The banking industry involves a risky business. To survive in the industry, the banks have to develop effective ways of taking and managing risks. The contemporary changes in banking and other financial markets have led to the complexity of the risks involved in banking. For instance, when a bank lends out money, there is the risk that the borrower may fail to pay back the borrowed amount as agreed (Musch, Ayadi, Nieto & Schmit 2008, p. 64).
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The measures that the banks employ in carrying out their practices and economic functions determine how these financial institutions operate to make profits. In addition, the governments’ involvement in the banking industry also influences the operations of the banks. As a result, the supervisory teams have always examined the performance of the financial sector to determine the capability of the sector in dealing with the risks (Musch, Ayadi, Nieto & Schmit 2008, p. 65).
To harmonize the operations of the banks and other financial institutions and to address the causes and consequences of the global financial crisis, Basel Capital Accord was initiated. The Accord was adopted to assist in establishing a work plan for capital adequacy standards for major international banks and other internationally active financial institutions.
The accord would also serve as a basis for assessing the risks that are related to capital. However, the Basel Accord did not take into account the changes that normally occur in the financial sector, which can ruin the efforts of the banks to handle the unexpected risks (Musch, Ayadi, Nieto & Schmit 2008, p. 67).
Basel II was formulated to look into the financial crises that the banks and other internationally active financial institutions were facing. The main objective of Basel II has been to enhance the framework of the regulatory capital for the active banks and other financial institutions (Brummer 2012, p. 63). By placing minimum capital requirements that are not only able to reinforce incentives for managing risks, but also ones that are more sensitive to the financial institutions’ risk profiles (Musch, Ayadi, Nieto & Schmit 2008, p. 68).
Modification of Basel II
Basel II is undergoing numerous modifications to make it more suitable to effectively address the financial crises facing the banking sector. The first principle is based on the minimum capital requirements and the rules of calculating the capital ratio. Basel II is being modified to allow for an easy calculation of the capital ratio. In the new model, the numerator of the ratio would be taken as the bank’s reserves, subordinated debt and certain equity, while the denominator would be the number of risks that are likely to be incurred by the bank (Englemann & Rauhmeier 2011, p. 251).
In comparison to the former Basel II, the only aspect that will be changed in the new model is the description of the risk-weighted assets, which refers to the techniques used to assess the riskiness of the investments and loans that the bank is holding. The modification will bring about positive changes in the way credit risk is handled.
It would also provide for appropriate treatment of securitization of risk. Besides, the modification would also provide better ways of dealing with the operational risk that normally results from the inadequacy of internal processes (Englemann & Rauhmeier 2011, p. 253).
Another modification is on the supervisory oversight. In the modification, the Basel II team recommends that the internationally active banks and other financial institutions should be able to operate beyond the minimum capital requirements to allow them to determine whether they have enough capital that can support their individual profiles in case of risks.
The modification also asserts that the supervisors, through their knowledge of the banking industry, should be able to provide crucial feedback to the banks’ managers regarding their internal evaluations (Englemann & Rauhmeier 2011, p. 254).
The third modification seeks to complement other modifications with a strict financial market discipline. This is geared towards ensuring that the banks disclose publicly the crucial information that will enable the investors and other payers in the market to easily assess and evaluate the levels of risks and capitalization of an individual bank. This modification is equally important, especially for the banks that will be relying mostly on internal techniques when evaluating risk (Englemann & Rauhmeier 2011, p. 257).
The Implementation of the Modified Basel II
The modified Basel II offers a number of ways through which the modifications can be implemented by the banks. It provides three options for evaluating operational risk and three ways for measuring credit risk. This is quite instrumental to the banks and their supervisors. The supervisors have a variety of options from which they can choose the most appropriate method that suits their banks’ operations and their ability in risk evaluation (Eubanks 2010, p. 2).
