Bank of international settlement (BIS) is established in 1930. It is the world oldest international financial institution that remains the principal centre for international central bank corporation. The major parties are the Governor of The Bank of England, Montagu Norman and Hjalmar Schacht counterpart from German. Bank international settlement is established by Young Committee in 1930. (Wikipedia, 2011) This is due to issue of facilitate reparation payments imposed on Germany by the Treaty of Versailles after the First World War. The purpose of the new bank is to take over the position performed previously by Agent General for Reparations in Berlin. The bank will act for collection, distribution of the annuities payable and distribution as reparations. Besides that, BIS also act as trustee for the Dawes and Young Loans which is international loans issued to finance reparations. The reparation is mostly focus on bank activities for the whole corporation and pursues other agencies for their financial stability. The Basel Committee is established in 1974 by central Governors consist representative of central banks and Group of Ten countries. They will conduct meeting three to four times a year but those main working groups will meet regularly for problem solving. The BIS provide Basel Committee on Banking Supervision consist of twelve member secretariat. In the meeting, each country is authorized to discuss about international banking system. Moreover, they also can come out with proposal that can help to achieve the goals. However, committee member cannot act legally binding banking standards as stated in Founding Document. Besides that, it has played a central role in establishing Basel Capital Accords for 1988 and 2004 (Wikipedia, 2011). In 1988, the committee decided to introduce capital measurement system commonly referred as Basel Capital Accord (Basel I). The function is to provide the implementation of credit risk measurement framework with minimum capital standard of 8%. Besides that, it is created to align with capital requirement of banks that competed across national boundaries (Bank International of Settlement, 2011). Bank supervisors in develop countries or less develop countries have implemented Basel I for all their bank operations.
Basel I, also known as 1988 Basel Accord, was proposed by Basel Committee, a committee gathering the central banks of the G-10 countries under the authority of the Bank of international regulations in 1988. Basel Accord referred to capital adequacy, in order to protect themselves against unforeseen losses. Thus, the 1988 capital adequacy requirements framework required banks to include two minimum standards. First is assets-to-capital multiple must be less than 20, followed by the introduction of Cooke ratio, in which the bank must hold capital equal to 8% of risk weighted assets and at least 50% of capital be required to be Tier 1. Bank’s capital comprised of two tiers. Tier 1, a core capital which usually consists of preferred stock (irredeemable and non-cumulative), common stock, and published reserves from after-tax retained earnings. Tier 2, referred to supplementary capital which always be composed of loan-loss reserves, long term subordinated debt and intermediate-term preferred stocks. Basel I primarily focused on credit risk, assets of bank was categorized into five groups according to credit risk, carrying risk weights of 0% to asset category such as cash, claims on OECD governments; 20% to claims on OECD banks; 50% to residential mortgages and 100% to corporate debt, real estate. After ten years implementation of Basel I, many weaknesses appear. The 1988 Basel Accord do not take into account the bank’s operational risk, and insufficiently recognize credit risk mitigation techniques, such as collateral and guarantees. Thereby, a revised and comprehensive framework that addresses the shortcomings and structural weaknesses in Basel I has been established, known as Basel II Accord.
Basel II implemented in 2008, and incorporates three pillars, which are new minimum capital requirements, supervisory committee, and market discipline. Pillar 1 deal with a new capital framework that has been set up after revises the 1988 Accord, and aligning the minimum capital requirements more closely to bank’s actual risk of economic loss. Banks are usually facing three major risk components, credit risk, operational risk, and market risk. The credit risk component can be measured in three different ways, namely standardized approach, foundation IRB (internal ratings based) approach, and advanced IRB approach. For operational risk, there are three approaches, viz. basic indicator approach (BIA), standardized approach, and internal measurement approach. In market risk components, there are two approaches which are standardized approach and internal models approach to estimate. This Basel II recommendation will move banking industry to more redefined and specific requirements that have been developed for each risk category, not merely follows a standardized approach. Pillar 2 deals with new capital framework which recognizes the significance of exercising effective supervisory review on banks’ internal assessments of their overall risks. Basel Committee suggests several principles to govern the review process. Banks are supposed to have a process for assessing their overall capital in relation to risk profile. Supervisors should review banks’ internal capital adequacy assessments, ensure their compliance with regulatory capital ratios. Additionally, supervisors should expect banks to hold excess capital and operate above the minimum required capital ratios, and offer rapid remedial action as well if capital is not maintained or restored. Pillar 3 referred to actions that leverage the ability of market discipline to motivate prudent management by enhancing the degree of transparency in banks’ public reporting, where market participants can better understand banks’ risk profile and the adequacy of their capital positions. Pillar 3 introduced a more detailed disclosure requirements and recommendation, including the method a bank measures its capital adequacy and risk, their recognition of internal methodologies for credit risk, mitigation techniques and asset securitization.
