Essay the relevance of basel ii capital adequacy framework in the aftermath of global financial crisis

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Essay

The relevance of Basel. II capital adequacy framework in the aftermath of Global Financial Crisis

9/19/2009

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The Relevance of Basel II Capital Adequacy Framework in the Aftermath of

Global Financial Crisis

SYNOPSIS:

This report consists on Basel II and its connection to Global Financial Crisis. The Basel II capital

adequacy framework describes the rules and requirements for banking that are of international

nature. Banking is a saving channel and it provides credit, hence its importance is vital. It is

necessary to regulate the banks to add value to banking system, financial system and at a broader

level to entire economy. The Basel Committee on Banking Supervision was found in 1974 with

the objective of adequate supervision of every internationally active bank. This committee first

introduced Basel I, which was an achievement as it helped to understand capital definition,

capital adequacy and capital regulatory adequacy. That was simple to apply and also addressed

risk management orientation. The outcome was that Basel I adopted in over 100 countries. The

Basel II is modified and amended rules for international banking and it is committed by more

than 100 countries. Basel II includes three pillars. Banking industry developing „culture‟ of risk

management (Pillar I)1. Effective supervision exists, compliance with Basel Core Principles for

effective supervision (Pillar II)2. Market has clear rules for disclosure and moving to greater

transparency (Pillar III)3. The proper implication of Basel II ensures improved safety and

soundness, improved governance, risk management and forward looking etc. The Basel II was

implemented in September 2008 just before the Global Financial Crisis. This report highlights

what the Base II is and whether it contributed to Global financial Crisis or not, what problems

Basel II is facing and what improvements are suggested in Basel II. The Basel II was in its

infancy stage and it was unable to handle the bubble of Financial Crisis that was evolving since a

decade. Now the past is done, what will be the future of Basel II? Further this report incorporates

the suggested improvements and changes to Basel II and also the impact which these

improvements and changes will leave on financial System.

1 Pillar I: Defined under WHAT IS BASEL.II CAPITAL ADEQUACY FRAMEWORK? 2 Pillar II: Defined under WHAT IS BASEL.II CAPITAL ADEQUACY FRAMEWORK? 3 Pillar III: Defined under WHAT IS BASEL.II CAPITAL ADEQUACY FRAMEWORK?



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WHAT IS BASEL.II CAPITAL ADEQUACY FRAMEWORK?

According to the rules and regulations of capital requirements, credit institutions e.g. banks,

should maintain the stated minimum amount of the financial capital in order to avoid the risks.

The aim is to ensure the soundness of these institutions and also to maintain customer

satisfaction for its rights in the institution and at a larger point of view to ensure the stability of

financial system. These rules also give defensive shield to depositors against losses. The

committee named “Basel Committee on Banking Supervision” was formed in 1974 to handle the

banking supervisory matters. The committee representatives of the Basel Committee comes from

the countries Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain,

Sweden, Switzerland, UK and US. After Basel I, in 1999 the committee issued a suggestion for a

new framework and after widespread communication with banks and industry groups. The

modified framework was issued in the year 2004. Some of the main requirements of Basel II are

to recognize credit risk, market risk and operational risk and then assigning sufficient capital to

cover up potential losses (Susan McKiernan, John Salmon, 2008).

The main objective of this framework - Basel II, is to renew the existing capital requirements

framework so that more risk could be avoided.

The Basel II framework consists of three main parts:

Pillar I: The first part talks about the minimum capital requirements, which the firms will be

required to meet in order to cover credit risk, market risk and operational risk.

Pillar II: The second part focuses on new supervisory review process. This thing involves

financial institutions to have their own system to judge their overall capital adequacy with regard

to their risk profile.

Pillar III: The third main part basically integrates part one and part two. It primarily focuses on

how to improve market discipline, capital and risk management.



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THE CAPITAL MANAGEMENT OF BANKS AND BASEL II

Credit Regulatory Capital solution helps financial institutions to go further than just meeting

Basel II requirements. It helps to increase operational efficiencies and to lower the cost of capital

(Bernanke, B.S, 2008).

Products & Features: The credit regulatory body for banks calculates Basel II capital ratios, and

to support compliance requirements of the first main part of Basel II. It also processes

information from the multiple resources. Credit Management for Banks proposes flexible

product coverage and the tools of managing data.

Benefits: Capital management enables the function of more advanced approaches to Basel II.

This framework illustrates a complete measure and minimum standard for capital sufficiency. It

seeks to improve on the offered rules by supporting capital requirements deeply for the risks that

banks face.

As a result, it is intended to be more flexible and better able to evolve with advances in markets

and risk management practices (Algo Access Portal, 2009).

LEADING INDICATORS OF GLOBAL FINANCIAL CRISIS

According to the experts, the main reason for the current financial crisis is Basel II. It has been

failed to prevent the financial disaster. Some of the industry practitioners have demanded for its

replacement. But all this bubble was evaluating since decade and Basel II came into existence

just at the beginning of 2008. The three major indicators for financial crisis are analysis of

financial markets (stock exchange), exchange rates, and commodity prices.