The first option in measuring the credit risk is called the standardized approach. In this approach, the bank assets will be categorized and weighted with regard to the fixed risk weights as specified by the supervisors. This approach adds more risk categories besides making utilizing the external credit ratings that assist in assessing the extent to which a financial institution is exposed to risks (Englemann & Rauhmeier 2011, p. 256).
The second approach in credit risk calculation is the internal-rating-based (IRB) approaches. In this technique, each bank will be expected to assess its assets in relation to the most significant components of credit risk. This will help to determine the possibility of a borrower defaulting payment in the agreed timeline, the amount of the loss in the event that default occurs, and the amount and maturity of the bank’s exposure as a result of the default (Eubanks 2010, p. 5).
The three main options that have been proposed for calculating the operational risk include the basic indicator approach, the advanced measurement approaches and the standardized approaches. The standardized and basic indicator approaches are suitable for banks that are less vulnerable to the operational risk.
The two approaches require banks to set a certain amount of capital against the operational risk. The amount to be set aside should be proportional to the bank’s annual gross revenues accrued in the preceding three years. The banks that will be using the two approaches will not have a chance of incorporating the risk-mitigating insurance effect into their systems (Eubanks 2010, p. 7).
The advanced measurement approaches are the most effective indicators of the operational risk since they are designed in such a way that they have high sensitivity to the risk. They are therefore, suitable for the internationally active banks that have greater significant exposure to the risk (Brummer 2012, p. 71).
It will allow the banks to apply their own methods to assess the extent to which they are exposed to operational risk. However, the supervisors of the banks will have to determine whether the methods are sufficiently comprehensive before they are used in the evaluation process (Eubanks 2010, p. 7).
The Influence and Benefits of Basel III on the Operations of Large Banks
Basel III is a modification of Basel I and II, which were found to have lacked some of the most important factors of addressing the global financial crisis. For instance, in Basel II, the banks’ minimum regulatory capital levels were not sufficient enough and could not determine the banks’ exposures actual amounts of losses incurred by the banks in the financial crisis.
The measures outline in the Basel II could not fully capture the risks that resulted from the banks’ exposures to derivatives, securitization, and the repurchase contracts. The working principles of Basel II were based on capital only, thereby ignoring the internationally agreed quantitative standards for liquidity (Eubanks 2010, p. 2).
Basel III is not a legally binding approach for the internationally active large banks. A bank may choose to modify certain elements of Basel III when it formulates its own rules. To enhance uniformity among the internationally active banks, the Basel Committee needs to develop a system that will ensure consistency in the banks. As a result, there will be a convergence in the implementation of the provisions of Basel III (Eubanks 2010, p. 3).
Basel III is a step in the right direction and is likely to make the international financial system safer. The Basel approach is enhancing the global capital framework by improving the resilience of the large banks. It raises the amount of the capital base as well as strengthening the ability of the banks in relation to the coverage of capital requirements. Basel III will introduce numerous macro-prudential elements into risk evaluation techniques, which will assist in managing risk that emanates from the interconnectedness of the banks (Eubanks 2010, p. 3).
Basel III has laid down a number of techniques that will help to prevent a re-occurrence of some of the problems that were witnessed during the financial crisis. The current Basel techniques raises the quality, transparency and consistency of the capital base on which the risks can be easily measured.
It became evident from the crisis that the credit write-down and losses are caused by retained earnings that form the major component of the common equity base of a bank. This is one of the unfortunate circumstances that the new model wants to prevent by raising the elements of the capital base (Eubanks 2010, p. 5).
The new Basel model has also designed measures that will see the risk coverage being enhanced in the banks and other financial institutions in the globe. As witnessed during the crisis, lack of strong measures of dealing with the major on-and-off-balance sheet associated risks and exposures related with derivatives became major destabilizing factors and which, fueled the crisis even more. To avoid a re-occurrence of the same, the new model raises capital requirements for securitization of complex exposures. Such exposures are known to result into major losses for most of the banks (Eubanks 2010, p. 6).
