Introduction of the History of Bank of International Settlement and Basel Financial Essay

The Bank for International Settlements (BIS) is the institutional home of the Basel Committee on Banking Supervision. Headquartered in Basel, Switzerland, the organization's mandates are to promote international monetary and financial cooperation and serve as a bank for central banks. The BIS also houses the secretariats of several committees and organizations focusing on the international financial system, including the Basel Committee, although these entities are not formally a part of the BIS. BIS membership currently totals 55 central banks.

The BIS was created in 1930 within the framework of the Young Plan to address the issue of German reparations. Its focus soon shifted to the promotion of international financial cooperation and monetary stability. These goals were initially pursued through regular meetings of central bank officials and economic experts directed toward promoting discussion and facilitating decision-making processes, as well as through the development of a research staff to compile and distribute financial statistics. The BIS also played a role in implementing and sustaining the Bretton Woods system.

Besides, Basel is third most populous city with about 166,000 inhabitants. Located where the Swiss, French and German borders meet, Basel also has suburbs in France and Germany. With 830,000 inhabitants in the tri-national urban agglomeration as of 2004, Basel is Switzerland's second largest urban area. Basel functions as a major industrial centre for the chemical and pharmaceutical industry. The Basel region, culturally extending into German Baden-Wuttemberg and French Alsace, reflects the heritage of its three states in the modern latin name "Regio TriRhena". It has the oldest university of the Swiss Confederation (1460). Basel is German-speaking; the local variant of the Swiss German dialect is called Basel German.

The detail indicator in Basel I, II, III.

Basel I, which is the first credit risk analysis instrument start used in 1998 and also called as Basel Accord. They are classified into different categories of the bank's assets according to different credit risk, carrying risk weights of zero, ten, twenty, fifty, and up to one hundred percent. The basic risk weighted assets are required to for bank's capital is equal to 8%. However, there is argument from JP Morgan Chase, he mentioned that 8%of minimum requirement is unreasonable, and implement credit default swaps so that in reality they would have to hold capital equivalent to only 1.6% of assets.

According to Ahmed & Khalidi (2007), they mentioned that Basel I was designed to establish minimum levels of capital for internationally active banks. The main setting of the standards is based on "rules of the thumb", that is relatively crude method of assigning risk weights on balance sheet and off balance sheet asset categories. Besides, this also focussed on credit risks but ignoring the bulk of the multiple risks may face in banking industry today.

For Basel II, there is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. Basel II uses "three pillars" concepts, which are minimum capital requirements, supervisory review and market discipline. From previous researchers Wignall & Atkinson (2010) found that, the simplified Basel II approach is more 'granular' than Basel I, but retains its basic features. When facing the financial crisis, the Basel Committee cutting the risk weight to mortgages by some 30% and much more in the complicated version. In additional, for the weight for lending between banks was in lower percentage which 20% under Basel I, and it still maintained the same portion in Basel II, but it likely to cut 20 - 30 % under the sophisticated approach.

Based on the research done by Ahmed & Khalidi (2007), they have examined the process of development of the Basel Accord from a simple and crude credit risk measurement based capital adequacy accord into a comprehensive risk control framework grounded on three different pillars as below.

The first pillar, which is aims to improve the link between bank capital and the risks that could lead to Bank insolvency. There are three major component of risks are can be calculated, which are credit risk, operational risk, and market risk. The calculation of credit risk may separate to three different degree namely standardized approach, which Foundation IRB and Advance IRB. IRB stands for "Internal Rating-Based Approach". Besides, also have three different approaches to mention, which is BIA, standardized approach, and the internal measurement approach. The method to measure the market risk is VaR (value at risk).

The second pillar is supervisory pillar which aims to improve the supervision capacity of regulators to control the risk of bank failure.

The deals of the first pillar, which giving regulators much improved "tools" over those available under Basel I, it also provides the framework to dealing with other risks may face by all banks. This will improve the risk management system of banking industry.

The third pillar is aims to promote greater stability in the financial system. This pillar is allowed the market discipline to operate by requiring lenders to publicly provide bank's risk management methods, risk rating measurement and risk distributions. In order to strengthen the bank's competitive; they must make that lend greater insight into the adequacy of their capitalisation.

