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Literature Review Of Basel Iis Significance Finance Essay

This review is on Basel II1, focusing on debates and progressive discussion about its importance and significance to the Banking industry and the overall macroeconomic needs of the countries incorporating it into their banking system.

1 Basel II is the second face of the Basel I accord establishing standards to assist in regulating banks capital adequacy supervision and disclosures. Refer to International Convergence of Capital measurement and Capital standards June 2004 (Basel Committee on Banking Supervision).

It utilises various Academic articles and journals in a balanced discussion of critical issues about its effective implementation and development among developed countries like Europe (EEC) through the CRD directives; India (emerging economies) and a developing economies.

In achieving this, consideration is given to some of the importance and critical problems and key fundamental issues within the various pillars such as the Pillar I (Credit risk: LGD; Operations risks; Market risks).

Pillar II: supervisory Review and Pillar III: Market discipline and disclosure matters and how it has impacted the current financial crisis around the world; especially among G-10 countries, and the urgency of regulatory reforms to make it better in the near future.

Conclusive analysis on this review looks into some of the loopholes and areas that need further research and general problematic areas that could be reformed in the future Basel III reforms


Basel II Accord published in 2004 is centred on banking laws supervision and regulatory framework issued by the Basel committee on Banking supervision as an international banking standards and improvement to the existing Basel (I) for the purpose of creating capital adequacy and correlating its sensitivity to bank’s activity; regulating and mitigating banking risks more prudently and rigorously, supervising and effectively regulating international banks to avoid re-occurrence of persistent bank failures due to the increasing level of sophistication in the banking sector in this new economic era. S/N 0113684 4

In fulfilling these summary objectives among others three foundational pillars have been erected to categorise and address various challenges that confront banking sectors operations and to promote effective regulation based on these new recommendations.

The overarching objective of the Basel II was to overcome the shortfalls of Basel I by:

 Strengthening the capital adequacy, and making it more risk sensitive and appropriate to protect the banking activity in case of financial crisis and to mitigate banks exposure to risks such as Credit risk, operations risks; market risks;

 Providing supervisory review and transparent disclosures in banking practices so as to be able to tackle any potential crisis arising before it worsens and weakens investor’s confidence; protection; public and international confidence in the system.

About 25 Academic author’s literature are reviewed for the purposes of examining the significance of Basel II; its developments, current status; and critical arguments on various elements of the subjects in today’s Banking regulations.


Pillar (I) Minimum Capital Requirements:

According to Van Roy, Patrick, (25, 2005); Banks have better knowledge; measure and control of sophisticated risks they face with the inception of the Basel II. Key risks that fall under these are Credit risks; Operational risks; and Market risks. Each of these risks has defined approaches of measuring them with varying levels of complexity in its calculation.

Operation risks uses basic indicator approach (BIA); internal Measurement Approach (AIRB) and Standardised approach whilst Market risks mostly adopts Value at Risk (VaR)

As a means of managing minimum capital requirement most banks have adopted the Standardised approach in credit risks and capital adequacy from Basel II. Survey of about 294 banks has shown that 38% of banks were resorting to the Standardised approach (KPMG 2003). Other banks are using advanced internal rating approach which requires S/N 0113684 5

banks to develop their own internal rating system in deciding their risk exposure to lending activity and setting of capital reserves. It has a better assessment for various loan portfolios to corporate bodies, interbank lending, businesses and individuals, using a more risk sensitive mechanism from Basel II and the extensive use of Credit assessment agencies to measure the sensitivity of risks and exposure of the bank’s lending activity to risks.

Significantly; Banking institutions have overcome regulatory capital arbitrage which was a common problem under Basel I with the introduction of Basel II and further consideration had been given to other areas of risks supported by supervisory review.

This new approach significantly alarms the banks of possibility of risks and gives them lead time to adjust to lending risks exposures appropriately depending on the volatility of the assets involved and markets.

He further clarifies that although different credit rating agencies risks-weighting gives different indications of risk percentage to the banks, none of the percentages has gone beyond 10%

Contrasts to this; Til Schuermann of Federal Reserve Bank of New York in his publication: ‘What Do We Know about Loss Given Default? (2004); has different views on the overall assessments and definition of some of the fundamental key components in credit risks such as the Loss Given Default. (LGD)2 and questions the appropriateness of the credit risks under Basel II. He is of the view that borrowers whom the LGD is used on can range from individual borrowers, business borrowers (who can go bankrupt) mortgage loans, bonds secured and unsecured loans among others and therefore banks need substantial knowledge about these creditors business environment, changing status as well as the risks they face to reflect it in the sensitive weightings of the LGD for effective judgement.

