Use of Basel III in Banking Laws and Regulations
Basel Accords which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision consists of Basel I, Basel II and Basel III. Basel I was adopted in 1988 and was enforced internationally in 1992. While Basel I is now outdated, Basel II was formed and implemented by a lot of countries. Soon after that Basel III came into place when the world was faced with Global Financial Crisis.
Basel I primarily focused on credit risk. This Accord was enforced by law in Group of Ten (G-10) countries which included Belgium, Canada, France, Germany, Italy, Japan, United Kingdom, United States of America, Spain, Switzerland, Sweden, Netherlands and Luxembourg.
Basel II is the second of Basel accords issued by the Basel committee on Banking Supervision. This framework was officially known as “International Convergence of Capital Measurement and Capital Standards”. The main purpose of Basel II, published in June of 2004, was to create an international standard that banking regulators would be able to use when creating regulations about the amount of capital that banks need to put aside to guard them against the financial and operational risks that most banks face.
Australia implemented Basel II framework on January 1 2008 through its Australian Prudential Regulation Authority
The 3 fundamental pillars of Basel II include:
Pillar 1: It deals with the Minimum Capital Requirement calculation which has to be maintained against Credit, Operational and Market risk.
Pillar 2: It deals with the Supervisory Review Process which describes the principles for effective supervision.
Pillar 3: It deals with the need for Market Discipline which requires the lenders to widely provide details of their risk rating processes, risk management activities and risk distributions.
Basel III was recently developed after taking in consideration the loopholes and weaknesses that contributed to the financial crisis. Basically, these rules intend to protect the world economy from the possible effects of any future financial crisis. In addition to that, they also aim to reduce the risk that would be imposed on governments to spend funds while protecting banks and their creditors.
Bank for International Settlements (BIS): It is an international organization of central banks which aims to make banking and monetary policy more clear and predictable
The new rules of Basel III seek to avoid the failure of Basel II -Imperfect and under-adopted rules now are no longer in use after the 2008 global financial crisis. It takes a more critical view of leverage in general, and of risk "insurance" and trading in debt between banks and other players. They ask the banks to hold a larger "buffer" of capital, and more liquid assets.
The most important changes in Basel III comprise of:
• Setting higher minimum capital requirements and changes to Tier 1 capital rules
• Strengthening both the quantum and quality of capital for banks and insurance companies
• Improving mechanisms for dealing with systemic risk found in the financial system
• Enhancing the system and institutions’ abilities to cope with liquidity shocks which have occurred throughout the GFC
• Improving forward-looking approaches to loan loss provisioning
• Encouraging long-term thinking by counter-cyclical prudential measures, and remuneration arrangements which better align reward and risk arising over the longer term.
Development of New Basel III Standard
First, The quality, consistency and transparency of the capital base will be raised.
Tier 1 capital will place greater emphasis on common equity component.
Tier 2 capital instruments will be harmonized.
Tier 3 capital will be eliminated.
Second, Enhancement of risk coverage through enhanced capital requirements for counterparty credit risk. Enhanced risk coverage will address issues that arise in connection with the use of derivatives, repos and securities financing arrangements
Third, Changes to non-risk adjusted leverage ratio. This ratio will supplement the Basel II risk capital framework.
Fourth, Measures to improve countercyclical capital framework.
Effect of Basel III on United Arab Emirates
Over the years, United Arab Emirates have been reporting to a BASEL I framework. Since, it is progressing well, there are doubts that there will be immediate implementation of BASEL III. However, over the past year or so, U.A.E has needed significant capital injections and liquidity support, so the ratios will report negative effects. Hence, there is no rush to adopt Basel III, as new standards would highlight capital and liquidity drawbacks.
