The Basel Agreements: Their Creation, Evolution, and Impact

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8th Feb 2020 Banking Reference this

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The Basel Agreements: Their Creation, Evolution, and Impact on International Banking in Developed and Emerging Economies

 

Introduction

 Throughout history there have been numerous financial systems and numerous financial system failures. From direct bartering to cryptocurrencies and from neighbor to neighbor exchanges to the now global economy, the media from which the exchange is made has changed and evolved into the extremely complex system that it is today. With the complexity of the exchange there presented the need for some sort of structural oversight—some set of rules to make the financial markets more secure and more protected for the long term health of the world economies.

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 One the more current ways that the world is trying to regulate the financial markets is through a series of agreements between the leading nations. These agreements are set in place to create minimum standards that banks must abide by in order to create the most stability for banks that work with them. This evolving set of agreements is known as the Basel Agreements.

Creation and Evolution

 In response to the market crash that led to the Great Depression, The Bank for International Settlements (BIS) was created. It was determined during this time that there was a need for something that would increase the worlds ability to work together in the financial markets and be a “banker to central banks” (“From Basel I to Basel III – Overview of the Journey (Basel 1, 2, 2.5 and 3) – AdvisoryHQ,” n.d.). The BIS fulfilled this need until the end of World War II. At this point, the Brenton Wood System brought forth the World Bank and the International Monetary Fund (IMF) and the leaders of those groups thought that they had made the BIS irrelevant. The BIS, however, is still active today, whereas the Brenton Wood System (which is based on fixed exchange rates) dissolved in the late 1960s and early 1970s.

 With extremely large losses in foreign exchanges causing notable disruption in the international markets, the banking license of Bankhaus Herstatt was suspended. The failure of this bank caused not only issues in West Germany but the effects were seen in all international financial markets. This particular failure spurred the Group of Ten’s central bank governors to take notice in 1974 and decide to try to prevent future occurrences like this in the future. These governors formed a committee that was initially named the Committee on Banking Regulations and Supervisory Practices. The committee met at the Bank for International Settlements in Basel and was later renamed The Basel Committee. It is stated that the committee was:

“…established to enhance the quality of banking supervision worldwide, and to serve as a forum for regular cooperation between its member countries on banking supervisory matters” (“History of the Basel Committee,” 2018).

 The committee’s work was set up as a foundation for multiple nation’s banking supervisors to work cooperatively to limit gaps in international supervisory coverage and thus allow no bank to escape supervision and ensure that the supervision would be consistent across jurisdictional lines. In 1975 the committee created a document called the Concordat. This initial publication established principles for cooperative, supervisory responsibilities across multinational branches. This paper has been supplemented and revised multiple times over the years including (“History of the Basel Committee,” 2018):

 1983- Revision titled “Principles for the supervision of banks’ foreign establishments”

 1990- Supplement titled “Exchanges of information between supervisors of participants in the financial markets”

 1992- Reformulation titled “Minimum standards for the supervision of international banking groups and their cross-border establishments”

Basel I

 Issued in 1988, Basel I was the first major agreement that addressed capital adequacy in international banks. The Latin American debt crisis in the 1980s brought to the forefront the issue that there were steady decreases in capital ratios in the main international banks occurring at the same time as growing international risks. The G10 governors decided to stop the deterioration of standards in capital areas and to set new standards for measurement of capital adequacy. The committee recognized that there would be competitive inequality due to the differences in national requirements of capital so they decided to create a weighted approach to risk measurement on and off of a bank’s balance sheets that would minimize the advantage. Minimizing the advantage would make the international banking system more stable and encourage nations to work together to keep it that way. The ratio of capital to risk-weighted assets was set at 8% and they said that it must be instituted by 1992. This was a standard set for member countries AND any country with active international banks.

 Basel I was designed to evolve over time and, in November of 1991, the committee further defined provisions on loan loss reserves that were used in capital adequacy calculations. It was amended again in April of 1995 to recognize the effects of credit exposures in derivative products and extend the add-on factors matrix. April 1996 brought another document that acknowledged the effects of multilateral netting. The next major amendment came in January of 1996, The Amendment to the Capital Accord, to incorporate market risks (commonly referred to as The Market Risk Amendment), which was to take place before the end of 1997. This amendment was set in place to define a capital requirement for the market risks and use the value-at-risk models as a basis for the measurement. These measurements were to abide strict qualitative and quantitative standards (“History of the Basel Committee,” 2018).