However on September 12 2010, Basel Committee has endorsed a capital and liquid reform package originally proposed in December 2009 and amended in July 2010, known as Basel III. The outlines of Basel III regulations include tighter definition of Tier 1 capital; the introduction of leverage ratio, medium-term quantitative liquidity ratios; a framework for counter-cyclical capital buffers and measurements to limit counterparty credit risk. The Basel III replaces the concept of Basel II in Tier 1 capital holdings to risk-weighting assets. The minimum requirement for common equity will be raised from current 2% level to 4.5%, while the total tier 1 capital requirement increases from 4% to 6%, this will be phased in by 1 January 2015. Under Basel III, total minimum capital requirement remains at 8%, however 6% of capital must be Tier 1, followed by Tier 2 for no more than 2% of capital. Tier 3, which is used solely for market risk purposes, will be eliminated. All banks will be required to hold a capital conservative buffer above the minimum 8% total capital, purposely ensure that banks can maintain their capital levels during downturn and will not induce depletion of capital buffers through dividend payments. Banks that failed to meet this buffer requirement will be restricted from paying dividends, buying back shares and distributing discretionary employee bonuses. Besides capital conservative buffer, banks may be required to hold a countercyclical buffer of up to 2.5% of capital in the form of common equity or other fully loss-absorbing capital. This represents as a tool to protect banks from excessive credit periods.
In the 80’s, the banks failures were quite serious which accounted to be eight bank failures from 1965 to 1981 (Investopedia, 2011). As the banks have a trend of operating internationally, it is agreed to set a minimum levels of capital that all banks must hold across the developed countries (Council of Mortgage Lenders, 2011). In the 1988, the Basel I Capital Accord was created with the general purposes to strengthen the stability of the international banking system, and set up a fair and a consistent international banking system. The Basel I set a capital ratio of 8% as the minimum risk-based capital adequacy. Besides, different risk weight is introduced for different asset class to calculate the Risk Weighted Assets (RWA). However, there are few pitfalls on Basel I, thus, the Basel II is created in the year 2007 in order to enhance the bank’s stability and liquity. However, the 2007-08 Mortgage-backed Subprime Crisis happened to make the whole financial market to go downward. It has revealed the weaknesses of the Basel II approach to the risk management (Council of Mortgage Lenders, 2011). The liquidity of the financial instrucment, for example, the mortgaged-backed securities were then being doubting to the investors that lost their confidence. The banks suffered from deep losses in the market values of the securities. One of the famous institution, Lehman Brothers Holdings Incorporation was collapsed. Policymakers then propsed a new approach which is known as the Basel III. Differences between Basel I, II, and III: Basel I Basel II Basel III year 1988 2007 2010 Capital requirement Total capital requirement must have a minimum level of 8%. Tier 1 = 4% Core Tier 1 = 2% Tier 1 = 6% Core Tier 1 = 4.5% Capital Conservation Buffer No No Banks required holding 2.5% to withstand future stress, bring total common equity req. to 7%. Countercyclical capital Buffer No No Range or 0% – 2.5% of common equity Capital for systemically important banks only No No Systemically important banks should have loss absorbing capacity. Capital ratio Tier 1 + Tier 2 Tier 1 + Tier 2 Tier 1 + Cap. Con. B. + Count. Cap. B. + Cap. for systemically important banks only Development from Basel I to Basel II: In Basel I, the lenders need to calculate the minimum level of capital cased on a single risk weight for different asset classes; Basel II allow lenders to calculate their own required regulatory capital based on they own risk measurement model. Basel II introduced pillar 1, 2, and 3, where pillar one focus on the minimum capital requirement, pillar 2 focus on supervisory review, and pillar 3 focuses on market discipline. Development from Basel II to Basel III: Increased capital requirement. Tier 1 will increase from 4% to 6% Minimum common equity ratio to absorb losses = 2.5% is introduced Countercyclical buffer with a range of 0% – 2.5% is introduced. Purpose to strengthen the loss absorbency of non common Tier 1 and Tier 2. Transition arrangement. All the large banks are required to hold a significant of additional capital to meet the new requirement. All the member countries will need to fully implement this begin on 1st Jan 2013, and translate these rules into national laws and regulations. All the ratios and regulatory adjustment will begin 20% in 2014, 40% in 2015, 60% in 2016, 80% in 2017, and completion in 2018. As for Malaysia, we have go through a few local banks and overseas banks annual report, and we find that basically all the banks are following the Basel II, and some are proposing to follow Basel III soon. The following table shows the accord followed by banks respectively. No Banks Basel Remarks