Currently, U.A.E's banks are reporting elevated capital ratios (15% Tier I ratios, 18% CAR), but this has been boosted by public sector injections of Tier I and Tier II capital. The equity- asset ratios of - 10 % has indicated how Tier I ratios might present itself under BASEL III framework, particularly if banks attempt to setback or smooth provisioning against a likely imminent decline in asset quality. Dr. Nasser Al Saidi, Executive Director of the Hawkamah- Institute for Corporate Governance said, "Banking regulations must proceed on a global basis but since the UAE banks are almost applying the same capital adequacy ratio as Basel III requirements, the new international rules would not have a direct impact on the UAE banking sector." However, due to the global recession, several banks buckled, while furthermore have botched various challenges, highlighting a elementary flaw amongst banks worldwide. Dr. Al Saidi also mentioned that the increase in capital requirement from 2% to 7% was a compulsory amendment as the increased capital would reduce the risk. If some banks still felt that the reserve wasn't enough, then they would tend to increase it out of further prudence and that would reduce the finances available to businesses, thus leading to added cost of loans.
UAE banks are among the paramount capitalised in the world, and traditionally inflexible principles set by the UAE Central Bank for principal needs means that local banks already outdo norms set by the Bank for International Settlements (BIS) as part of the Basel III accord, which has a 2019 deadline, analysts say. Analysts also feel that the U.A.E's banking regulations are already stricter than those proposed by BASEL III. U.A.E's banks are safer as compared to majority of their Western and European counterparts. At present, the Tier I and total capital requirement ratios stand at 8 percent and 12 percent respectively, which are already higher than the 2019 target ratios proposed by BASEL III of 6 percent and 8 percent respectively. The Bank for International Settlements reported that it has developed an accord for boosting of vital capital ratios for all the banks. The least necessity for general equity, the peak form of loss absorbing capital, will be lifted from the existing 2 to 4.5 per cent after the submission of much strict adjustments, which will be ushered in by 2015. The total Tier 1 capital necessity, which includes regular equity and other qualifying financial instruments depending upon harsh grounds, will raise from 4 percent to that of 6 percent during the existing phase. A 'buffer requirement' of 2.5 per cent that can be strained down to the 4.5 per cent least necessity when called for. Effectively, this will elevate general equity necessities to 7 per cent. If a bank falls under the 7 per cent general equity necessities, including the cushion, allocation of income should condense atleast till 7 per cent stage is improved. The margins above would relate to dividends and managerial reimbursement, including bonuses.
These changes are supposed to reinforce the bank's stability to absorb future potential losses. The transition period for banks to comply with these rules was set at 2012, however, it has now been extended to January, 2019. Since U.A.E's banks are still adjusting to Basel II's policies since November, 2009, it will be far too early to comment upon the consequences of these new regulation changes.
"Basel III rules on capital adequacy rates stipulate phased increases — from 2 per cent to 3.5 per cent in 2012, to 4.5 per cent by 2015 and to the full 7 per cent by the end of 2018."
Although U.A.E is in recession, these regulations give banks a necessary amount of time to adjust. There is faith in the U.A.E's financial system, as it has been able to cope flexibly and effectively to unforeseen shocks.
Effect of Basel III on United Kingdom
All though there is still an uncertainly on the impact of the implementation of Basel iii, there are many concerns which are bothering all the banks in the United Kingdom.
According to Basel iii there is a tighter capital requirement on the funding costs of a bank which has become one of the bigger concern faced by the country.
The main requirement of Basel rules set to come into force by 2019 is a Tier 1 capital ratio of 7 percent. Many banks' Tier 1 ratios are already above this but the Basel III regime is much stricter on what can be counted as Tier 1 capital, prompting fears of more rights issues in the sector.BNP (British National Party) is in a position to be above that 7 percent threshold, without ever raising any capital.
Despite assurance on meeting Basel requirements, quantifying the exact force of Basel III is difficult because global regulators are still discussing extra proposals such as a systemic risk capital surcharge for large banks. Barclays bank believes that a new regime could add 150 pounds to the bank's risk-weighted assets, with 60 billion to assess market risk. The broader effects of Basel include rising funding costs as banks focus on generating returns on retained capital.
There is a positive side to it which is- banks will be better prepared for another downturn so we avoid a re-run of the financial crisis. Instead of holding capital equivalent to just 2% of their risk-bearing assets, banks will have to hold 7% of top-quality capital in reserve.
