Implications from regulatory changes on the Swiss banking sector

TABLE OF CONTENTS

Executive Summary

Introduction

Section 1: Basel I & Basel II
1.1 Basel I
1.1.1. Origin of Basel Accord
1.1.2 The Four Pillars of Basel I Accord
1.1.3 Basel I: Success and Criticisms
1.2 Basel II
1.2.1 The Three Pillars of Basel II Accord
1.2.2 Basel II: Success and Criticisms

Section 2: The Financial Crisis
2.1 The Causes of the Financial Crisis
2.2 Basel II as a catalyst to the financial crisis?
2.3 Financial Crisis and the Swiss Banking Industry

Section 3: Basel III
3.1 Key Focus areas of Basel III
3.2 How Basel III has tried to overcome drawbacks of Basel II
3.3 Concerns of Basel III
3.4 Basel III and its expected Impact on Europe
3.4.1 Impact on European banks
3.4.2 Business Impact of Basel III
3.4.3 The Swiss Banking Industry
3.4.4 Analysis of financial results

Section 4: Central Banks and the Regulatory Impact
4.1 Impact on Monetary policy
4.2 Impact on Fiscal policy

Section 5: Conclusion

Bibliography & References

EXECUTIVE SUMMARY

In response to the latest global financial crisis, a number of regulatory policies such as Anti-Money Laundering (AML) and stringent compliance were adopted over the past years but the finance sector called for an international standard, a global regulation. The planned implementation of Basel Accords by January 1, 2019 focuses on much higher capital requirements as well as increased liquidity and funding requirements at the same time. The core goal of Basel III is to make sure that government will never have to bail out banks again as they did in many cases over the past years. This objective of this thesis is to analyze and describe the Basel III framework and focus on its implications on the banking industry, with a focus on the Swiss Banking Sector.

The main challenges ahead for the banking sector due to the extensive regulatory changes are to review the profitability of their business models as intensification of compliance will bring pressure on bank’s profit margins. The report will describe how financial institutions will also have to review funding strategies and also deal with the impact of increased capital and liquidity costs. Further will the technical compliance with the new rules and required key ratios be a significant challenge in itself.

This thesis will present the beginning of today’s regulatory set of regulations which began in July 1988 known as the Basel I Accord and explain the different intermediate stages until the newest regulatory framework: Basel III. The Basel III Accord will be gradually implemented over a transition period from 2013 - 2018. Further to analyzing the impact of the new Accord on the financial system and Switzerland in particular, this thesis will also review the sufficiency of different key ratios that have to be achieved by the Banks in order to meet the regulators standards and will provide key findings and suggestions for improvement for the body of rules to be more efficient and meaningful.

The latest official financial statements by the Banks suggest that the system-relevant banks are well on the way of not only meeting the required standards but also to find alternatives to maintain current profitability. This report will analyze and compare the latest published figures and put it into perspectives of the target ratios and draw conclusions there from.

INTRODUCTION

For the past decades, the banking sector has played a pivotal role in boosting the development of the Swiss economy, contributing more than 12% of GDP as calculated by State Secretariat for Economic Affairs (2012) and with a share in the country’s economic value added of 15%. In 2010, the banking sector contributed more than CHF 63.7 billion to the national income through revenue in relation to 2009 which recorded CHF 57.8 billion. This noticeable positive outcome has been attributed to introduction of new policies that were implemented towards enhancing efficiency in service delivery and risk management strategies. Based on the current global economic trend, the Swiss Bankers Association (2011) in connection with the Boston Consulting Group has estimated that its banking sector would grow by 16% by 2015 hence providing an advantageous environment for both local and international investors.

Other than providing financial services to the public, the Swiss banking sector has taken an active role in addressing the issue of unemployment by offering credit facilities to private or corporate investors with the aim of creating employment opportunities. It has also supported community and national based projects that are intended towards generating income, improving standards of living and replenish the condition of infrastructure by boosting regional development.

However, the dynamics of the recent financial crisis highlighted the areas of the global financial system (including the Swiss Banking system) that need to be revised and require an improvement in their design. The centrality of banks in the recent financial and economic crisis demonstrated the need for more efficient regulation of banking industry. Based on the continuing work in the field of financial system regulation and as a response to the crisis, Basel Committee on Banking Supervision issued a number of documents proposing the establishment of a new regulatory capital and liquidity regime, which are expected to reassure a fundamental strengthening of global capital standards.

The deliberations of for the Basel I Accord started six years before it came into effect in July 1988, designed by the Basel committee. It was implemented by internationally active banks that were part of the G10 countries. Basel I had the twin objectives of ensuring an adequate level of capital in international banking system and creating a level playing field to prevent banks from building big businesses without adequate capital on their books. Basel I is now widely viewed as outdated.

