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Role Of Capital Adequacy In Enhancing Financial Systems Finance Essay

The purpose of this paper is to outline the distinction between capital adequacy and the role behind its importance and the different approaches it has created to enhance financial system. Most significantly the Basel Committee has taken extreme measurements in securing banking requirements with the concerning of credit risk. The context of this paper will also highlight the first Capital Adequacy Framework versus the new framework and the pillars that make up the new requirements. Also, there is an in-depth look into the future of capital adequacy and its efficiency to provide an evaluation of banking system soundness due to past revelation which has forced the issue of capital adequacy. The study also introduces Basel I and II to show how capital adequacy being implied to pioneer an international standard for security in the banking sectors worldwide.

There has been a tremendous growth in banks in the past few decades and the banking activity in the financial sectors continues to grow in the market. Banks have tremendously shaped and developed the world emerging market economy. The complexity of the banking system consolidated with other banks making it more efficient; mostly because of the cross-border activity and internationalisation of markets that have evolved. The transformation of banks solely has been depicted from financial collapses and the inadequate regulations of banking. This has enforced recent developments in the importance of capital adequacy regulation, with the strengthening of capital requirements to reduce credit risk, and the safety and soundness of the banking system. The achievement of adequate solvent standards for individual banks has been depict theoretically behind the issue of banks holding an amount of capital that lowers the likelihood of losses exceeding capital. Every bank bares systematic risk; and with this, banks can be volatile to risk. Due to the growth of bank holdings and the instability of the economy during financial crisis, it has shown that banks are getting more and more exposed to market risk. The implications of bank failures or solvency are damaging to the economy than the failures of any other firms of the same size. Understanding the importance of capital adequacy and regulatory regime is vital due to the constraints of the global economy. Historically, banks have been perceived as being prone to failure even when depositors withdraw large amounts of funds. In fact, this could lead into a spiral affect were other depositors decide on following their counter partners in withdrawing significant amount of funds as well. In the prevention of failure across banking sectors capital adequacy measure the underlining risk. Understanding the distinction between bank’s capital problems and its liquidity problem is necessary in the reasons behind capital adequacy and why its implementation for the Basel Accord.

The assumption in banking failure first appeared in the balance sheets of banks. A variety of banks balance sheets in comparison to other banks were an indication that these institutions were conducting themselves in risky behaviour. The ratio analysis that comprised of these banks failure showed a result in banks that were bound to fail, or were already unstable. In the early periods of the 1900’s banks did not rely on income statements because they were not available at that time. The banking system was vulnerable to economic activity and qualitative operations of banking. Taking into account that other factors could also contribute to failure. However, due to volatile economic conditions, the results of institutions failing were 741 national banks in the years 1925 to 1932. Similar results in 1979 and through 1987, 33 national banks failed and the trend continue onward into the late 1980’s. Majority were small institutions. The likelihood of country that had the most failure was in the U.S. It was based on the control level of banks and their operating standards. The G-10 central bankers affirmed the importance of capital adequacy. With the recession in the U.S. and Japan, it was clear to see that some sort of decree in capital adequacy was needed.

Therefore, a need to create an approach that would regulate the banking system was operable. When the Capital Adequacy Accord was first established it was concerned with the minimum standards of credit risk that the banks held. In perspective, banks were ignoring the risk levels and paid little attention to risk-free borrowers such as government and other prominent institutions. Taking into consideration that risk-free borrowers were unlikely to default on loans or mortgages. Nonetheless, the banks lent out further credit to riskier borrows an underestimated the risk that could arise if those risk-free borrowers did defaulted on there loans. And if so, would the banks have enough equity to sustain the loan that was borrowed without crippling the banks liquidity. Since banking has changed over time, the assurance of a banks being able to maintain stability was concerning and a perceived notion to introduce international standards for adequate banks that would cushion itself against large risk and central bank bailout. However, banks acting under capital would be affected in credit behaviour. Banks under regulations of Capital Adequacy would either reduce risk –taking incentives of loan options or it can cause a credit crunch.