Basel III is a new global regulatory standard on bank capital adequacy and liquidity agreed by the members of the Basel Committee on Banking Supervision. This third version of the Basel is found during the global Financial Crisis. Basel III is more focussed on the bank's capital requirements and introduces the new rules of bank liquidity or bank leverage. Based on the OECD estimation, the implementation of this Basel III may improve the annual GDP growth by 0.005 - 0.15 % point.

The development of Basel I, II, III and beyond

From Basel I to Basel II

The initial Basel I Accord was based on a simple model to measure capital. The starting objective for Basel I was to ensure banks to maintain enough capital to absorb losses without causing systemic problems. Besides it also play an important role in the soundness of banks by avoiding competitiveness conflicts between each others (Wignall & Atkinson, 2010). Although it was very simple to be used but this approach had became less effective for the bank to measure its capital over these years. There are problems appeared in Basel I such as it measure the risk based across exposure groups and not the individual elements of credit worthiness within these groups. Besides, this approach also lack of sufficient risk differentiation for individual loans and no recognition of diversification benefits. In conclusion, Basel I is lack of soundness in risk management.

After many issues appearing during the time of implementation of Basel I, Basel II was created as the improvement of Basel I to overcome its limitations. The main difference between Basel 1 accord and Basel II accord is Basel II accord was not confined with the rating factor and was based on the fact "one size fits all". However, Basel II accord mainly focuses on the rating factors of the borrowers. In Basel II, there are changes in internal processes and have developed a better risk management practices such as securitization monitoring and management of exposures and activities. Basel II has included three compliance frameworks based on the business model of the bank. The Standardized Approach which is almost similar to the Basel I rules was created and smaller, less-complex banks is required to follow it. However, for larger and more complex banks will be encouraged to adopt an Internal Ratings Based (IRB) Approach that directly links a bank's risk ratings with its regulatory capital requirements. IRB approach seeks to differentiate risk on an asset-by-asset level for better decision making (Powell). Comparing to Standardized approach, IRB required more highly-complex modeling and expertise. Under the requirement in Basel I the weight for lending between banks was only 20% and the percentage still maintain at the same level under the simplified Basel II. However it has increased by 10% under the sophisticated approach. Lastly, Basel 3 pillar was applied in the Basel II. Pillar 1 provides guidelines for minimum capital requirements more accurate to each bank's actual risk of economic loss. Next, pillar 2 evaluates the activities and risk profiles of individual banks. However, pillar 3 leverages the ability of market discipline to motivate prudent management by enhancing the degree of transparency in banks' public reporting to shareholders and customers.

From Basel II to Basel III

However, there was also imperfection for Basel II in practicing the approach. In Basel II pillar 2 which is supervisory review process, is difficult to keep up with changes in market structure, practices and complexity. If there was a mistake in the supervisory in the review process, it will cause the policy makers will be ineffective in countering defects in Pillar 1 and therefore the Pillar 2 will be affected as well (Wignall & Atkinson, 2010). Basel III have listed down the new capital and liquidity requirement to replace the Basel II for a better performance of job. There are few changes of development in Basel III compare to Basel II. First, there was an increased of quality of capital which there should be more than 50% of common equities and retained earnings as predominant component in tier 1instead of debt-like instruments. Besides, Basel III also increased the quantity of capital as well. The minimum common equity of tier 1 has increased from 2.0% to 4.5%. However, the total capital increased from 8.0% to 10.5%. Basel III now requires the banks to determine their capital requirement for counterparty credit risk using of stressed inputs. It can help to remove pro-cyclicality which will appear with using current volatility-based risk inputs. Moreover, leverage ratio was introduced for the intention of helping to avoid the build-up in excess leverage that can lead to a deleveraging 'credit crunch' in a crisis situation. Leverage has been reduced through introduction of backstop leverage ratio. The leverage limit is set as 3%, i.e. a bank's total assets should not be more than 33 time bank capital. Next, it also increase short term liquidity coverage by introducing the 30-day Liquidity Coverage Ratio (LCR) which helps ensure that global banks have sufficient high-quality liquid assets to withstand a stressed funding scenario specified by supervisors. The following table represents the summary of Basel I, II, and III.