The system for enhancing the coverage of risk uses a stressed value-at-risk capital requirement that is based on continuous twelve month duration, which is quite important in financial stress.
The new system will also assist to enhance the capital requirements between banks to counteract the credit exposures that normally originate from derivatives of the banks and activities used to fund securities. In addition, the risk management springing from counter-party credit exposures will automatically be enhanced within the work plan (Eubanks 2010, p. 7).
Another benefit of the Basel III implementation within the banking industry is the reduction of pro-cyclicality. During the crisis, most banks suffered from the pro-cyclical rise of financial mayhem throughout the global financial markets. The new Basel model has introduced a number of measures that will prevent the bank from re-encountering such problems. Some of the measures outlined within the model include viable accounting standards for held-to-maturity loans, mark-to-market assets, and timely release of leverage among the banks and other participants in the financial market (Eubanks 2010, p. 8).
The new model has set strategies, which will ensure that the pro-cyclicality is reduced while on the hand, enhancing the resilience of the banks especially at the times of favorable business seasons. The model seeks to preserve capital and construct buffers in every bank, which can be used to manage stress, reduce excess cyclicality set for the minimum requirements, and ensure that the macro-prudential objectives are attained so as to continue protecting the banking industry even during the period of excess credit growth (Eubanks 2010, p. 8).
International Financial Regulation
The international financial regulation is important in that it monitors and regulates global financial services. The regulator comprises of a network of experts drawn from different parts of the world. The experts regulate the financial services according to the regulations set by different jurisdictions (Brummer 2012, p. 3).
For that reason, the International financial regulation assesses the advice that financial institutions give to their clients so as to verify whether the advice comprises of the key international developments and their impact in the global financial market. Lastly, it ensures that all the participants are updated on the developments of cross-border financial issues (Alexander, Dhumale & Eatwell 2006, p. 3).
The international financial regulation system has undergone numerous changes over the last twenty years (Brummer 2012, p. 10). The major cause of these changes has been the move by several governments to lift the barriers to cross-border flows of capital, which has in turn opened the domestic markets to foreign banks and other financial institutions. A number of western countries and policymakers have pointed out that these changes are calling for an increased international regulation of the financial institutions (Oatley 2001, p. 36).
Need for Regulation
The main aim for regulating the operations of banks and other financial institutions is to enhance the protection of bank shareholders and depositors. The regulation therefore, involves creation of environment that is safe for enacting financial transactions (Alexander, Dhumale & Eatwell 2006, p. 7).
Such environment is composed of explicit deposit insurance and implicitly assures the shareholders of getting interest on their investments. Without a proper international regulation system for internationally active financial institutions, a financial crisis and insolvency are likely to occur and impact negatively on the economic, political, and social structures of a country (Brummer 2012, p. 7).
As a result of the financial crises such as the one witnessed in the Great Depression, governments have always set strategies of bailing out banks to avoid the widespread insolvency, which may result in social crisis (Brummer 2012, p. 8). The regulation, to an extent, provides incentives for the banks and encourages them to take an additional risk. The banks, through the insurance and guarantees, tend to give out even the high-interest loans to risky borrowers. Such loans are known to give huge returns on the event that the borrowers settle them (Oatley 2001, p. 36).
Despite the potential for political and economic crises associated with the banks malpractices, the international regulation is still obligated to continue with the maintenance of a good working environment for the internationally active financial institutions. The banks, however, have to be regulated to prevent them from incurring the risks (Brummer 2012, p. 9). Regulation may include imposing capital requirements that will help the banks to operate at sufficient capital, to assist them in covering the unexpected losses, should the borrowers default in paying their loans (Alexander, Dhumale & Eatwell 2006, p. 11).