By monitoring these indicators one can easily help to understand the likeliness going to be

happening. By monitoring financial institutes the trends and growth or fall can be seen.

Monitoring of exchange rates gives a better insight for understanding global economy and by

monitoring commodity prices; the situation of trade as well as trade within a country can be

easily evaluated. (AfDB 2008)



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CONTRIBUTING FACTORS TO GLOBAL FINANCIAL CRISIS

The global financial crisis was worsened by many contributors like Bad Loans. The Basel II has

emphasized rules and requirements for advancing a loan but the financial crisis was not stopped

by Basel II because its appearance was too late to manage a bubble that was growing since a

decade. These bad loans become a severe reason for the Global financial Crisis. The

nonperforming asset doesn‟t generate any income to the lender.

The conditions of financial markets also lead to the Global Financial crisis. The dynamic

changes in the market in late 2007 created problems for global economy and it has its role in

Global Financial Crisis as it lost the confidence of investors and they were to bear huge losses

and all the leading financial markets has to crash.

It is a structured finance process that is used to distribute risk by aggregating debt instruments in

a pool and then issues new securities backed by the pool. This term is named as “securitization”

because it is derived from the fact that the form of financial instruments used to obtain funds

from the investors is securities. It gives many advantages to issuer like as it reduces fund costs,

reduces asset liability and lowers capital requirements etc. (Raynes, Sylvain and Ann Rutledge,

2003).

ATTITUDE OF REGULATORS – US FEDERAL RESERVE, BANK OF ENGLAND

Basel II is regulated by authorities like US federal reserve and Bank of England. These are

responsible for the proper implementation of Basel II rules and any amendments made to these

rules and requirements. The US Federal Reserve and Bank of England are making great

contributions toward betterment and improvement of the rules and for this purpose they conduct

researches and keep in touch in other countries‟ leading banks.



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HOW THE GLOBAL FINANCIAL CRISIS IS BEING MANAGED

What the loss is to be bear is born. Now there comes the question of managing the aftermaths of

financial crisis. For this purpose many suggestions have been presented and still the work is on.

Some of the areas identified for managing this crisis and to avoid it in future are likely to be;

deposit insurance, bailouts, and bankruptcies (Nicholas bliss, 2007).

Deposit Insurance: It is a measure implemented in many countries to protect bank deposits

whether in full or in part, from losses caused by a bank‟s inability to pay its debts when due. It is

a component of financial system safety net that ensures financial stability.

Bailouts: it is an act of giving capital to such a company that is in danger of failing in an attempt

to save itself from bankruptcy, insolvency or total liquidation. Bailout is a matter of

circumstances; the bailer wants some hold in the company being bailed out.

Bankruptcies: it is legal proceeding involving a business that is unable to repay outstanding

debts. When companies were suffering in global financial crisis, the cases of bankruptcy evolved

at stage. Many companies came to court for being bankrupt whether by the debtor or on behalf of

creditors.

ROLE OF REGULATORS IN RESPONDING TO GLOBAL FINANCIAL CRISIS

In collaboration with the giant banks, Federal Reserve has produced the greatest financial crisis

of the world. The underlying factors of the crisis like, unlimited amounts of money and credit,

created an artificial wealth environment. Federal Reserve printed massive Dollars, the hidden

buying up of deadly assets, behind the scenes deals with the biggest banks, secret currency swap

deals with foreign Central Banks, and forced the FASB to change accounting rules to allow

banks to fraudulently value bad loans. Therefore, regulators are responsible for this global

financial crisis. The Federal Reserve cannot face the extreme behaviors of investors. The Federal

Reserve authorization of long-term interest rates has not been met (Susan McKiernan, John

Salmon, 2008).



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PROBLEMS WITH BASEL II; LESSONS FROM GLOBAL FINANCIAL CRISIS

The fundamental problem with the Basel II framework was that it created perverse incentives to

underestimate credit risk. The regulators had allowed large banks with sophisticated and refined

risk management systems to form risk assessment that are their own frameworks. The regulator

did not realize that the internal risk models of many banks could perform poorly and seriously

under-estimated risk exposure of the borrower. In recent crisis banks had relaxed their lending

policies to great extent not keeping in mind the pay back ability of the borrower and extended

loans to such borrowers who didn‟t had capacity to pay interest payments and principal if

something goes wrong. Banks justified their practices by showing on their risk assessment sheets

that they had enough collateral in the form of property or borrowers home but again their risk

models could realize the important fact that if things go badly wrong, how they would be able to

liquidate those collateral to get their money back. In recent crisis banks had extended more than

US $5 trillion and when recession hit US and people started losing their job, it created such a

panic in the market that people were unable to pay their interest and principal back, it forced

banks to liquidate their collaterals and severely caused US home market to go down and forced

banks to reassess and re-price credit risk (Elliot, Larry, 2008). Due to this the world‟s largest

banks either went under bankruptcy like Lehman brothers or they were sold at a very cheap price

to other bank. The lessons bank regulators learnt from this turmoil is that central banks should

devise a policy about the risk exposure and assessment of all the banks in a country and make

every necessary step to implement it and hold a tight control over the banking system rather than

allow every single bank to devise their own risk management. Central bank should make sure

that every bank has state of the art risk assessment time and credit risk department and it should

audit banks credit risk system on a regular basis.

