Basel I that was introduced in 1988 has led the banks to hold higher capital ratios. This can be proven by the data collected by De Nederlandsche Bank to plot the evolution of capital ratios in a group of 29 OECD countries over the years 1990-2001. It is clear that capital-to-asset ratios increased significantly from roughly 8.5 to about 12%. (Jablecki, This result is parallel with Bondt and Prast (1999) who report an increase of about two percentage points (from 9 to 11%) in a selected group of G-10 countries (the UK, US, Italy, France, Germany, and the Netherlands) in the years 1990-1997. On the other hand, implementation of Basel I which requires a minimum of 8% capital backing for loans and 0% for government securities may have led to a slowdown of the economy. (Haubrich and Wachtel, 1993) Besides, Hall (1993) had found out that from 1990 to 1992 American banks have reduced their loans by approximately $150 billion, and this was largely due to the introduction of Basel I. On the other hand, the adoption of Basel I standards was seen by large investment banks as a sign of regulatory strength and financial stability in emerging market.
There are a few criticisms for the Basel 1 which includes the perceived omissions in the Accord. Basel 1 only covers credit risk and only targets G-10 countries and hence it can't ensure adequate financial stability in the international financial system. Besides, it's omission of market discipline is seen to restrict the accord's ability to influence countries and banks to follow the guidelines. On the other hand, there are also criticisms on the way in which Basel I was publicized and implemented by banking authorities. The inability of these authorities to translate Basel I's recommendations properly into "layman's terms" and the strong desire to enact its terms quickly caused regulators to over-generalize and oversell the terms of Basel I to the G-10's public. Thus, this created a misguided view that Basel I was the primary and last accord a country needed to implement to achieve banking sector stability. In addition, since short-run non-OECD bank debt is risk weighted at a lower relative riskiness than long term debt, Basel I has encouraged international investors to move from holding long-run emerging market bank debt to holding short-run developing market instruments. This has result in the increase of the risk of " hot money " in emerging markets and has created more volatile emerging market currency fluctuations.
According to Ferguson (2003) alleged that Basel I was considered too simplistic to address the activities of the complex banking institutions. It considered four risk categories; most of the loan received the same regulatory capital charge even though loans made by banks included the whole spectrum of credit quality. Besides, the calculation for the capital ratios is uninformative and might provide misleading information for banks with risky or problem credits or, for that matter, with portfolios dominated by very safe loans.
The limited number of risk categories creates incentives for banks to game the system through capital arbitrage which is the avoidance of certain minimum capital charges through the sale or securitization of bank assets for which the capital requirement that the market would impose is less than the current regulatory capital charge. Basel I requires capital charges for all the banks' assets such as credit card loans, and residential mortgages which is securitized in volume, rather than held on banks' balance sheet due to the market requires less capital. It indicates that banks engage in such arbitrage retain the higher risk asset for which the regulatory capital charge such as calibrated to assets of average quality is on average too low.
Eventually, the examination process supervisors are still able to evaluate the true risk position of the bank, but the regulatory minimum capital ratios becoming less meaningful as well as the regulations and statutory requirements tied to capital ratios for the larger banks. Besides, there is less availability to evaluate the capital strength of individual banks form what are supposed to be risk based capital ratios. Thus, Basel I capital ratios neither adequately reflect the risk nor measure bank strength at the larger banks.
Implementation of Basel II
The implementation of Basel II has a major improvement by having a close linkage between capital requirements and the method that banks manage in actual risk compared with Basel I which has a limited measure of risk sensitivity as well as risk at large complex organization (Bies, 2006). According to Bies (2006) alleged that the bank's capital requirement does not sufficiently reflect gradations in asset quality and does not change over time to reflect deterioration in asset quality as well as no explicit capital requirement to account for the operational risk.
Furthermore, Basel II enables to ensure that supervision and regulation takes a forward looking view on risk, that it remains up to date with sound practices in the industry and supervisory framework motivates responsible risk taking and prudent behavior in the market. Besides, the more formalized risk management of the Basel II will have a better assessment, quantification and greater awareness of risks. As a result, it could lessen the likelihood of making bad decisions and will improve adjusted pricing policies. On the other hand, it provides a prompt detection of errors and deviations from targets which allow banks to take initiatives on taking proper measures which also implied to a smoother adjustment to new conditions or to the correction of mistakes, making decisions less abrupt.