1 Maybank I, II Basel II for risk management. Using Internal-Ratings Based (IRB) approach for credit risk Using Standardized approach for operating risk. Basel Committee on the Banking Supervision is updating their guidelines as part of the Basel III by end of 2012. 2 Public Bank II, III Gradually implementing Basel III. Transitional phased period from 2013 to 2018. Still implementing the existing Basel II. 3 CIMB II Implementation of Basel II. All major risks are measured accordance to Basel II.
1 Citibank II Computing the Risk Weighted Capital Adequacy according to Basel II. Following the regulatory capital adequac requirement of 8%. 2 HSBC II Computing the Risk Weighted Capital Adequacy according to Basel II. Using Standardized Approach to calculate the capital ratio. 3 UOB I, II Computing the Capital ratios in accordance to Basel II, with the IRB Approach. The comparative figures are computed based on Basel I.
This chapter is further explaining the previous researchers’ discussion on the changes in the indicator, along the development of Basel I to II to III. Basel I, primarily concern on credit risk. It stated the minimum total risk-adjusted assets equal to 8% which was accepted and implemented by over 100 countries international. Ultimately, it is globally accepted as standard for credit risk measurement framework for banks. Undoubtedly, implementation of Basel I really provided much stability on global banking system and improving the international financial system’s capital base. However, there were many issues occurred and eventually leading the appearance of Basel II. The first issues is the rapid changing in the developments such as banking business, risk management practices, supervisory approaches, financial market and eventually making Basel I unable to cope with these changing developments. In addition, Innovation of financial derivatives had further caused the failure of the Basel I. Besides, Carvalho. F. J. (2005) argued that the imposition of capital requirement was a way to create similar regulator costs to competing banks, not as an instrument of protection of systemic stability in the banking industry. Third, Hai et al. (2007) add that Basel I was risk insensitive because it focused mainly the credit risk and ignore the liquidity risk and other risk. Lastly, Basel I didn’t make justice to the complexity of risks to which banks were actually encountered although it defined classes of risk associated to groups of assets to serve as the basic for the calculation of capital coefficients. In such way, it had been suspended that actually increased the overall systematic risk because it allowed regulatory capital arbitrage. Basel II doesn’t only focus on capital, but also on maintaining a level playing field and strengthening incentives to foster sound systemic risk management through the 3 mutually reinforcing pillars. (Caruana, 2003) it consists of 3 pillars – minimum capital requirement, the supervisory review process and market discipline. On the constraint, there are many researches indicated the drawbacks of the Basel II. According to Griffith-Jones and Spratt (2000), adoption of Basel II, particular the IRB approach ( Internal Risk Based – one of the method in risk evaluations prepared at least in part by the bank itself) will lead to a significant reduction of bank lending to the developing countries and/or sharp increase in the cost of international lending to the developing countries. At the same time, public also view adoption of Basel II will result in an increase in the cost and volatility of bank lending to developing countries. Next, Basel II have been argued that it may destabilize the financial system because oprocyclicality because capital charges are positively dependent on the probability of default. In the following, adoption of the Basel II has posted a challenge to banks as it requires very complex system for risk measurement and management. Poor of development rating agencies also play an important challenge in adoption of Basel II because it helps in coming up with the risk-weight of the assets that are used in the standardized approach