For customers in the country there won't be a return to the era of cheap money as banks build up their capital reserves ahead of the deadlines. UK banks have already made big efforts to raise their capital levels since the crisis struck, and taxpayer-backed Lloyds Banking Group now has a core tier-one capital ratio of 9% while Barclays's is 10%.
Adair Turner, chairman of Britain's Financial Services Authority said- "I think it's a very, very balanced package which is designed to achieve future resilience without in any way restricting the ability of the banking system to support the real economy”.
Therefore it is unlikely to find a conclusion whether Basel iii is a positive or a negative change. As we have seen it has become one of the bigger concerns of every country to rise from the financial crisis. Only time can tell the effectiveness of Basel iii on all the countries.
Global Financial Crisis and its effects on Banks
The term financial crisis is applied largely to an array of situations in which some financial institutions and assets all of a sudden lose a large part of their worth. They are mostly associated with recessions, bank runs, currency crisis, bubbles etc. When a bank experiences a sudden rush of withdrawals by its depositors it is known as a bank run. A situation where the bank run is extensive it’s called a banking panic. A situation without extensive bank runs, but in which banks are unwilling to lend, because they agonize that they have inadequate funds available, is often called a credit crunch. Since banks lend out most of the cash of their deposits by the customers, it gets difficult for them to immediately pay back all the deposits if they are demanded at once, which may leave the bank in bankruptcy. Many banks lose their customers due to this problem. In this way, the banks become an accelerator of a financial crisis.
The recent financial crisis that started at the end of 2007, caused by a liquidity deficit in the United States banking system and affected the economy worldwide, made a huge impact on majority of the banks worldwide. One of the main sources of the Global financial crisis was a boom that took place in US housing prices between the years 2002 and 2005.The International Monetary Fund anticipated that a lot of U.S and European banks lost over $ 1 trillion on bad loans and toxic assets. As a result, the crisis lead to the initiation of Basel II, which was introduced in USA over 2008 in similarity with the current requirements and applied only to the banks which were internationally active. However, in Australia it was introduced at the start of 2008.
The Global Financial Crisis drew attention towards the bank’s inconsistent approaches to their
- Definitions of capital
- The type of capital employed
- The level of disclosure provided on the nature of regulatory capital held.
After the commencement of the GFC, it was noted that various banks in the Europe and the US were involved in the setting up of central counterparties (CCP’s), mainly those to clear and decrease the notional volume of over the counter (OTC) credit derivatives. Institutions have a greater incentive to make use of the CCP’s by applying a zero per cent risk weighting to depiction with certain central counterparties.
The crisis resulted in the collapse of a lot of banks and also in bank bailouts. For example:The Northern Rock (British bank) was one of the first victims of the crisis. The high leverage nature of its transactions led the bank to ask for protection from the Bank of England. This led to investors panic and deposit withdrawals by their customers who believed that the bank might become insolvent.
The fourth largest bank of the US, Lehman Brothers filed for bankruptcy in September 2008. The reason is discussed in the next few lines. In those days there was mortgage crisis in United States due to decline in prices of real-estates. As a result, housing loans made by the bank for the people with very slight support made these loans very risky, and when interest rates were raised by these banks, these borrowers could no more repay Lehman. This led to huge losses for Lehman. It caused $60 billion loss in bad real estate loans for Lehman Bros. One of the main reason for its downfall was its poor relations with top banks of United States. They refused to do business with Lehman due to over-confidence of its CEO over the Lehman financial assets. And after big debt of $639 billion, when Lehman asked Barclays and Bank of America for acquisition, they simply rejected the offer.
There were a few banks which were not affected by the financial crisis. Japanese banks were not affected seriously by the US financial turmoil because they invested relatively small amounts of their portfolios in subprime-related financial products. Even the Islamic banks have been less affected than many conservative banks in the existing global crisis as they are forbidden from the activities that have contributed to the credit crunch such as investment in toxic assets and dependence on wholesale funds. Other banks which were least affected by the crisis were North Korean banks, Malaysian banks, Morocco’s banks and Australian banks.