According to Caruana (2006) stated that Basel II promotes an effective corporate governance to enhance the financial stability. By adopting Basel II enables banks to have a comprehensive and sound planning and governance system to oversee all aspects of their risk measurement and management process. Plus, adopting Basel II will provides a safer, sounder, and more resilient to all the banks.
Basel II promotes a powerful lever for banks to significantly enhance both long term resilience and competitive advantage by promises greater financial stability through the closer alignment of risk with capital. In order to absorb the full benefits from the implementation of Basel II, it should overwhelm the multi-faceted dimensions and well integrated with the financial structures, institutional practices, as well as supervisory system (Aziz, 2008).
In addition, Basel II provides a unique opportunity to banks to integrate risk considerations with their business strategies especially at the institutional level. Several leading financial institutions have successfully taken Basel Ii beyond the narrow and mechanistic risk applications to a more strategic implementation of the framework across the organization.
Shortcoming of Basel II
Moreover, both Basel I and II has been criticized in terms of emerging market economies. For Basel I which did not target on developing countries, its application to these economies under the pressure of the international business and policy communities created foreseen and unforeseen distortions within the banking sectors of industrializing economies. While for Basel II, the Basel Committee has stated that its recommendations are for its G-10 member states and not for developing economies. Although the Basel Committee has created a set of standards for emerging market economies called Core Principles for Effective Banking Supervision which are mainly for emerging market, their broadness and relative obscurity in the policymaking community have limited their impact upon international banking.
Besides that, Basel II relies on rating agencies to value risks and this may cause unfavorable implications in industrialized and industrializing markets alike. For example, many banks in emerging markets may not be able to afford rating agencies as compared with the large firms. Therefore, global banks will be less apt to loan to emerging market banks because such loans will have to be matched to larger, rated banks.
Implementation of Basel III
The new implementation of Basel III enables to reduce the probability of bank failures by improving banks' loss absorption possibilities. Furthermore, Basel III also showing improvement in additional non-risk based leverage ratio and two liquidity ratios instead of the extension in the capital requirement. Under the Basel III framework, it consists of two liquidity ratios which are liquidity coverage ratio (LCR) follows a short term approach, the net stable funding ratio (NSFR) address longer term problems arising from illiquidity. The liquidity coverage ratio require banks to hold an adequate amount of liquid assets with a high quality to anticipate the short term problem whereas the NSFR will encompass the entire balance sheet to prevent structural longer term disruption arising for liquidity mismatches. (Georg, 2011)
Meanwhile, the improved of supervisory guidance of regulatory authorities under Pillar 2 from Basel III enables to give authorities' capacity to enhance their ability to manage myriad kind of risks such as liquidity, off balance or concentration risks. Plus, in order to have a greater detection of systemic risks stress tests have to be conducted. (Geory, 2011)
Shortcoming of Basel III
According to Blundell-Wignall and Atkinson (2010) highlighted that shortcoming of Basel III framework mostly probably are rooted in Basel II. They alleged that the promises in the financial system are not treated fairly no matter where they are located, thus the regulator arbitrate will exist. On the other hand, the increasing regulation in the banking sector will lead to a high capital shift to the unregulated shadow banking sector, as the cost of capital in the regulated sector increases.
Besides, Basel II risk weighting resulted in a "perverse outcome in the crisis" as banks with higher Tier 1 capital prior to the crisis generated higher losses when turbulences hit (Blundell-Wignall & Atkinson, 2011). The danger of perverse incentives still exist even though Basel III making a minor adjustments to the risk weighting procedure and the risk weighting approach might compromise with leverage ratio.
Another shortcoming of the Basel III is the failure to mitigate the systemic risk due to the risk weights and asset value correlation factor does not take into account the different magnitudes of correlation of different asset. Plus, there are insufficient of the relevant information about the network structure of the financial system which would lead banks to underestimate the correlation of their portfolios and unable to conduct optimal risk management.
