on their income. As such, the ability of banks to finance the real estate sector will reduce.

Deficiencies of Rules Covering Loans

The regulations that were implemented in the early 2000s allowed banks to undertake internal risk-assessment of loans. Under this model, banks were incentivised to underestimate the risks that were tied to the loans with the goal of maximising the return on equity (Benink & Kaufman, 2008). As such, most banks underestimated the risk of the capital with the view of reducing the capital requirements that would keep the bank afloat in case the loanee failed to meet their obligations. The provision for banks to use their own models when deciding on capitalization created vulnerabilities in the banking sector. 

The rules covering loans were unsuited to the financial to the financial sector because of the lack of risk sensitivity. Banks provided corporate loans to small businesses and large companies based on similar regulatory capital foundations despite differences in leverage and risk. Consequently, the failure of the big corporations to repay was more destructive to the banks than it was for small companies because of risk insensitivity. The difficulties encountered by the banks were a clear manifestation that the one-size fits all approach to risk-management was untenable. The 8% capital requirement established by the BCBS was a subjective percentage that the regulator failed to base on clear solvency targets. In hindsight, the 8% capital requirement was too low for the risky financials sector. Another challenge that the regulations posed was that bonds that were tied to mortgages were recorded as mortgages rather than bonds as provided in the regulations on bookkeeping, which underwrote the risk attached. 

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The deficiencies relating to risk weighting could have been overcome through the implementation of a non risk-weighted ratio restriction (Bessis, 2015, pp.19-20). The non risk-weighted ratio would help to supplement the capital requirements in the Basel accords. It would be necessary to raise the capital requirements for banks to provide a cushion during economic downtimes. Raising the capital requirements would allow banks to recognise and overcome losses while absorbing the shock on behalf of the economy. The next regulation that would alleviate the deficiencies is the incorporation of market risk factors in risk management (Persaud, 2008, pp.33).  The regulators needed to reinforce loan-loss provisions that would inculcate a higher level of macroeconomic stability. Another solution would require banks to satisfy a liquidity coverage ratio to guarantee that the banks would possess enough liquidity to combat severe and sudden market shocks (Edwards, et al., 2010, pp.2). Finally, banks would be required to hold common equity that was at least 5% of the total assets. (Michel & Ligon, 2014)

Practical Recommendations to Comply with Basel IV

The considerations in Basel IV will be broad and extensive in impact and regulators need to prepare. Firstly, regulators will require banks to reduce the dependence on internal models of calculating risk. Banks will need to develop risk sensitivity models that will better reflect the prevalent market conditions (Capgemini, 2015, pp.13). The new models will place restrictions on the input of data from internal models hence creating more efficient and reliable risk-management processes. Regulators should impose floors in some benchmarks such as probability of default. They will develop regulations requiring banks to change the process of risk differentiation. The regulations will require the banks to reduce the importance of external credit ratings when calculating risk-weights. Regulators will establish disciplinary mechanisms that will punish banks that will fail to provide necessary data on counterparties (Davies & Green, 2013, pp.23-25).

Regulators will need to develop new calibrations that will help to manage control risk (Cecchetti, 2012, pp.6-7). Creating a new calibration for risk weighting will instil simplicity in the process of calculating risk and nurture confidence among banks and their shareholders. Regulators would need to develop new avenues for communication with banks. Regular communication with banks will enable the regulators to fulfil the supervisory scope of the accords. The regulators will have to establish new guidelines on business specifications that will be crucial in defining aggregation and the reporting (PWC, 2016b, pp.35). The regulators would need to create a methodology for the valuation of curvature risk charges. Regulators in the banking industry will need to undertake an impact study to assess the impact of the increased capital requirements for banks. The impact study will help to understand how the considerations in Basel IV will influence low-risk market to enable the regulators to create contingency plans to shield such organizations (SBA, et al., 2016, pp.2). Under Basel IV regulations, it will be necessary for regulators to increase resources towards monitoring of credit risk. The regulators will undertake an assessment of the progress of banks in implementing the guidelines of Basel IV. Additionally, regulators will undertake follow-up to ensure that banks implement the measures after any compliance challenges emerge. 

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Banking regulations instil trust and confidence in the financial services sector and foster a fair playing field for financial institutions by promoting healthy competition, and discouraging unethical practices. BCBS coordinates and cooperates with other regulators in the financial sector to cultivate stability and develop sound financial practices. Basel I required banks to have a regulatory capital that was not less than 8% of the value of the risk-weighted assets of the bank. The framework allowed regulatory bodies to have a higher level of discretion in regards to implementing the regulations in their respective markets. Basel II created a new more methodical way of calculating risk based on risk-reward characteristics of new financial instruments. Basel II was anchored on the pillars of capital requirements, regulatory supervision, and discipline. Basel III guidelines improved the capacity of the financial services sector to tackle any challenges that would arise from economic downtimes. Basel IV will introduce a more streamlined approach for assessing capital requirements. Under Basel IV, banks would probably reduce lending to new businesses and funding of public infrastructure projects. 

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