To ensure that the banks work on sufficient capital, the banks are supposed to hold capital whose amount is equivalent to a specific percentage of their assets as will be determined by the regulator. In addition, the international regulators may also implement a risk-weighted requirement in which banks are expected to hold a certain amount of capital that is proportional to the risks attached to their loans (Oatley 2001, p. 37).
The international regulators hope to accomplish their goal by matching the specific capital requirements and the possible risks that the banks are likely to incur. This is a strategy that is intended to lower risky portfolios and to ensure that the banks hold sufficient amounts of capital that can be used to counter losses that may result from loans with greater risks. This has a general effect of minimizing the cost and losses to shareholders and customers when banking crisis occurs (Brummer 2012, p. 11).
International Financial Regulation as a Legal System
Despite the fact that governments have the ability to regulate banks that are within their jurisdictions, there is still need to incorporate the international financial regulation into the system since the international regulators are the ones that can set common rules that govern the operations of the internationally active banks and other financial institutions (Brummer 2012, p. 61).
Besides, the financial crises that have been witnessed in most regions have shown that the governments can no longer rely only on the domestic regulation to maintain and prevent the banks that are incorporated in their countries from suffering the same crises (Alexander, Dhumale & Eatwell 2006, p. 34).
The laws set by the international financial regulation reflect the international corporate laws, unlike the ones set by the governments that depend entirely on the independent national authorities. It is through the international regulation that countries can arrange and formulate an appropriate coordination based on proper agreements and internationally harmonized prudential laws (Oatley 2001, p. 37).
The international regulation is also considered as a proper political redress to unfair competition between banks that operate under strict national rules and those that work under no such national rules. The national regulators normally set rules that suit the business environment in their countries. As a result, some banks in some countries find themselves working under more strict rules than others in different countries (Brummer 2012, p. 65).
The banks that work under lax atmosphere are likely to offer services to their customers at relatively low prices as compared to the banks that operate under stringent rules. This phenomenon does result into an unfair competition between the banks. The international regulation, by ensuring that governments implement common banking standards, wipes out the unfair competition. Therefore, the international regulation creates an environment with a flat playing field in the international finance and market (Oatley 2001, p. 38).
In the international regulation, the governments willing to prevent the domestic mayhems between them and their banks are supposed to leave the banks to entirely be controlled by the international regulation. The goal of the international regulation is not to correct the market failures that are caused by the international financial integration, but to reduce the distributional impacts of regulatory reform in the international integration (Brummer 2012, p. 72).
Criticism of the International Financial Regulation
The critics of the international financial regulation feel that this system is illegitimate, obscure and unaccountable. Even though the governments will be doing their banks more good than harm when they comply with the international regulation requirements, there are some problems associated with this system (Brummer 2012, p. 179).
Some of these problems are likely to come as a result of the interaction between the unfriendly nature of the decision making techniques set by the regulation and the unforeseen penalties of financial regulation. This problem can even result into a very unsafe banking environment (Alexander, Dhumale & Eatwell 2006, p. 79).
The act of the international regulation of assigning the same costs of capital and risk weighting to all loans within a certain region is seen by some people as obscure and unrealistic. The banks still have the right to change to higher-interest assets which are highly risky within a given category (Alexander, Dhumale & Eatwell 2006, p. 80).
In such a situation, a loan issued to highly rated firm will receive a similar weighted risk as the one given to a highly indebted start-up corporation, even though the latter firm has a higher possibility of not repaying the loan. The banks are quite ready to issue such loans due to the higher interest charged in case of the start-up firms (Brummer 2012, p. 182).
The risk classification system set by the international regulation creates situations in which banks can easily engage in regulatory capital arbitrage whenever they want to. The international regulation system does not set capital requirements that take into account elements such as probability of insolvency, thereby giving banks an opportunity to redesign their portfolios in a way that reduces their regulatory capital requirements without affecting their risk (Alexander, Dhumale & Eatwell 2006, p. 82).