2 Loss Given Default (LGD): It refers to the amount of money or funds bank losses when a borrower defaults on loans. It is a sensitive component of the advanced internal Based approach which banks are allowed to develop and apply subject to regulatory criteria and approval. S/N 0113684 6

He further clarified that with the level of freedom and the rate at which banks prefer to perform their own internal risks assessments on risk exposure, supervisory review will be effective if the supervisors will obtain their own independent data on LGD of bank’s clients in accordance with Basel II in order to offer independent advice and supervision to banks

This is due to the varying nature of factors to consider in developing the model and the level of accurate knowledge and availability of information about the borrowers.

Acharya, Bharath and Srinivasan (2003) revealed that in times of economic recession there is increase in LGD whilst during economic recovery seasons there is reduction in LGD. The implications of this is such that banks will have to hold back lending to the various economic sector ( to mitigate risks) in recession times when financing will be needed most and rather lend when there is economic growth.

Sabato, Gabriele, et al (2008) in his research pointed out a problem in Vasicek Model (Vasicek, 2000), applied in Basel II risks assessment on LGD. He clarified an underestimation in the model of credit risks banks face especially when many firms are defaulting and there are low recoveries on bank lending thereby giving inadequate information for risks management.

Significantly Acharya and Til both hold Views that there is no connection between risk modelling; supervisory review; and disclosure; to warrant effective intervention like bank takeover or closure indicating that banking risks information is not put to relevant use.

This progresses us into relevant issues under pillar II and Pillar II deliberations.

Basel II pillars are imbalanced:

Critiques such as Koehn; Thakor (1996) Foot and Stein (1998) are of the strong view that there is lack of sufficient and equal consideration for the pillar II and Pillar III of the Accord as more consideration was given to the pillar I to the detriment of the other two pillars. Also they are of the view that there is no proper link and coherence between pillar one and the other two pillars, making it weak and incapable of sustaining the banking system.

Jean-Charles Rochet further suggests the need for rebalancing the three pillars for effectiveness. S/N 0113684 7


(Stigler, 1971) and most recently Beck et al. (2006) hold the view that supervisors vested with strong powers to supervise banking activity can in the long term improve the corporate governance of banking institutions, reduce corruption in bank lending activity and improve the financial activities of the banks. However Becker et al, 1983 to the contrary sees power of supervision in the hands of supervisors as a means to seeking their own private welfare rather than social welfare of banks and the economy. This is further expanded by Barth et al 2004 indicating the following adverse factors:

Political influence: politicians may influence supervisors by persuading banks to lend to their group of favoured clients to their political advantage; they may then embark on this to lend to some favoured regions; solicit bribes and donations (Djan kov et al., 2006).

The intention of Basel II supervision and the compliance to risk- return and risk sensitivity completely fails if politicians negatively influence bank lending to their advantage and supervisors take undue advantage to help their selves with banks capital.

According to Levine, (2003), efficiency in banks credit allocation will fail and there will be decrease in integrity of the financial system.

Fernandez Gonzalez (2005) finds out that countries that has low or weaker accounting and auditing framework tends to have a very effective and productive banking supervision and management discipline and sound banking system.

Excess delegation of supervisory discretion:

David VanHoose (2007) is of the strong view that the supervisory process pillar does nothing but over delegate discretionary powers to banks without any consideration for rules based approach to banking regulation. This leads to a compromise of the long term safety and soundness of the financial system and potential bank crisis as there is not enough to counteract abusive use of such wide discretion. Potential consequences of this pillar will be exacerbating incentive perverse outcomes and increase in moral hazards.

Tax Burden to Citizens: there is statistical indication that the consequences of wide discretionary practices as opposed to rules based between 1970 to 1900’s lead to regulatory S/N 0113684 8

forbearance when such banks landed in trouble and the resulting effects of financial bail outs which was passed on unfairly to the tax payer like the US tax payer who has to cough out huge billions of US dollars to redeem and recapitalise insolvent banks and protect savers and investors.

Barth et al: in their cross country study of banks and financial institutions adds to this criticisms indicating that nations where banks supervisor have wide discretionary powers tends to be the most undeveloped financial systems with large corruption rate and banking crisis whilst countries with less supervisory discretionary control have stronger economies, low corruption and stronger and safer system. It is therefore seen as a failed element of the Basel II accord.

Lack of International Coordination of Supervisory Standards according to Gilbert (2006) is incompatible with Basel II Accord. Most countries such as USA Europe Hong Kong in implementing Basel II have a huge regulatory divergence from the main objective of the pillar II. Different countries are adopting different capital leverage ratios and allowing capital levels to change to their own satisfaction as long as its still linked to risk sensitivity requirement. This means total capital requirement in US could rise whilst that in Europe may be falling. This has the effects of banks moving into different territories with favourable capital requirements or engaging in cross border mergers with other banks thereby igniting regional regulatory arbitrage

Pointing to the four principles under the BIS 20063 documents, he further clarifies the second pillar is weak to sustain the banking system especially among the inventors of the Basel II accord.