The Basel Committee was established in 1974 and there efforts to create an international standard for banking across all borders seemed inedible, because the process didn’t reflect all countries. There were many measures implied, but in perspective nothing remained permanent. In 1988, the Basel Accord (familiar known as Basel I) was the first permanent solution in place that obliges banks to maintain equity funding equal to risk-weighted proportion of the asset based with a minimum capital standard. Basel I was merely a guide. Therefore, banks were able to adopt financially stability and to establish a levelled competitive field for banks in different countries under the Accord regulations, but in relations to larger scaled banks, Basel I was not as useful and fulfilling to generate the competition in which the largest of banks already sustained. The strongest of banks were boosting capital and retaining capital, in contrast to weaker banks who improved their ratios by selling assets and restricting loans.(See Appendix 1) This also caused a rift in international markets, were Japanese banks that once thrived in the market, had major set backs had to withdraw. Under much consideration from U.S. supervisors, Basel I needed some adjustments. The reason for this was because it lacked risk management and internal economic measurements that were competitive. It also control their credit loses which had evolved in larger banks and the banking system had become increasingly rigorous. Over several years of Basel I was adjusted to reflect the major flaws and undergone many precise changes. However, Basel I was a major step forward in capital regulation and it was foreseeable that the future depended on it.

The Latin America debt crisis due to the loss of provisions was an important matter in 1991; therefore, amendments were made in 1993 to exclude provisions against country risk.

Due to market pressures and the consolidation of banks, the Basel Committee began to change the Basle Accord to reflect the changes in the banking system. Therefore, the Basle Accord was amended in 1996, in order to reflect the advancements of risk practises. The measurement of risk difference from bank to bank and a standardised approach did not reflect all banks in all markets.

The Basle Accord simply stated that banks should have available a ‘regulatory capital’ which in combination was equity, loan-loss reserves, and other accepted instruments of at least 8 percent of the value of its risk-weighted assets. (See Appendix 2) To further explain this, commercial loans are weighted at 100 percent, whereas residential property loans weight were consider less risky and were weighted at 50 percent. The total risk-weighted assets are multiplied by 8 percent to determine the bank’s minimum capital requirement. This however changed the risk weights to the capital ratio. Banker Magazine (2003) studied that an average capital ratio found that 26 international banks were 11.61 percent and the highest was found to be 18.2 percent. This was the introduction of capital adequacy used in foreign banks varied in unsuccessful attempts and in turn some faced decline in property loans. Also, SME’s (Small Medium Sized Enterprises) who relied on loans were directly affected. More sophisticated banks Internal Ratings-Based Approach that would place greater emphasis on the bank’s internal credit risk-rating practises. United Stated also implemented a similar standardised approach which four different risk weight categories, (0, 20, 50 and 100 percent categories). The framework was designed to establish the level of minimum requirement, but it was free to adopt arrangements that set higher levels. The emphasis on capital adequacy is represented by the measured framework and the importance of taken into account that many of the factors are used in assessing the strength of the bank.

The new Accord consisted of three reciprocal pillars which in cohesion acted together strengthen the financial system. Taking into consideration that countries practice different accounting standards and these standards can classify a liability in one country but in another it could be classified as an asset. The difference between the new frameworks versus the original Accord was the approach with capital charges in proportion to risk; meaning that it did not distinguish the difference between customers in business areas with various levels of risk. However, the Capital Accord has been the turning point of a global standard for banks worldwide. Having a substantial amount of capital promotes public confidence in banks and reassures the depositors of its financial strength. Therefore, it must be strong enough to reassure borrowers that the bank will be able to meet their needs. In addition, capital provides the growth and development for new services and facilities. Also it limits risk.

Over time the Capital Accord was a momentous step forward in the Capital Adequacy Regulation but there were potential flaws that were increasingly noticeable. The measurement of credit risk failed to reflect the actual likelihood of default, which led to mispricing and misallocation of credit. This damaged bank’s competitive position in the security market as a source of finance. If you take in example of two companies receiving the same risk weight, regardless if they are highly rated or lower rated, the risk can be perceived as the same.