In view of the identified gaps of Basel 1(detailed in Section 1), the Basel Committee released an updated document that was endorsed on 26th June, 2004, and came to be known as Basel II. The Basel II rested on three pillars: Minimum capital requirements, Supervisory review process, and Market Discipline. Apart from credit risk, operational and market risk were also brought in the ambit. Despite the Basel II’s sophistication, its biggest impact and its biggest criticism was that it gave impulse to pro-cyclicality in the financial system. This pro-cyclicality manifested itself in the financial crisis of 2008, increased the severity of the crisis. Banks had excessive leverage, excessively risky assets, and books with mismatched maturities, loose underwriting standards, amidst other mismanaged aspects, which the Basel II Accord failed to recognize, fine and correct.

In reaction to the crisis and the shortcoming of Basel II, the Basel Committee on Banking Supervision has created Basel III. Basel III regulatory initiative is a further attempt to narrow the gap that provides room for a bank’s misbehavior which makes the financial (and therefore the overall economic) system fragile. The key dimensions of the Accord are building in a leverage ratio, liquidity ratio, a capital buffer and the attempt to dampen pro-cyclicality. The Basel III accord’s requirements are stringent and are expected to make certain fundamental changes in the financial and money markets. The accord will also have an impact on the transmission of monetary tools. Due to this, the Basel III Accord’s implementation timelines are long, to enable the banks and financial market as a whole, to make the transition as smoothly as possible. The Swiss banking industry, however, has undertaken several incremental steps to ensure the stability of its Industry: It has undertaken to apply both the Basel III as well as its own Too Big to Fail (TBTF) regulatory standards. In fact, a majority of the Swiss banks are already complaint on Basel III capital requirements. The focus of the Swiss government and the central authority is now to stabilize its largest two financial institutions, which contribute a total of 600 percent of the Swiss economy’s GDP.

The aim of this paper is to understand how Basel III regulations are expected to impact the Swiss banking sector. The research question will be answered by conducting a literature review and conversations with senior people in the financial industry that are directly dealing with the topic. The author believes by reading and analyzing relevant journals, participating on Basel III relevant events and interviews with people in the financial industry, the problem will be tackled in depth. In addition, the author has a track record in the financial industry (Banks and Asset Managers) of 15 years in which he directly dealt with the previous Basel Accords while performing bank statistics to the Swiss National Bank and the regulator, the Swiss Financial Market Authority.

The information was gathered by the use of secondary data, most of all by reliable and reputable publications and internationally recognized relevant regulatory bodies and the researched Banks. The author’s own conclusions and analysis conducted led to primary data with the use of public information. The author has applied conclusions from selected qualitative research to the Swiss Banking sector in combination with his own domestic market knowledge and is convinced to add value by highlighting potential risks and subject relevant improvement measures.

Literature research is limited to available reading material and has the risk of misinterpret the quoted person’s real intention which would possible by personally interviewing key people of the relevant institutions. The reliance on published research is less of an issue for this topic as the most important factors are the official standards published by the Basel Committee on Banking Supervision. However, this approach can not reflect the (thought)-processes the Banks went through while analyzing the best scenario of moving their companies towards the required standards.

The author has worked for different private banks and had the chance of leading an IT- project that dealt with implementing reporting and analyzing software for the amended Basel 2.5 standards relevant for Swiss Bank and is therefore familiar and very interested in the subject in 2002. This software called “Abacus Fire” was the first to use risk weighted assets of a bank for stress tests and is still the standard for all Swiss banks. The author was also dealing with the matter while working abroad (British West Indies) hence working under the British regulatory standards. The analysis of sufficient equity has accompanied the author during the past 16 years.

RESEARCH QUESTION:

“HOW HAS THE SWISS BANKING SECTOR BEEN AFFECTED BY THE BASEL III REGULATIONS THAT HAVE ALREADY BEEN IMPLEMENTED. HOW ARE THE REGULATIONS THAT ARE YET TO BE IMPLEMENTED EXPECTED TO

AFFECT THE SWISS BANKING SECTOR?”

The thesis proceeds in the following manner:

Section 1: Basel I and Basel II

In order to understand the new Basel Accord it seems essential to understand its beginnings. This section attempts to understand the key factors of Basel I and Basel II. It will also address the shortcomings of Basel I, and how Basel II accord attempted to cover these pitfalls. The same analysis will be carried out for Basel II as well with an attempt to understand the criticism of Basel II.

Section 2: Financial Crisis of 2007 - 2009

This section will attempt to explore the root causes of the financial crisis of 2007. It will also analyze how the Basel II shortcomings actually induced and favored the magnitude of the financial crisis. It will explain how the learning and lessons of financial crisis have given Basel III its current shape.