 There were many criticisms of Basel I including the limited differentiation of credit risk, the failure to recognize the changing nature of default risk, no recognition of term structure of risk, the simplified calculations of potential future counterparty risk, and not taking into account the effects of portfolio diversification. Although Basel I was a groundbreaking international agreement recognizing the importance of risk in relation to capital, the criticisms made it very clear that Basel I needed an overhaul and set the ground work for Basel II (Zaher, 2018).

Basel II

 June of 1999 brought the Committee’s proposal to replace the 1988 Basel I accord that defined capital adequacy. It wasn’t until June of 2004 that the revised capital framework was released as Basel II. This new accord was based upon three pillars that included (“History of the Basel Committee,” 2018):

  1. Minimal capital requirements.
  2. Supervisory review of capital adequacy and internal assessment processes.
  3. Use of disclosure as a lever to strengthen market discipline and encourage sound banking practices.

 These revisions were designed to more fully address risk management, and they did, but it was quickly found that it didn’t do enough. This brought out the revision, known as Basel 2.5, which encompassed a broader view of the risks in the financial market. It broadened its scope to make it applicable to international banking on a consolidated level, it excluded insurance activity from financial activity, and it excluded investments in other commercial entities when calculating risk thresholds. Other changes included (“From Basel I to Basel III – Overview of the Journey (Basel 1, 2, 2.5 and 3) – AdvisoryHQ,” n.d.):

  1. Changed Value at risk (VaR) measurement to Stressed Value at Risk (SVaR).
  2. Incremental Risk Charge (IRC).
  3. Charges for securitization/re-securitization of banks’ positions.
  4. Introduced Comprehensive Risk Measure (CRM) to assess exposure of default and mitigation risks.

 Basel II and II.5 strengthened the position of Basel I and created safety nets for persons trying to avoid Basel I rules with circumvents such as Credit Swaps (“From Basel I to Basel III – Overview of the Journey (Basel 1, 2, 2.5 and 3) – AdvisoryHQ,” n.d.). The new accord, though, was determined to be inadequate following the financial crisis of 2008 for several reasons. It is said that the capital requirement levels were too low and the assessment of credit risk was improperly delegated to non-banking institutions. It was also criticized for making assumptions that the internal risk exposure measurement models were superior to those that external agencies could have implemented. There is also the accusation that the framework provided an incentive for banking intermediaries to deconsolidate (hide) risky exposures from the balance sheets. The issues leading up to the financial crisis and these resultant criticisms led to the formulation and implementation of Basel III.

Basel III

 The time period leading up to 2007 was a time of high leverage in the banking sector and inadequate liquidity buffers. The combination of that with poor governance and risk management and inappropriate incentive structures led to mispriced credit and excessive credit growth. The Committee issued “Principles for sound liquidity risk management and supervision” in response to the concerns about those issues. Unfortunately it was late in coming and when the Lehman Brothers bank failed within a month of the publication, the effects of those issues were felt via the financial meltdown of 2008 (“History of the Basel Committee,” 2018).

 Basel III was the result of the decision of the committee to do more to foster transparency and accountability in international banking after the financial disaster. In an attempt to reduce the frequency and strength of banking disasters (Ghosh, Sugawara, & Zalduendo, 2011), this new Basel rule set its primary targets to (“From Basel I to Basel III – Overview of the Journey (Basel 1, 2, 2.5 and 3) – AdvisoryHQ,” n.d.):

  1. Make participating banks strong enough to withstand future financial shocks without causing contagion to other economies or sectors.
  2. Enforce greater risk management within all aspects of the financial industry including operational aspects.
  3. Strengthen financial transparency, governance, and disclosure practices.

 Basel III accomplished these targets by strengthening Basel II requirements and addressing several more areas of the system. It had banks exclude preferred equity and other hybrid capital from calculations and mandated that banks keep higher levels of “true” capital. It also focused on stress testing, “fair value” assessments, executive compensation practices, corporate governance, scrutiny over large exposures, and increased oversight of “concentration risk.”

 Many of the reforms of Basel III are to be instituted between 2013 and 2019. Along with increasing the capital adequacy to 11.5% (Tuteja, 2013), the new role of common equity has an additional layer that, when crossed, limits payouts in order to keep the minimum common equity requirement. It also includes a countercyclical capital buffer that stops banks from participating in credit booms with the goal of reducing losses in credit busts. A liquidity coverage ratio (LCR) will also be created, regardless of weighting, that will make sure that the bank has enough cash to cover funding needs for a 30 day stress period and a Net Stable Funding Ratio (NSFR) that addresses maturity mismatches in the balance sheet. Basel III also standardized counterparty credit risk with derivative transactions and enhanced the way that capital requirements for securitizations are to be calculated. It also introduced exposure limits to limit the max loss that a bank could face if there were a sudden failure of a counterparty (“History of the Basel Committee,” 2018).