The future depended on a system that would be resilient to the future demands of banking and it was crucial that the banking system to remain stable under financial crisis and moral hazards. The changes of the Basel Committee’s proposal set out a new proposal under ‘The New Capital Adequacy Framework’. Provisions were made to address all issues that the old had neglected or failed to measure. The framework was subsequently built on three pillars that were revised from the previous framework, but better revised to which should align capital requirements with actual bank risk.

Pillar one was the minimum capital requirements, were firms had to cover the minimum requirement credit, market and operational risk (8 percent). The second pillar was a supervisory review process of the capital adequacy. It was to ensure that institutions not only have adequate capital, but to develop and use risk management techniques in supervising and managing these risks. Internal approaches were an opportunity for supervisors to indicate where such approaches do not appear to be sufficient. In addition, supervision can be exercised in discretion and is vulnerable to government failure if the discretion is not used for public good, then regulations will be ineffective. Lastly, the third pillar was the disclosure of requirements. The pillars were considered essential when taking a complete consideration of an effective capital framework. With regards to regulatory requirement and building on the foundation of the current accord, the standardised approach will now depend on the external credit rating provided by commercial rating agencies, such as Moody’s or Standard & Poor’s. However, there have many issues of the competency of the rating agencies due to accuracy of rating and whether or not they are sufficient for capital changes. Nevertheless, external credit rating provides logical sense generally because they are more accurate and less influential.

The innovative approach of the framework also took into perspective to not only credit and market risk, but also to operational risk and interest rate risk in the banking book. Operational risk was the risk resulting from failed internal processes and was to be 20 per cent of the total capital requirements but lowered to 12 per cent. It was also the most difficult to measure in terms, because they were only a few historical operational incidents that were acknowledge; suggesting in furthering the approaches to calculating the capital requirement to cover operational risk. But the high risk markets characterises high credit risk and a high operational risk results of substantial interest income. Alternatively business may apply loans and advances instead of gross income to calculate operational risk. Under standard approach, operational risk was supposed to increase relatively in small amounts to gross income. Operational risk was later set out in three different methods under Basel II, to calculate risk capital charges. These three methods were the basic indicator approach, standardised approach, and advance measurement approach (AMA). The AMA in further detail encourages banks to determine were risk is more likely to occur. Such measurements as the expected loss (EL), and unexpected (UL) internal and external data as well scenario analysis under their regulators permission.

Secondly, credit risk was differentiated in the capital requirements based on borrower’s probability of default. The Committee realised that bank’s own capital should be consistent with their overall risk profiles. [1] Credit models were challenging and unreliable because applying that in parameters where the market was different was inaccurate.

CONCLUSION

The impact of the Basel Capital Accord was aimed at internationally active banks. Since there were such few developing countries with emerging banks, it didn’t stop countries from adopted the Basel capital standards. The consequences were directly linked on their provision of credit. However, researchers believed that countries who adopted Basel I or II was not an improvement of domestic financial sectors. It was thought that it was deteriorating those particular sectors and may also experience severe banking crisis. Capital adequacy played an important role throughout the banking system under the Basel I and Basel II. In fair detail, bank supervisors from over a dozen financial nations believed that the rules regarding capital adequacy were justifiable and harmonising for the financial sector. The improvement for the banks to price risk was evident. It has also been implemented not in banks but to reflect all corporations that engage in risky functions.

Basel I was the beginning of frameworks in place for capital adequacy and Basel II has major impacts on the way banks conduct their business. Without the implications of either, the institution would find themselves in major catastrophes and the banking sector, would probably not be as evolved as it is today, mainly because most of the financial institution would not have been able to withstand downturns in the economy which led to financial crisis.

Appendix 2

Example of Ration Risk Weight under Basel Regulation:

REGULATOR CAPITAL = MINIMUM REQUIRED CAPITAL

MEASURE OF RISK EXPOSURE (8% MINIUMUM UNCHANGED)

(RISK-WEIGHTED ASSETS)

CREDIT RISK + MARKET RISK + OPERATIONAL RISK

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