Basel I

Basel II

Basel III

Main Functions

-also called Basel Accord

- classified the different categories of the bank's assets according to different credit risk

- uses "three pillars" concepts

- minimum capital requirements, supervisory review and market discipline

- Pillar 1

- Minimum

Capital

Requirements

- Pillar 2

- Supervisory Review

- Pillar 3

- Market Discipline

- strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage

Capital for Systemically Important Banks only

-No capital for Systemically Important Banks only

-Systemically important banks should have loss absorbing capacity beyond the standards announced today

2 New Liquidity Ratio

-Liquidity Coverage Ratio (LCR)

-Net Stable Funding Ratio (NSFR)

No

-LCR focuses on the shorter end of the time horizon.

-NSFR looks at a medium term horizon.

Common

Equity

Tier 1

capital

Total

Capital

Common

Equity

Tier 1

capital

Total

Capital

Minimum

Requirements

2.0%

4.0%

8.0%

4.5%

6.0%

8.0%

Additional

Capital

Conservation Buffer

Not applicable

2.5%

-

-

Additional

Countercyclical

Buffer Range

Not applicable

0% - 2.5%

-

-

Additional

Requirements

For Systemically

Important Financial Institutions

Not applicable

May be added to the other risk-weighted requirements

Leverage ratio

Not applicable

May in effect add to the risk-weight requirements

The related paper discussion on the changes in the indicator, along the development of Basel I to II to III.

Basel I is the framework of minimum capital standards introduced in 1988 by the Basel Committee on Banking Supervision and it was designed to enhance the safety and soundness of the international banking system thus to increase the competitive pressure for creating a more level playing field among internationally competitive banks where small difference on pricing could have competitive impact (Ahmed & Khalidi (2007). Basel I was emphasized on the credit risk, all of the bank's assets were categorized on five classification based on credit risk, such as holding risk weights of 0%, 20%, 50%, and 100%. A new 150% rating comes in Basel II for borrowers with poor credit ratings (Wikipedia, 2011). According to Basel I, those international banks are required to maintain their capital equivalent to 8% of risk weighted assets. However, it has been criticized because the low risk sensitiveness of its capital requirements may lead to greater risk raking and regulatory capital arbitrage practices by banks, furthermore it focused only on the credit risk while ignoring the bulk of multiple risks facing by banks today. Therefore, Basel II has been developed which relies on the three pillars as such capital requirement, supervisory review and market discipline to achieve the safety and soundness of the financial system. The new framework addresses the perceived shortcomings and structural weakness of Basel I and it is fairly complex compare to the crude risk weight of the Basel I in order to make its understanding implementation a challenge to both regulatory and the regulated community.

In Basel II, it was focused on financial and operational risk that faced by bank. It created an international standard for banking regulators to exercise when decided the amount of capital that banks need to maintain and guard against the financial and operational risk. Basically, regulatory capital requirements for credit risk in Basel II are calculated according to two alternative approaches which are the Standardized and the Internal Ratings-Based (IRB). Standardized approach of the Basel II framework assembles the simplest options with the objective by simplifying choices for certain banks and supervisors for measuring the other determinants. For operational risk, there are 3 different approaches which are basic indicator approach, standardized approach, and the internal measurement approach whereas for the market risk, the preferred approach is VaR (value at risk). Besides that, Basel II was highlight on the three main fundamentals which are capital allocation to be more risk sensitive, divided operational risk from credit risk and reduce the scope for regulatory arbitrage. Moreover, it has provided clearer picture on the definition of bank capital by using three pillars concept. In addition, Basel II put more attention on Pillar 1 by describing the different approaches to compute the minimum requirement. It seems that the principles and objectives of Pillar 2 and Pillar 3 is not very precise which left to national supervisors' discretion. For Pillar 2, the supervisory review, supervisor tend to determine the bank's rating based on its capital and risk levels. Low rated banks will be comparing to high rated banks to tighter the dividend restrictions in order to build capital. For Pillar 3, market discipline, public statement about the bank's rating has been made by supervisor through showing the informational role played by rating agencies. It also shown the discipline enforced by uninsured depositors in order to allow the supervisor to reduce banks' risk taking incentives by reducing the fraction of insured deposits. Overall, Basel II represents a rise in the risk sensitivity of banking regulation and supervision hence it reduces banks' risk taking incentives and supervision cost (Elizalde, 2007).