Section 3: Basel III regulations

The section will analyze the Basel III regulations and its key factors in detail. It will also try and analyze the shortcomings of Basel III. A separate sub-section would deal with its regulatory impact: impact on monetary and fiscal policies. The report will also discuss the impact of Basel III regulations on the Europe region, the expected business impact and the Swiss banking industry in particular.

Section 4: Conclusion

This section summarizes the key factors and findings of the three sections above. It will also put forward the future roadmap for the banking industry with the new stringent regulations of Basel III, and the resulting changed financial environment.

The author will finally propose his opinions about the Basel III regulations on what the main positive and negative impacts on the Swiss banking system are.

Abbildung in dieser Leseprobe nicht enthalten

Source: Accenture, Basel III Handbook, 2011

SECTION 1: BASEL I & BASEL II

1.1 Basel I

1.1.1. Origin of Basel Accord

In 1974, regulators closed Bankhaus Herstatt, a small bank in Germany, in the middle of the day. On the fateful day of June 26, 1974, a number of banks released payment of DEM to Herstatt in Frankfurt in exchange for USD to be delivered in New York. Because of time zone differences, Herstatt ceased operations and the banks in New York did not receive their dollar payments. This was a classic case of settlement risk, which international banks dealing with foreign exchange routinely face, and which has incidentally now come to be known as “Herstatt risk”.

Following the closure of the Herstatt bank, under the backings of the Bank of International Settlements (BIS) in Switzerland, the Basel Committee on Banking Supervision was established. The central bank governors of G10 countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, United Kingdom and United States) and monetary authorities of Switzerland and Luxembourg met to form this cooperative council to harmonize the banking regulations and standards within and between all member countries (Balin, 2008, p1). The committee was authorized to discuss international regulatory standards and regulations and issue recommendations. However, its recommendations were not legally binding by its member states. As per BIS (2007, p1), the Committee does not have any legal, supranational supervisory authority. Its conclusions and recommendations are not legally binding for any nation. The committee’s role is to formulate broad supervisory standards and guidelines and recommend best practices for the industry. It is up to the individual nation’s authorities to take steps for implementation of same through further detailed arrangements.

These arrangements can be statutory or otherwise, as decided by each individual nation keepings their own national systems in perspective.

During the years of 1970s and 80s, the internationally active banks sought to exploit the loopholes in the Basel committee recommendations. There was also a tendency to relocate to countries which had less stringent capitalization standards. However, between 1973-1980, due to the combined effect of increasing economic growth leading to an increase in demand for oil and other commodities, abandonment of the Bretton Woods System by US in 1971 leading to high inflation, and the Arab - Israeli war of 1973, oil prices increased ten-fold. This had a direct impact on the financial system, in turn creating a debt crisis (El-Gamal and Jaffe, 2010, pp. 2). The subsequent banking crisis due to this petrodollar crash highlighted and amplified the need for a common banking capitalization standard (Balin, 2008, pp. 2). After six years of discussions and deliberations, in July 1988, an agreement was reached in the form of International Convergence of Capital Measurements and Capital Standards. This agreement came to be known as Basel I. The twin objectives of the accord were “to ensure an adequate level of capital in international banking system and to create a more level playing field in competitive terms so that banks could no longer build business without adequate capital backlog” (Benzin, pp. 4).

1.1.2 The Four Pillars of Basel I Accord

As per Balin (2008, pp. 2), domestic currency and debt as well as financial instruments were considered the most reliable under Basel I. A maximum level of risk was used to calculate capital requirements. However, a minimum level of capital level was made mandatory for internationally active banks, with the individual member states’ central banks being required to impose more stringent standards at their level. Also, the capital adequacy levels recommended intended to cover only the risks arising from the creditworthiness of a bank’s balance sheet. The capital recommended did not take into account external risks such as changes in the value of national currency and interest rate fluctuations. Though Basel I was explicitly meant to cover developed countries, emerging markets also rapidly adapted the Basel I accord. By 1999, almost all countries were Basel I compliant.

What are the 4 pillars that the first Basel Accord was built upon?

- The Constituents of Capital: This pillar provided a definition of constituents of reserve capital and the amount of reserve capital a bank can keep on its books. The capital reserve itself is divided into two tiers: Tier I and Tier II capital. Tier I capital consists of disclosed cash reserves and other capital paid for by the sale of bank equity (Balin, 2008, pp. 3). Basel I accord required banks to hold equal quantities of Tier I and Tier II capital.
- Risk Weighting: This pillar provides a system of risk weighting the assets of a bank. Assets have been classified into five different categories based on the risk weight assigned to them. These categories are: riskless (0% risk weight), low risk (20% risk weight), moderate risk (50% risk weight), high risk (100% risk weight) and variable risk category (variable risk at 0, 10, 20 or 50%, depending on central bank’s discretion).
- Target Standard Ratio: This pillar defined the capital requirement as a percentage of risk weighted assets. It stated that 8% of a bank’s risk weighted assets had to be covered under Tier 1 and Tier 2 capital reserves. In addition, 4% of risk weighted assets had to be covered by Tier 2 capital reserve.
- Transitional and Implementing Agreements: These were a series of agreements to ensure adaption of the Basel Accord recommendations by member countries. A four year period was provided to the member states to adapt to the Basel guidelines.

