The purpose of the essay is to answer and investigate the pros and cons of the Basel I and II Capital Accord on bank capital requirements and critically give some comments on the proposals for a New Basel Capital Accord. In the view of history, Basel Capital Accord was put forward by the Basel Committee on Banking Supervision (BCBS), who plays a crucial role in the financial risk regulation network, setting risk management regulations to financial institutions worldwide (Chernobai et.al. 2007: 35). Indeed, the Basel Capital Accord has been experienced a lot of amendments and compensation in order to maintain the normal operation of financial institutions. The first edition of Basel Capital Accord was released by the Basel Committee in July 1988, also known as Basel I. The main advantage of Basel I was that it would protect banks from credit risk by establishing minimum capital standards (Chernobai et.al. 2007: 35). However, Basel I was still not perfect, such as it only addressed the credit risk, so in order to keep up with the rapid development of international financial markets and overcome some financial crises(like1997 Asia crisis), some adjustments had to be taken to let the Basel Capital become more mature and to enhance the stability of banking system. For instance, In April 1993, the Basel Committee intended to extend the risks that subject to capital requirements to market risk, which was finally put into practice in 1996(Allen, L. 2003). Compared with Basel I, Basel II emphasized the importance of the combination of credit risk, market risk and operational risk in capital requirements and was publicized in 1998(BCBS`s Consultative Document, 2003). But the complication of Base II, it was not implemented until June 2006. In terms of Basel III, this is the latest Basel Capital Accord and the Basel Committee continues to make the regulatory capital measure more risk sensitive. Therefore, one of the obvious changes is that the Basel Committee intends to add a new risk��liquidity risk in capital accord (Barua et.al, 2010). As a whole, the new Basel Capital Accord will introduce a more complicated risk model but it has a long way to implement in Practice.
In this paper, it will focus on the capital requirements in both Basel I and Basel II and give a relative objective comment on their strengths and shortcomings, while at the same time critically evaluate the proposal for the new Basel Capital Accord.
The merits and shortcomings of the Basel I on bank capital requirements
The critical advantage of Basel Capital Accord released in 1988 (Basel I) was that it tried to establish a single risk-adjusted capital standard to enhance the efficiency, productivity, safety and soundness of the global financial system (Allen L., 2003). Due to its contribution, Heffernan (2005, P. 181) regard Basel I as ��a watershed��. Nevertheless, the Basel also encountered some serious failures and unexpected consequences in spite of its success. Allen (2003) pointed out some key factors that ignored in the regulation ware potentially exploited by banks, which usually known as regulatory capital arbitrage. For instance, the Basel I did not include the market risk in the capital requirements, so it permitted the banks to transfer priced credit risk to unpriced market risk. Such a kind of oversight did not resolve until 1996, the Committee compulsorily require a capital charge in market risk.
At a transformational stage, there are two factors which belong to material progress in Basel I. The one is that Basel I divided the capital into Core capital (tier 1) and Supplementary capital (tier 2). The other is that it put forward a standard calculation of risk-weighted assets (RWA) (Roy,P. 2003). As for RWA, it aimed to prevent internationally active banks from credit risks. However, Roy (2003) also argued that some empirical literature proved that changes in capital ratios and credit risk appear to be mostly unrelated. In spite of this phenomenon, the Basel I generally made a contribution in protecting internationally active banks from risker business activities.
To summarize, some advantages in Basel I are as followed. Firstly, it let under-capitalized banks to improve their capital ratios. Secondly, the ratio of Capital to risk-weighted assets for major G10 banks increased from 9.3% in 1988 to 11.2% in 1996. Thirdly, it was universally accepted that common definitions of capital and capital adequacy put forward by Basel I. By contrast, some negatives also need to be considered, the one is that Basel I was failed to identify what was good credits. The other is that capital arbitrage opportunities supported growth in securitization.
The advantages and defects of the Basel II on bank capital requirements
Although the Basel II is a revised and compensated version of Basel I, Basel seems more practical and meaningful than Basel I in modern financial market. In the aspect of bank capital requirements, Basel II made a substantial progress in risk exposure in comparison with Basel I. Generally, there is some consistency between Basel I and Basel II in bank capital requirements. Under the Basel I and II Accord, banks were required to maintain a weighted assets at least 8% capital ratio in total capital (BCBS`s Consultative Document, 2003).