Basel III is a comprehensive set of measures to strengthen the regulation, supervision and risk management of the banking sector. It helps to improve the banking sector's ability to absorb shocks arising from economic and financial stress. The minimum regulatory standard for Tier 1 capital ratio has been increased from 4% in Basel II to 6% in Basel III. Basel III continues to be viable capital standard and it does not replace Basel I or Basel II in which Basel III is about more than just capital ratios. It proposed stronger capital framework by increasing the significantly the quality, the coverage, and the required level of bank capital. The components which include credit risk, market risk and operational risk have been adjusted in Basel III. Besides, the new definition of capital also has been adjusted where there are no sub-categories of Tier 2, elimination of Tier 3 category due to no real impact, and minimum requirements established for common equity Tier 1, Tier 2 and total capital has been set. Furthermore, there are new rules for counterparty credit risk to be finalized, for instance, the capital adequacy ratio is being raised where the minimum common equity requirement will be 4.5% as compare to the current 2%. A capital conservation buffer of 2.5% is to make sure that banks maintain the level of buffer of capital that can be used to absorb losses during periods of financial and economic stress, thus it will be added to the 4.5% to make a total requirement of 7% common equity to total risk-weighted assets. In Basel III, a countercyclical buffer within a range of 0% - 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. There are also two new liquidity ratios which consist of liquidity coverage ratio and net stable funding ratio are introduced in Basel III. Liquidity coverage ratio is focused on the shorter end of the time horizon and is aimed at ensuring that each bank owns liquid resources to such an amount that short term cash obligations are fulfilled even under a severe stress. In addition, Basel III is introducing a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio. While, net stable funding ratio looks at a medium term horizon and focused on the structural balance between maturities of a bank's assets and liabilities. It is aimed at preventing banks from exposing themselves to extreme maturity transformation risks by funding medium and long term assets with very short term liabilities. Besides that, based on Wikipedia (2011), the introduction of leverage ratio is an additional measurement of Basel II risk-based framework. The purposes of the introduction of leverage ratio are put a floor under the buildup of leverage in banking sector and to introduce additional safeguards against model risk and measurement error by increasing the risk based with the measurement based on gross exposures. Moreover, in Basel III, it will help to strengthen the risk coverage of the capital frameworks especially for counterparty credit exposures arising from banks' derivatives, repo and securities financing transactions. Hence, it also emphasize on raising the capital buffers backing these exposures while reduce procyclicality (Wikipedia, 2011). It would help to provide additional incentives to move OTC derivative contracts to central counterparties and most probably will be clearing houses.

Student should gather own conclusion that Include: Agree, Disagree or Unable to make conclusion due to scarcity of data or information.

In a nutshell, we can see that there is improvement through the development of Basel which is useful to adapt in fast changing economic and financial environment. Moreover, it is acts as a comprehensive guideline in helping the financial institutions to reshape their capital structure in order to improve their performance in gaining confidence from the public. Since the happening of global financial crisis, Basel has become one of the most important elements to ensure the banks always maintain its capital requirement for its soundness. In addition, the Basel developments show that the country issue is being focused thus it can enhance the ownership of the standard developed.

There are few advantages of using the Basel to operate the bank's performance level, which is it can raise the quality, consistency and transparency of capital base Tier 1 capital. Next, it helps to enhance risk coverage, from Basel II to Basel III there is apply a multiple of 1.25 to the asset value correlation of exposures to regulate financial firms with assets of at least $ 25 billion. This would have the effect of raising risk weights for such exposures.

It may reduce the exposure risk of the assets of financial institutions and minimize the mistake when calculated the intrinsic value of the assets through the Basel. Last but not least, it may improve the leverage ratio of financial institution through Basel III.

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