1.1.3 Basel I: Success and Criticisms

The success of Basel I can be assessed by measuring the change in capital ratios of the countries after the implementation of the Accord. A study undertaken by De Netherlandsche Bank illustrated the data of capital ratios of 29 OECD countries from 1990 - 2001. The data shows the capital adequacy ratios increasing from approximately 8.5% to 12% (Jabelecki, pp. 19). Another report by Bondt and Prast (1999 cited in Jabelecki, pp.20) that studied the countries of UK, US, France, Italy, Germany and the Netherlands over 1990-1997 reported an increase of 2 percentage points. A further study by Haubrich and Wachtel (1993 cited in Jabelecki, pp. 21), found out that American banks increased their holdings of government securities from 15% in 1989 to 22% of their total assets by 1993. This change in portfolio holding was attributed to Basel I, where sovereign debt was considered riskless and hence no additional capital reserve was required against the same.

What were the limitations of Basel I?

Basel I received criticism due to the existing deficiencies within the agreement. As it covered only credit risk and a limited number of countries, its scope was considered too narrow for ensuing international financial system stability (Balin, 2008, pp. 4). The most serious criticism was the lacunas in the definition and calculation of risk weightings (Balin, 2008, pp. 5); loopholes which led to widespread use of capital arbitrage. Banks sought to splice their risk weighted assets and sold of the least risky assets, in effect making its remaining portfolio more risky. However, as per the risk weighted definition of assets as per Basel I, the bank’s overall risk does not change. At the same time, the sale of loans enabled it to add cash to its reserves, further enabling it to lend additional loans, and making its portfolio even riskier. A second way was to swap the higher risk weighted long term debt into lower risk weighted short term debt instruments. This strategy was specifically used for swapping long term OECD debt, wherein the volatile OECD markets carried a 100% risk-weighting. This also led to creation of so called “hot money”, which could move out of the OECD countries at extremely short notice, creating volatile currency fluctuations.

The phenomenon of capital securitization was seen to have a much higher occurrence in American banks. Within the European Union, EU regulations banned the creation of vehicles that banks could use to sell off their assets, which were further sold as securities by the Special Purpose Vehicles. More so, in 1990s, within Europe, a single harmonious financial market did not exist that would have provided an incentive to securitization of assets (Jabelecki, pp. 27). Subsequently, countries where banks found the regulations difficult to adhere to reflected a higher degree of such capital arbitrage. In addition, the Basel I did not give due weighting to credit risk mitigation techniques like collaterals, guarantees or taking offsetting positions (Benzin et al, pp. 4).

However, despite the gaps and unintended negative fallouts of the Basel I Accord, the new standard was still a landmark achievement for attempting a harmonization of the international banking system. It brought into one range, the banks of the then twelve and economically powerful developed nations. The internationally active banks could have an assurance when dealing with branches in other nations or banks of other nations of a certain level of soundness and credibility. The adaption and implementation was immediate by the G10 countries, though, as described above, with mixed effects. The created incentives and the perceived soundness of system associated with the Basel I led some emerging countries central authorities as well as international banks active in emerging countries to adapt to the system, with negative fallouts, which however, the Accord itself had cautioned against. In 1999, the Basel I committee, with a view towards the existing gaps in the Basel I accord and the 1990s banking crises, released an updated document: A Revised Framework on International Convergence of Capital Standards. This accord came to be informally known as Basel II.

1.2 Basel II

1.2.1 The Three Pillars of Basel II Accord

During the 1990s, the international banking system was hit by a series of crises. In response to these events and to amend the existing gaps in the Basel I accord, in 1999, the Basel Committee on Banking Supervision released an updated document; a revised framework on International Convergence of Capital Standards. This document came to be known as the Basel II Accord. The updated accord, while maintaining the pillar framework of Basel I, has further detailed each of these pillars. It expanded the risk coverage to include credit, market, operational and interest rate risk. The other important steps were to incorporate additional approaches to credit risk, introduce market based surveillance and regulation, and adaption to the securitization of bank assets (Balin, 2008 pp.6). After the release of the first draft, two subsequent consultative packages were released in 2001 and 2003. On 26th June, 2004, the heads of the G10 countries formally endorsed this revised framework.

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