In order to adapt to the rapid development of financial markets, the Basel Committee adopted a series of amendments in Basel Capital Accords, especially for Basel II. There are three pillars in Basel II, including Minimum Capital Requirements (pillar I), Supervisory Review Process (pillar II) and Market Discipline (pillar III). As for Basel II, it was based on the framework of Basel I and intended to execute rigorous new credit risk measurement techniques to maintain bank credit quality. Therefore, the committee took such kinds of measures to protect international active banks from credit risk exposure.
In Basel II, the minimum capital requirement include three areas of risk��credit risk, market risk and operational risk (A report from KPMG). In a word, the substantial improvements in Basel II were that the Committee adopted a three-pillar mutually reinforcing structure and address three types of risk, including credit risk, market risk and operational risk. In the KPMG report, it also points out that Basel II is beneficial in strengthening sound risk management. For instance, the Basel II owns a lot of approaches of different levels of sophistication in dealing with the three areas of risks in minimum capital requirement, which will allow the banks to manage their credit risk effectively. Specifically, the Committee intends to give banks two methods for calculating their capital requirements for credit risk. One approach is called a standardized manner through external credit assessments. By contrast, the other is that the banks` supervisors utilize their internal rating systems to comment on credit risk.
Obviously, the improvement of Basel II is significant. Basically, there are some positive effects of Basel II. To begin with, the approaches in calculating credit risks are relatively more complicated and potentially better in comparison with Basel I. Additionally, the banks` internal rating system was the basis for the capital allocation. Moreover, Basel II addresses several capital arbitrage problems in Basel I, such as securitization. Last but not least, the scope of risk was extended to market risk and operational risk compared with the former Basel Capital Accord.
The shortcomings are still existed in Basel II in spite of its amendments in Basel I. So, An Australian Banker`s report pointed out six aspects of disadvantage in Basel two. The first one is that the anxieties on the potential for Basel II to introduce greater procyclicality. The second is loss data availability, especially for the institutions where defaults are rare. The third is the potential for greater model risk. The forth is that a potential for multiple layers of supervisory caution to produce capital levels about the same as the current levels. The fifth is challenges in achieving consistent implementation across national jurisdictions, for example, regulators are working to address this issue. The last is the moral hazard of regulator.
Assessments on the proposals for a New Basel Capital Accord
The recent US subprime crisis caused a substantial damage on the global financial system and negative effects on the real economy. The serious phenomenon let the Basel committee has to reconsider the Basel II Capital Accord and take essentially steps to improve the systemic soundness of the financial sectors. Most recent analysis taken by institutions, such as IMF, World Bank and BIS (Bank for International Settlements) pointed out that the major reason caused financial crisis is the failure of banking regulation and supervision (Dr. Goeth P. 2010). The Basel III is regarded as the response of the current crisis, including some comprehensive actions with the aim to recover and reinforce the regulation, supervision and risk management of the bank sectors. Compared with Basel II, the purpose of Basel is to greatly increase capital and liquidity requirements with both risk weighted assets and capital percentages rising, which is not capital neutral.
Most importantly, the proposal of Basel III made some adjustments targeted on dealing with procayclicality, which usually related to the failure of risk management and capital frameworks to capture key exposures, such as complex trading activities, re-securitization and exposures to off-balance sheet vehicles-in advance of the crisis.
In capital requirements, Masters (2010) argued that ��the Basel III sets a new core capital ratio of 4.5%, more than double the current 2 percent level, plus a new buffer of a further 2.5 percent. The banks whose capital falls within the buffer zone will face restrictions on paying dividends and discretionary. �� Therefore, the overall capital requirement is 7 percent which might effectively protect financial intermediaries from economy crisis. These results are consistent with the Figure 1, which comes from the report of Credit Susse.
In a report from Credit Suisse (2010), it claimed that the effect of the 7%percent core capital required in Basel III will depend on the discretion of regulators during the periods of excessive credit growth. The report also illustrated that the phases of application in Basel III are generous, which are beneficial for some financial institutions and it also predicts that the publication of Basel III will be a positive news for dividend increase.
Conclusion
The development of Basel Capital Accord is moving towards a holistic system (Barua R., 2010). In general, the Basel I is seemed as a revolution in the international financial institutions. On capital requirements, the main advantage of Basel I is that it firstly put the credit risk into account and then adds the market risk in 1996. As for Basel II, on capital requirement, the strength is that it established a more complicated and practical risk models covering three areas of risks (credit risk, market risk and operational risk) to further reinforce the regular operation of financial institutions. In terms of the proposal for a new Basel Capital Accord, it continues to enrich the method to manage risk with a sophisticated management establishing a detailed, clearly defined of the overall risk preference of the bank, which will make sure that the shareholders, deposit holders and other stakeholders have a good understanding of the business strategy.
Reference
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