When the banks successfully securitize their assets with restructured portfolios, they can easily unbundle the risks and repackage them to assist them in converting the on-balance sheet assets into off-balance ones that have lower weighted risks. As a result, the international regulation is seen to affect the on-balance sheet assets while on the other hand, favors the off-balance sheet assets (Oatley 2001, p. 39).
Since the banks can only securitize the high quality assets at a certain cost, the international regulation has the effect of moving the assets with higher quality from the banks’ balance sheets. This has a serious negative impact on the operations of most banks. It causes the disappearance of the high quality assets while retaining the low quality ones thereby making the average credit of the on-balance sheet assets of a bank to depreciate significantly (Alexander, Dhumale & Eatwell 2006, p. 87).
The regulation assigns as little as eight percent capital requirements on the lower quality balance sheets, a value that may be insufficient and which is likely to affect the ability of a bank’s capital ratio in providing reliable information regarding the indicators of a bank’s true financial status. The clients and other participants within the financial markets rely on the bank’s capital ratio when determining the banks’ lending ability. Therefore, when such information is affected, the participants will not be able to effectively determine the status of these lending institutions (Brummer 2012, p. 192).
Alternative Approaches to the International Financial Regulation
As a result of the problems caused by the international financial regulation, the regulation system seems to have imposed the banks to more risks as opposed to enhancing their safety as was supposed to be the case. It is difficult also to amend the contentious components of the international financial regulation as it will involve elaborate consultations among the experts who are responsible for the making of the regulations (Oatley 2001, p. 39).
There are some alternatives that could be used in the replacement of the international regulation to avoid the problems caused by the regulations. The first alternative involves the use of external rating agencies for the measurement of risks. In this option, the governments are required to rely overtly on the rating agencies, which will connect the measurements with the appropriate risk categories (Oatley 2001, p. 39).
It is obvious that this alternative is likely to maintain the same number of risk categories as outlined in the international regulation, the difference is the degree of the categories. This approach will add greater degrees to these categories. The governments or the banks’ supervisors are supposed to implement this approach according to the way it is outlined in any of the external rating agencies, which include Poor’s, Moody’s, and Standard. This approach provides an effective way of avoiding the problem of unfair competition, which occurs when different banks from different jurisdictions are forced to work under the same conditions set by the international regulation (Alexander, Dhumale & Eatwell 2006, p. 174).
The second alternative would be to use the banks’ internal rating criteria in the assessment of risks attached to various loans and investments. The large banks and other internationally active financial institutions rely exclusively in complicated techniques for the evaluation of the risk that emanate from the individual exposures to eventualities such as default in payment. Most of these methods are reliable and are known to give accurate platform for risk evaluation (Alexander, Dhumale & Eatwell 2006, p. 175).
This approach therefore, when adopted, will give the banks an opportunity to use the methods developed by their supervisors to measure the risk associated with a given exposure. Unlike in the case of the international regulation in which the methods cannot be revised, this approach allows for regular revision of the techniques to suit the changes in the financial market (Oatley 2001, p. 39).
Alexander, K, Dhumale, R & Eatwell, J 2006, Global governance of financial systems: the international regulation of systematic risk, Oxford University Press, Oxford.
Brummer, C 2012, Soft law and global financial system: rule making in the 21st century, Cambridge University Press, New York, NY.
Englemann, B & Rauhmeier, R 2011, The Basel II risk parameters: estimation, validation, stress testing: with application to loan risk management, Springer, New York, NY.
Eubanks, WW 2010, The status of the Basel III capital adequacy accord, DIANE Publishing, New York, NY.
Musch, FC, Ayadi, R, Nieto, M & Schmit, M 2008, Basel II implementation in the midst of turbulence, Center for European Policy Studies, Brussels.
Oatley, T 2001, ‘The dilemmas of international financial regulation: consequences of the 1988 Basel Accord should concern those who want more international regulation of financial institutions’, Regulation Magazine, vol. 23, no. 4, pp. 36-39.