3 Refer to Documents Bank for International Settlement 2006 recommendation on capital adequacy; review and bank evaluation; supervisory intervention of banks; minimum capital standards.


Pillar (III): is designed to work as the third pillar holding the Basel II foundation in the areas of ensuring qualitative and quantitative information disclosure that will enable all the market participants to carry out a comparative analysis and assessment of the key S/N 0113684 9

information on capital adequacy requirement and adherence to risk exposure rules. It stands to place checks and balances on the wide discretionary work by the supervisory review body.

Disclosure requirement4 is to enhance market discipline through release of certain information such as the Accounting and auditing reports of the institution, details of rating and risk exposure calculations that bring out the internal or external mechanism adopted to maintain minimum capital requirement rules.

4 Refer to full information in BIS (2006, p. 226) spells out key pillar of Basel II framework

Significantly, it forms a good framework with more provisions for banks especially in developing countries to adopt it and use it as a yard stick to promote better banking regulations that create good governance financial and operational soundness in the banking industry. Abijit Sarkar and L H Bhole (November 25, 2008). The further establish that effective market discipline has the potential to reinforce minimum capital standards however they believe is not a mechanism that can replace the supervisory review and the supervision pillar has to ensure reliable and accurate accounting standards promoted minimum moral hazards and better credibility.

Adverse to this David VanHoose 2007) argues that the disclosure and market discipline pillar is only useful for developing countries. However, it does not meet the complex regulatory needs of the advanced countries that propagated them. He further brings across the following:

‘Market Discipline’ is a misleading caption and does not do much among the developed countries who promoted it: BIS 2006 raises the need for consistency in disclosure of banking information with risk management however, there are no clearly defined and transparent guidelines for penalizing banks that fail to such information.

Distortions in Disclosure Requirements: He further clarifies that BIS page 227 offers wide discretionary and voluntary disclosure statement which allows for individual countries to S/N 0113684 10

adopt what they consider to declare and disclose under the concept of accounting materiality5 concept.

5 Information will be considered here a material provided its omission affects the user of the accounting information on it to make strategic decision .A misstatement or alteration can lead to mislead assessment of information.

He is also against the proposition that managers of the banks have to decide and implement appropriate assessment for disclosure measures as well as the frequency of their disclosures. This will give room to inconsistency in reporting.

Flannery (2001) stated that the essence of market discipline is to enable suppliers of funds and equity owners influence the market by withholding or withdrawing funds, or demanding higher returns due to risks banks are engaging in. This has to be revealed by accurate information made available to market participants beyond the mere issue of annual and periodical financial reports.

Hamalainen, Hall, and Howcroft are of the view that the Basel (II) market discipline is just first positive step towards proper future disclosure, however the true intention is not to over engage the activities of fund providers as that may affect the soundness and liquidity of the banks. As a result they only provide limited information focused on balance sheet and final accounts in relation to banks capital at given periods just to allow some degree of market monitoring.


From the above review couple of issues comes to mind.

The Basel II is instrumental and a useful banking regulatory tool that enhances and sets a developed regulation and capital adequacy, bank supervision an disclosure policy for the banking institutions among the G-10 countries and rest of the world almost about 100 countries are implementing it to enhance their banking practices, It is a better improvement over the Basel I giving it a wider risk sensitive and analytical strength. S/N 0113684 11

However, it is also perceived that there is lack of Effective enforcement Mechanism and clarity in some areas: It cannot compel the countries applying it to enforce or implement its policy.

Has no proper legal Structure: Unlike the USA and Europe, financial regulation that is supported by codified rules and Directives respectively, Basel two does not on its own have effective judicial powers over its users or implementers. It therefore rely on the full countries to give it the force of law by incorporating it into the financial regulation example is the CRD Directives in UK ( use of European directives) to enforce it in UK.

There are discrepancies in the risk assessment and modelling despite tremendous research in the area. Example is the LGD computation.

Supervisors have too much discretionary power that can lead to political abuse and render the whole regulation ineffective.

Banking Crisis that occurred is attributed to the implementation of the Basel to especially in the area of systemic risk due to the high risk sensitivity it has among other factors like unsupervised risks from the sub-prime mortgage market.

The way forward is a revision and reforms for a new Basel accord that will have a better enforcement capability and involve other banking institutions from the developed and less developed countries.

There is room for research into creating an international Legal framework that can be directly applied in various economic countries with international legal enforcement mechanism. S/N 0113684 12

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