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 The objective of all of these reforms was to reduce the extreme variability of risk-weighted assets (RWA) that is believed to have been the cause of the loss of faith by the stakeholders in the global financial crisis (“History of the Basel Committee,” 2018) and institute safeguards to protect financial institutions that are “too big to fail” (Staff, 2018). Basel III did not get the same acceptance as the previous accords had received. Observers felt that the time line for implementation had been watered down and that it doesn’t do enough to correct the problems seen in Basel II. For instance the calculation of risk weights versus the capital that is held against higher risk assets isn’t to be enforced. On the other hand, it does increase costs for banks that indulge in high-risk behavior and it created a more effective warning system to detect and prevent financial disasters.

International Effects

 The effects of the Basel Accords are wide ranging. This version of the Agreements was designed to strengthen the international banking markets and it has done that but it has also had consequences as a result. As with any increase in regulation there are costs that are associated. Those costs may be absorbed or mitigated depending on the institution.

 The regulatory capital requirement increased the amount of money that a bank must keep in reserve with every loan made and thus restricts the amount of business that a bank enters into to raise new capital. This causes a loss of money in the form of loan interest, which is rarely met by interest earned on the allocation. Banks will also now have to limit shareholder distributions in the event of the capital ratio not being met. Although this may seem like common sense, the lack of payouts to the shareholders can create the “sense” that the bank is not doing well financially when that may not be the case. If the institution is able to educate its shareholders in advance of the decreased payout, this obstacle may not be as detrimental as it could be. Overall the new requirements will have lasting effects in the lending ability of international banks and, without corrective action in other areas, have negative effects on the economies of those established markets (Ghosh, Sugawara, & Zalduendo, 2011).

 The new capital requirements, the capital buffers, and the minimum liquidity requirements have the potential to decrease the return on equity for banks. This will lead to the banks covering those losses through various means including decreased earning rates on deposits, decreased staff compensation, and possibly increased margins on product loans (Vine & Gray, 2010). These new requirements will make the system safer but what does it do the bank’s ability to increase returns? One author projects that ROE will decrease from 15% to approximately 8-10%–putting it on the same footing as a public utility—and offers the question of why would anyone buy common stock in a bank (Saunders, 2015)?

 The effect of Basel III in the developed marketplace was anticipated to be profound and may potentially limit what participants in that sector can get involved with, but the effect on emerging markets may be even more pronounced. Because emerging markets need large amounts of cash for the creation of infrastructure, these projects may be slowed due to the inability of banks, especially smaller banks, to extend those loans. Banks will now have to match long term lending (like the loans needed for infrastructure projects) with long term funding and, in response to that, higher liquid assets (Saunders, 2015). Emerging markets are less likely to be able to meet those requirements and certainly will have to limit the quantity of projects that they will be able to undertake if the increased capital requirement of the banks are to be obtained through profits (Beck, 2018).

 SME (small and medium enterprise) funding was also anticipated to be more difficult to obtain due to Basel III requirements. Without an external credit rating, collateral will be the only way for the bank to judge the worthiness of a borrower. SMEs, in general, have low levels of collateral and therefore borrowing from a bank will now be more expensive possibly to the extent that the cost of borrowing outweighs the ability to repay.

 As stated previously, cross border banking flows are decreasing as a result of Basel III. Since record lending highs in 2007, lending (following the financial crisis) from developed markets to emerging markets has decreased substantially, although, there has been a moderate rebound of these loans recently. The tighter leverage rules have incited many banks to rethink their strategic approach and reevaluate the need for a physical presence in some of these emerging market areas as a result (Tiftik, 2017).

 Added to the decrease in funding for infrastructure and enterprise growth, experts expected that there would be a sharp decrease in funding for trade also (Ghosh, Sugawara, & Zalduendo, 2011). Established markets may decrease their exposure to trade with emerging markets in order to meet the capital ratios that are now necessary. The trade slow down could be further slowed because of the concern with China’s future and the fall in commodity prices but the more stringent international funding conditions are the main risk for cross border trade.