of Pillar 1. (IMF, 2005) Introduce of Basel III has produced a mix result. Many economic journalists have been discussed the benefit/drawback of this new regulation, whether it could help on recover the global economic instead of slow down it. How the bank will respond to meet these new rules and how it indirectly affect the public. It is still unknown. However, obviously it have posted the ‘too big to fail’ dilemma, pertaining the fact that some banking corporations have grown to the extent that letting them go down simply isn’t an option, given the systemic risk involved and the potential impact on the economy as a whole such a liquidation might have. ( Hugo & Jens, 2010) In addition, the concept of risk weighting has also been viewed as one weakness as it requires the bank should hold more capita against risky assets than they do against much safer assets. And this is a problem that it reckons that the securities which have been risky in the past are the same as the securities which will be risky in the future. Nevertheless, The Wall Street Journal support the Basel III by the size of the new liquidity buffers packed with easy-to-sell assets could prevent the banks from moving capital around the world to meet their funding needs at the slightest whim.
We agree with the changes to Basel III. This is because the changes will help to improve the banking sector ability to absorb shocks that arising from financial economic stress thus reducing the risk of spillover from the financial sector to the real economy. Moreover, improvement from Basel I to Basel III is to help to overcome the weaknesses from the previous Basel. Basel III is more focus on capital. Capital is the amount of high quality assets a bank must hold to against losses. The major of changes is to force bank to hold more capital. By holding more capital, bank will not suffer losses during the economic downturn such as financial crisis because we cannot predict. Under Basel II, bank requires to hold 2% common equity. While Basel III require bank to add additional 2.5 during good times while 4.5% when economic is in bad condition. The capital requirement also has tightens up to focus on higher quality asset such as common equity. Besides that, Tier 1 and Tier 2 capital are adjusted to be more conservative compare to previous Basel. One important amendment is operational requirements for credit analysis for banks holding securitization exposures. We believe that increase of the requirement for credit analysis for banks holding securitized exposures will be an important element to improved risk management. Improve of risk management will help the organization to raised awareness of risk, come out an action plan to deal with significant risk and identify new business opportunities. Moreover, it also ensures that banks with the necessary information and analytical tools to hold securitized products. This is because securitized product offers attractive yields, diversification and safe. Besides that, Basel II is mostly focus minimum capital requirements, supervisory committee, and market discipline but not really focuses on liquidity. Liquidity is important to all company on their ability to turn assets into cash. The major problem is credit crunch. This is because when the assets is deflation banks will not able to unload their assets or even make payments thus many large banks need government help to survive. These happen during financial crisis 2007. The financial crisis triggered by a liquidity shortfall in the United States banking system and resulted in the collapse of large financial institutions. In Basel III, liquidity is concern and they has set numerical standard for liquidity. New rules require banks to have enough high quality assets that can cover cash outflows over 30 days during the stress period. Moreover, it includes liquid assets such as government securities for safety in generate cash in short period. Besides that, new rule include to overcome the fluctuation of economic cycles. Financial crisis has affected the bank capital and some banks even face bankruptcy. In the new Basel, the purpose is to ensure banks build up more padding during the improvement to protect against downturns. The reason is to guard against exceed of lending in the banks. Finally, the new rules had provided timeline guidance for when and how these changes will be implemented. The process will be slowly developed and will not take in full effect until 2019 but the implementation done is clear and smart way. Moreover, it had provided benchmarks within the process to ensure that banks would slowly take full compliance of the Basel III.
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