WHAT IMPROVEMENTS IN BASEL. II AND REGULATION CAN BE SUGGESTED IN

MANAGING FUTURE FINANCIAL CRISIS

Now it is the responsibility of the committee to take some concerete steps in managing the future

financial crisis. The committee should learn the lesson and be careful for such type of situation in

the future. Basel II should be reviewed by the committee again and work on its three major parts.

They should design the capital requirements in a way that have no bad impact on the society and



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as well as on the world economy. And what they will propose or plan, it should be implemented

with complete transparency and efficiently. In order to manage future financial crisis, the

committee announced to enhance the three major components of Basel II. It is focusing on some

securitizations which is related to minimum capital requirements. The committee has proposed

the recommendation that in future banks should follow more rigorous process in their credit

analysis. The improvement in the market discipline includes strengthening disclosure

requirements for securitization, trading activities and off-balance sheet exposures. These things

will help to reduce market uncertainties (John M. Pachkowski, 2009). It is the expectation that

the banks and supervisors begins the implementation of the second major part of Basel II

immediately. The Committee of Basel II has decided that the first and third part of the Basel II

should be implemented with no later than 31st December, 2010. It has been also approved in the

Committee that the floor limit should keep in place even beyond the end of the year 2009.

WHY WESTERN BANKS WERE MORE INVOLVED IN GLOBAL FINANCIAL CRISIS

One of the reasons that pushed the western banks to be involved in Subprime Mortgage loans is,

population of western countries was increased because of people coming from other countries

like Asia, Africa. People migrated in abundance from War Targeted areas i.e. Afghanistan,

Pakistan, and Iraq (Office of the Superintendent of Bankruptcy – Industry Canada, 2006). And

they didn't have to leave the western countries because of Attractive Income Opportunities and

bad conditions of their countries. And other foreigners were also there to get money, peace and

other modern facilities. All these factors made the landlords to increase the rent of land. This

caused migrated people to get their own house. So they went to banks for loans. Banks due to

increased demand accepted them. Houses were bought, then because of low income or to handle

pressure of bank payments, they mortgaged the lands. So this is one of the reasons of more

involvement of western banks in this process lead to Financial Crisis (Dirk Willem te Velde,

2008).



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CONCLUSION

It is concluded that Banks have a significant position in the financial sector of the world

economy and if anything goes wrong with them, its effects could be seen everywhere in the

world. The present financial crisis is due to the inefficiencies of Basel II. But instead of wasting

time on criticizing it, it‟s a time to think about the improvements in Basel II that could bring

change in the financial system.



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REFERENCES:

1. Algo ACCESS Portal (2009), Credit Regulatory Capital Management for Banks,

available at http://www.algorithmics.com/EN/solutions/regulatorycapital, reviewed at

07/09/09

2. Nicholas bliss (2007), Basel II: capital management Strategies, available at

http://www.freshfields.com/publications/pdfs/2007/mar14/17464.pdf, accessed at

05/09/09

3. Susan McKiernan, John Salmon (2008), Basel II: an introduction to the new Capital

Adequacy Rules, available at http://www.out-law.com/page-7096, accessed at 09/09/09

4. Dirk Willem te Velde (2008), The global financial crisis and developing countries,

available at http://www.odi.org.uk/resources/download/2462.pdf, accessed at 10/09/09

5. John M. Pachkowski, J.D. (2009), Improvements to Basel II Approved available on

http://www.financialcrisisupdate.com/2009/07/improvements-to-basel-ii-approved.html,

accessed at 11/09/09

6. AfDB (2008), Indicators, http://www.afdb.org/en/topics-sectors/topics/financial-

crisis/indicators/, accessed at 04/09/09

7. Elliott, Larry (2008), "Credit crisis - how it all began", The Guardian,

http://www.guardian.co.uk/business/2008/aug/05/northernrock.banking, retrieved

07/09/09



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8. Bernanke, B. S. (2008) “The Future of Mortgage Finance in the United States.” Speech

given at the UC Berkeley/UCLA

9. Raynes, Sylvain and Ann Rutledge (2003), The Analysis of Structured Securities, Oxford

U Press, p. 103.

10. "Insolvency in Canada in 2006": Office of the Superintendent of Bankruptcy (Industry

Canada). Retrieved 09/09/09



Economy & Finance

Essay the relevance of basel ii capital adequacy framework in the aftermath of global financial crisis