Effect of Global Financial Crisis on United Arab Emirates
In the first 6 months of 2008, the world saw a steady rise in oil prices. These, however didn't last long due to the varied factors of supply and demand. It had reached a peak of 147.27 $ on July 11th, but after that, the oil prices declined at a drastic rate, reaching as low as 60$ a barrel. Since 35.9% of the U.A.E's GDP in 2007 consisted of oil revenue, surely this meant bad news. In addition to this, the U.A.E's property market has been declining due to the government's recent rule which allows foreign investors to purchase real estate on a freehold basis. Similarly, the stocks crashed, in Abu Dhabi and Dubai. The Dubai Financial Market(DFM) index incurred a loss of 1.27 billion dollars, along with the Abu Dhabi Securities Exchange(ADX) incurring a loss of 413.8 million dollars.
3 days after the Lehman brothers filed for bankruptcy, the U.A.E Central Bank met with representatives of other banks to assess the current situation. A conclusive statement was released that there was no universal risk for the U.A.E. However, during these meetings, it wa also discovered that the liquidity level for banks were low, and feedback was taken as to how to boost it. In order to do so, an emergency lending facility was created with a total of 50 billion dirhams so as to inject liquidity in the U.A.E's local banks. In addition, the government will also promise all inter-bank lending operations between banks functioning within the country and introduce adequate liquidity in the financial system if and when obligatory. The government also decided to infuse another 70 billion dirhams into the banking system.
Over the past few years, U.A.E has witnessed a huge boom in the property market, with prices of properties quadrupling. This has been a successful vision of the country's leaders so as to divert the sole dependence of national revenue from oil. However, even the real estate industry of U.A.E has been affected by the financial crisis. Almost all major developers operating in U.A.E have shelved their plans of expansion or development due to the current financial turmoil.
However, there is strong hope for U.A.E's economy. The IMF has proposed a 1.5% increase in the GDP of U.A.E for 2010, as well as a 3.1% increase in GDP for 2011. With an increase in oil prices, the U.A.E is poised to post a surplus of 19.7 billion dollars, as compared to a debit of 7 billion dollars in 2009. At first, it seemed that most of the Gulf countries took the recession for granted, however the Lehman incident served as an eye-opener for most of them. However, U.A.E states that it was one of the first countries to take notice of the budding problem and took measures to reassure investors by securing deposits, pumping liquidity into the system and filling gaps in the legal construction of the country. Analysts are optimistic that the debt issue can be resolved without affecting the credit standing between Abu Dhabi and Dubai. An example can be provided with a reference to Dubai Water and Electricity Authority(DEWA). DEWA raised $1 billion with the help of an international bond issue paying 8.5% in May 2010 while the demand for the issue surpassed $11 billion. However, investors know the recovery in the UAE could be quicker due to the fundamental strength of the federal economy and strong infrastructure. Analysts feel although the real estate prices shall undergo a sharp decline, there are convincing reasons that assure a firm recovery of the U.A.E's economy.
Recovery of Global Financial Crisis
The recovery of the global Financial Crisis said to be slowing faster than the forecast. One of the major challenges faced by the government today is to strike a balance between cutting public debt and boosting growth.
According to the OECD’s (organization for economic Co-operation and development) latest assessment- growth is expected to be around 1.5% on a yearly basis in the second half of 2010, compared to the OECD’s earlier assessment of around 2.5% carried out in May.
Robert Zoellick, the World Bank President, said that while the economy is undergoing recovery from the financial crisis, governments still face the problem of uncertainty and volatility after the economic downturn in 2008 as millions of people were rendered insolvent.
Many countries are recovering from this crisis, however the recovery is said to be at a slow pace and is not able to create sufficient jobs, which are raising fears among the people, that there will be a jobless recovery which will lead to long-term unemployment which is expected to stay high until the end of 2011 due to the fragility of the global economy.
A series of efforts are being made to reform financial markets and clamp down tax evasion.
