Developing Economies and Basel III. Reforms brought by Basel III to the International Regulatory Framework set in Basel I and II.
Term Paper (Advanced seminar) 2017 15 Pages
TABLE OF CONTENTS
Bank regulation in the advent of Basel I and II
The main reforms under Basel III accord
Applicability of Basel III in developing economies (A Case study of Africa)
Appendix I: Detailed Summary of Basel III Reforms
Over the last three and half decades, bank regulators in developed economies have focused largely on strengthening the capital rules underlying the operations of banks with an aim of minimising the likelihood and severity of a systemic risk crisis. This was achieved through the 1988 Bank for International Settlements (BIS) Accord which later became known as Basel I (Hull, 2015). On realising its maiden flaws in Basel I, the Basel Committee made an amendment through ‘1996 Amendment’ and later replaced it with Basel II in 2006 with an aim of aligning capital requirements with risks in the banking sector. Anchored in three pillars, Basel II shaped the banking regulation for a couple of years before it was realised in a period slightly before the 2008/2007 financial crisis that it was incapable of detecting, circumventing risk exposures and prevent the then impending crisis, thus prompting efforts to reform the regulation (BCBS, 2010).
In 2010, the Basel Committee on Banking Supervision (BCBS)1 initiated a raft of reforms to the banking regulation, dubbed Basel III, introducing new liquidity and leverage ratios and strengthening the banks’ capital requirements ratio with an aim of improving their ability to absorb shocks whilst refining risk management approaches and tightening the banks’ disclosures requirements substantially. This article examines key reforms that were brought by Basel III vis- à-vis the propositions of Basel I and II in reducing bank failures and risk levels using emerging markets (e.g. Africa) as a case study.
Bank regulation in the advent of Basel I and II
In the recent past, the regulation of financial institutions has grown almost continually. This may in part be attributed to increased consumer demand for regulation, in response to public reaction to scandals and financial innovations (Allen, et.al, 2012). The Basel accords are some of the regulatory frameworks that have shaped the banking regulation in the recent past. Issued in 1988 and 2006, Basel I and II have through their quantitative and technical benchmarks helped harmonise the regulatory and capital adequacy standards amongst the G-102 states and other emerging economies across the world. Basel I, for instance, constituted the first effort to introduce a minimum capital ratio of 8% to be held against the sum of risk-weighted assets (RWA) thereby providing an adequate guard to the risks associated with credit lending. The major flaws in this accord was that of overlooking other risks (i.e. interest risks, operational risks, and market risks), however, according to Kadrimi (2015), BCBS quickly recognised this during the early 1990s economic recession and initiated a subsequent amendment in 1996 to incorporate those risks, further introducing more stringent internal measurement models like value at risk (VaR). Furthermore, its over-simplified calculations based on the assumption that 8 percent capital ratio was sufficient to protect banks from failure without taking into consideration the changing nature of default risk and the term structure of credit risk was yet another flaw.
The narrowness in scope, omissions and the Basel I’s inability to focus its applications on emerging markets/economies amongst other criticisms paved way for the Basel capital accord of June 2006 (Basel II) with a more comprehensive view of measuring the bank’s risk-weighted assets while trying to do away with the loopholes in Basel I of taking on additional risk while conforming to the minimum capital adequacy requirements. Basel II was anchored in three pillars with pillar 1 introducing a new capital charge for operational risk and a number of approaches (i.e. standardised approach, IRB, VaR, and basic indicator approach) to measure risk leaving the 8% capital ratio unchanged. Pillar 2’s supervisory view unified qualitative and quantitative aspects of the ways in which risk is managed within a bank and provided a discretion for banks to develop internal risk management techniques, at the same time relying on the credit rating agencies3 to assess their debt. Pillar 3, on the other hand, sought to enhance effective market discipline by introducing high and timely disclosure standards with regards to bank capital, requiring them to disclose information regarding their risk exposure, capital adequacy and all other relevant material information that will enable market participants to make better risk assessments (BCBS, 2006).
Basel II also had its fair share of weaknesses. Just like Basel I, it failed to base its applicability to fit the demands of emerging economies. This is evident from the assertions of BIS (2011) that the recommendations of Basel II were made exclusively for the G-10 member states and not for developing economies. On this note, it is difficult to establish the correct rating of debt instruments in emerging markets’ banks since they are not rated by popular credit rating agencies (like S&P, Moody’s, or Fitch) thus creating an uncertainty for developed countries to lend their funds to developing economies (Dissananyake, 2012). Additionally, Basel II relied heavy of the aforementioned credit rating agencies to value debt-related risks thus creating a conflict of interest as seen in the 2008 US Sub-prime loan securitization where credit rating agencies also acted as risk management advisors to large banks (Casu, et.al, 2015). Another fundamental weakness that manifested slightly before the 2007-2009 financial crisis is a requirement in Basel II that encouraged banks to get rid of some credit risks from their balance sheet (i.e. in asset-backed loan securitization) where banks were allowed to transfer credit risk to special purpose entities (SPE) thus creating a moral hazard4 (Acharya, 2012).). Finally, the other flow is the pro-cyclicality issue arising from the minimum capital requirements because of its tendency to move with the economic cycle. This is a recipe to amplify recessions or even lead to increased inflation during the periods of high economic growth (Elliot, 2009).