 Basel III will also affect the way hedging occurs in emerging markets. Hedging is needed to cover risks in inflation along with changing interest rates. The Basel agreements will penalize the instruments used to hedge in corporations and SMEs. This translates to funding shortages during stress episodes for emerging markets and will be especially apparent in the real estate areas (Tiftik, 2017).

Discussion

 The Basel agreements have progressively tried to institute changes that protect the world markets from financial breakdown. They have somewhat succeeded in that many banks have increased their capital on hand and are better able to cover swings in the markets. The expected cost however was the chief complaint of the banking sector. By increasing the capital requirements and decreasing the leveraging ability of the banks, these accords would increase the cost of lending and borrowing money. Before the costs of implementing these agreements can be accurately measured, though, the complexity of the documents must be addressed to actually determine IF the banks are implementing them correctly. Basel III, by itself, is over 1000 pages long and has multiple addendums that lend to its complexity (Kupiec, 2013). As international economies struggle to maintain growth, they will find ways to interpret the accords to best allow them to meet their nation’s needs. This was seen after Basel II in the “shadow banking” policies employed to circumvent the accord. In so doing, the blame of the financial disaster in 2008 was placed upon those circumventions. This national discretion is allowed to occur because, even though the Basel committee has structured the regulations to support a stable global economy, there is no supervisory regulation to enforce them. This lack of oversight also leads to lack of standard measurements and essentially reduces the accords to mere suggestions (Micossi, 2012).

 Another criticism of Basel III is the applicability to all institutions across the board. For instance, a community bank in the US, insured by FDIC, has little chance of causing a financial meltdown if it should cease to exist. The FDIC coverage protects the money. Increasing capital requirements will do nothing more than the FDIC insurance already does except increase costs in other areas. This type of situation raises the question of if the Basel accords should be selectively applicable depending on the situation (Kupiec, 2013).

 Critics agree that Basel has increased the cost of financial transactions and the because of that there has been a decrease in the amount of lending in the short term. This has been shown to affect both emerging economies as well as developed ones. Advocates, though, acknowledge that this is true but the greater good—the stability of the entire global financial system—is worth the costs (Gooptu, 2012).

 Newer studies, though, are lessening the opinion of dread that resulted from the initial release of Basel III. It has been found that emerging markets, in particular, have not been subject to decreased lending (Andrle, Tomsik, & Vlcek, 2017, p. 16) or decreased profitability (Mashamba, 2018) in the long-term. It has been found in these studies that emerging markets had increased their capital ratios through the use of retained earnings (Andrle, Tomsik, & Vlcek, 2017, p. 2) instead of increased lending costs..

 Resource, an alternate investment solutions firm, took data from a Bank of England study (Bridges et al., 2014, p. 23) and created the following figure. It depicts a similar conclusion as the Andrle study showing initial short-term decreases of lending in specific markets but in the long-term (defined in the study as more than 3 years) there is actually loan growth (“Is Basel III Drying Up Bank Lending?,” 2018).

Figure 1. Adapted from: Is Basel III Drying Up Bank Lending? 2018

 It is apparent that the outcomes of Basel III will be ongoing but after studying the data so far, it can be concluded that the new regulations that were set in place appear to be favorable to the long-term stability of the international banking system.

Conclusion

 The Basel agreements have continually made recommendations that support the reason the committee was created—to create a cooperative, multinational supported set of standards that serve to keep a healthy financial global marketplace. They recognize that there is a need to continually supplement the agreements according to the changing atmosphere of the world economies. This is seen by the multiple versions of the Agreements that have been published. Each agreement has created new requirements that have been met with varying degrees of acceptance and anticipatory outcomes. For example, Basel III was thought to decrease lending and profitability, but has actually led to loan growth and decreased funding costs.

 As the committee works on the next version of Basel—Basel IV is in the planning stages— they will look at the ways that some in the market have interpreted the new regulations and the effects that they have had in the market. They will revise and create the regulations accordingly. It is hoped that they will address the lack of interpretive guidelines and enforceability in order to continue to support healthy growth.

 Up until now the Basel Agreements have had overall positive effects on the economies of both developed and emerging economies. They have created a more stable financial atmosphere for the world markets. Each version of the agreements increases the stringency of preparation for disaster and has been met with initial skepticism about the ability of markets, especially emerging markets, to be able to grow within the bounds of the new rules. Following Basel III, numerous studies have determined that after an initial slowing, the markets in both developing and emerging markets have continued to grow despite the limitations.

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