Us economic growth, in the first quarter hit 3.7 per cent, compared to the 2.7 per cent earlier reported by the government. Due to weak consumer spending and a widening trade gap, it brought about a sense of relief among the people, and the data appeared to confirm that the US recession had come to an end.
However, in the second quarter it showed much of a slowdown which is said to have come from businesses reining in inventory spending, which had grown rapidly in the wake of the financial crisis.
World Bank managing director Juan Jose Daboub stated that Australia can be a model for developing nations struggling to recover from the global financial crisis. Dr Daboub said that “the macro – economic reforms taken up by Australia in the past 20 years have paid off”. These reforms include
Macro-economic stability, flexible labor markets and nurturing an open economy. He also praised the "persistence and the consistency" of the reforms.
"This is a recovery but there are still fragilities and there is still (the) risk of unemployment (growing) at dimensions that we need to be very concerned about," Dr Daboub said.
The above graph places emphasis on the quality of capital required. The new capital requirement will emerge in a period of five years, and over this period the minimum capital ratio will remain at 8%- However, its composition may change. Ordinary shares which are the highest quality capital are seen to move from 2% under Basel II to 4% under Basel III.
As a result, the relevance of Tier 2/3 which is the lower quality capital will reduce to a quarter of the total required. Apart from the minimum capital requirement, institutions are expected to hold a conservation buffer also in common equity of 2.5%, which will act as a measure of relief in times of stress.
After the release of Basel II, the capital requirement was at 2%. With the arrival of Basel III updates the value has increased to 4.5%. (I.e. an increase of 2.5%).
Basel III’s stated aims are to improve the banking sector's ability to
Improve risk management
Strengthen banks' transparency
To achieve this it laid down two areas of regulation, which are: micro prudential – this includes dealing with the flexibility of individual banks – and macro prudential – which includes dealing with the strength of the banking sector as a whole.
According to the Basel III reforms, one of the methods to bring about the change from procyclical lending to countercyclical lending, include increasing capital requirements and adding more capital buffers to deal with times of stress, rising from 2.5% to 7%.
The Tier 1 capital requirement, that covers various qualifying financial resources which are based on rigid criteria, and common equity, will increase to 6% from its current value of 4% during the same time.
Basel III Summary also affects the Risk weighted assets or RWAs and the date of implementation is the same. The first section is 3.5% common equity for every RWA. The next one is to have 4.5% Tier 1 capital for every RWA, amounting to the total of 8% capital for every RWA.
Basel III also brings forward the minimum common equity requirement that to be followed from 1st January 2013 till 1st January 2015. The change in the minimum common equity requirement from 2% to 3.5% is effective from 1st January 2013.
The Tier 1 capital requirements have also risen to 5.5% from 4%, which is a slight change.
The banks should aim to reach 4% minimum common equity plus 5.5% of Tier 1 capital by 1st January 2014.
From the above it can be noted that Basel III summary has made 1st January 2015 into an important date, as we can see that by that time the banks will have common equity raised to 4.5% and the Tier 1 requirements raised to 6%.
While many bank investors loved Basel III, there were some problems encountered in Basel III.
Basel III was considered to be implemented really quick even though Basel II took a decade to be put together but never got implemented properly.
It was said that Basel III adopted some of the same problems faced in Basel II
The risk weighing concept: The banks were told to hold more capital against the riskier assets than they do against safer assets.
Basel III is considered to be backward-looking.
A few drawbacks of Basel III were the following:
Capital requirements in Basel III were too low;
Credit ratings were depended upon the most;
Internal Models could be used by banks to measure the risk;
Banks could get around the rules by setting up off-balance-sheet entities like SIVs;
It lacked any kind of liquidity requirements.
Execution of Basel III has been described as a long journey rather than a goal itself. Undoubtedly, it would require commitment of substantial capital and human resources on the part of both banks and the supervisors. Most of the economies have decided to follow a consultative process while implementing Basel III norms and move in a steady, sequential and co-ordinate manner. As envisaged by the Basel Committee, all the professionals will make a positive contribution in this respect to the Indian Banking System stronger.
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