The Bank for International Settlements (BIS) is an intergovernmental organization of central banks which 'fosters international monetary and financial cooperation and serves as a bank for central banks' (Bank for International Settlements, 2011). The BIS was established in 1930. It is the world's oldest international financial institution and remains the principal centre for international central bank cooperation (Bank for International Settlements - BIS, n.d.).
It was organized along the lines of the U.S. Federal Reserve System and it's mainly responsible for the orderly settlement of transactions among the central banks of individual countries. On the other hand, it sets standards for capital adequacy among the central banks and coordinates the orderly distribution of a sufficient supply of currency in circulation necessary to support international trade and commerce (History and Development of Bank Instruments, 2010).
The BIS was established in the context of the Young Plan (1930) to address the issue of the reparation payments imposed on Germany by the Treaty of Versailles following the First World War. Its focus soon shifted to the promotion of international financial cooperation and monetary stability. The BIS was also created to act as a trustee for the Dawes and Young Loans (international loans issued to finance reparations) and to promote central bank cooperation in general. The reparations issue quickly faded, focusing the Bank's activities entirely on cooperation among central banks and, increasingly, other agencies in pursuit of monetary and financial stability (Road to a new world order, n.d.).
A set of agreements set by the Basel Committee on Bank Supervision provides recommendations on banking regulations in regards to capital risk, market risk and operational risk. The purpose of the accords is to ensure that financial institutions have enough capital on the account to meet obligations and absorb unexpected losses (Basel II Capital Accord, Basel Initiatives and other Basel-Related Matters, 2008).
From 1965 to 1981 there were about eight bank failures in the United States which were particularly prominent during the 80's, a time which is referred to as the "savings and loan crisis". Because of this, banks all over the world were lending extensively and the potential for the bankruptcy of the major international banks increased significantly (Zaher, n.d.). The Basel Committee on Banking Supervision had mainly been making efforts to close gaps in international supervision and to develop suitable supervisory standards, and at that point capital adequacy recommendations are published, which is Basel I, that is, the 1988 Basel Accord (Basel II History, n.d.).
Details indicator in Basel I, II and III and beyond
Detail indicator in Basel I
The general purpose of Basel I was to strengthen the stability of international banking system and set up a fair and a consistent international banking system in order to decrease competitive inequality among international banks (Zaher, n.d.). Basel I defines capital based on two tiers which is Tier 1 (Core Capital) and Tier 2 (Supplementary Capital). Banks with international presence are required to maintain the total capital equal to at least 8% of its risk-weighted assets. Basel I primarily focused on . Assets of banks were classified and grouped in five categories according to credit risk (Basel Committee, n.d.). The classification of risk weights are 0%, 10%, 20%, 50% and 100%.
Limitation of Basel I
However, Basel I Capital Accord has been criticized on several grounds. The first one is the limited differentiation of credit risk as there are only five relative risk weight categories. The second limitation is about the static measure of default risk as the minimum 8% capital ratio does not take into account the changing of nature of default risk. Next, there is no recognition of term-structure of credit risk. The capital charges are set at the same level regardless of the maturity of a credit exposure. The following limitation is the simplified calculation of potential future counterparty risk. As we know that, there are different levels of risks associated with different currencies and macroeconomic risk but the current capital requirements ignore it. The last limitation is the lack of recognition of portfolio diversification effects. The sum of all risk might provide incorrect judgment of risk as the sum of the individual risk exposures is not the same as the risk reduction through portfolio diversification (Zaher, n.d.). These criticisms formed much of the motivation for the launch of Basel II.
Detail indicator in Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The main objectives of Basel II were to reform credit risk weightings, making them more risk sensitive and in line with bank practices and introduce a capital charge for operational risk. The other purpose of Basel II is to create standards and regulations on how much capital banks need to put aside to safeguard against the types of financial and operational risks banks face. In theory, Basel II attempted to achieve this by setting up risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. It means that the greater the risk the bank is exposed to, the greater the amount of capital it needed to hold to safeguard its solvency and overall economic stability (Basel II, n.d.).
Basel II uses a 'three pillars' concept that are minimum capital requirements, supervisory review and market discipline. The first pillar, minimum capital requirements, deals with credit risk, operational risk and market risk. The credit risk can be calculated by using Standardized Approach, Foundation Internal Rating-Based Approach and Advanced Internal Rating-Based Approach (Basel II, n.d.). Besides that, the operational risk can be calculated by using Basic Indicator Approach, Standardized Approach and Advanced Measurement Approach. Lastly, the approach that used by market risk are Standardized Approach and Internal models Approach.
While the second pillar, supervisory review, provides a framework for dealing with all other risks that may be face by a bank such as concentration risk, strategic risk, liquidity risk and systemic risk (Basel II, n.d.). An active role for supervisory authorities will give the banks a power to review their risk management models and system.
The objective of the third pillar, market discipline, is to promote a greater stability in the financial system. The banks will be required to publish the information related to their business profile, risk exposure and risk management. Both qualitative and quantitative information must be disclosed. Hence, disclosure is required on the structure and adequacy of capital, and should therefore include details on the core capital (Dierick, 2005).
Limitation of Basel II
In spite of this, there is a fundamental problem that appeared in Basel II that is, it creates perverse incentives to underestimate credit risk. This is because banks are allowed to use their own models for assessing risk and determining the amount of regulatory capital, they may be tempted to be overoptimistic about their risk exposure in order to minimize required regulatory capital and to maximize return on equity (Smith, 2008). Besides that, there is also a criticism that has been insistently raised against Basel II which is the method that it used to calculate the capital requirements may be too sophisticated. This excessive complexity leads some problems to those banks that have to comply with the new rules and also generate problem for the supervisors that has to validate the bank's methods of compliance. Due to these problems, there is no more precise orientation to be given to the supervisors than general statements of Basel II's expectation that they will fulfill their duties satisfactory. However, Basel II can be said that to be a wrong strategy as the compliance will be too costly and complicated, and the supervision probably will be inefficient. At the end of the day, banking systems may become weak and unsafe by applying its provisions, and the loans may become more expensive (Carvalho, 2005). It is perhaps no surprise that Basel II has been subject to the some of the most scathing criticism to come out of the financial crisis and thus Basel III is formed.
Detail indicator in Basel III
Basel III developed by the Basel Committee on Banking Supervision to strengthen bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage (The Basel III Accord, n.d.) A focus of Basel III is to foster greater flexibility at the individual bank level in order to have the ability to absorb shocks arising from financial and economic stress, improve risk management and governance and strengthen banks' transparency and disclosures (International regulatory framework for banks (Basel III), n.d.)
Limitations of Basel III
Initially Basel III received harsh criticisms from the banking industry and some regulators. For instance, the stated aim of Basel III to control banks' leverage and increase capital ratios to prevent future financial catastrophes, but the one-size-fits-all nature of the regulation could hinder trade finance and damage business across the globe. The next criticism is about the bankers have complained since 2008 that Basel II failed to properly distinguish trade finance from other forms of corporate lending, but Basel III has doubled down the mistakes of Basel II (Evans, 2011). As Basel III require the banks to maintain a higher level of capital, and this requirement does not favor the European banks as the level of capital maintained by them is low. This is because the private sector in Europe will find it more difficult in raising the capital (Eubanks, 2010).
Observation of Basel III
In parallel to the Committee's focus on implementation, the future work programme covers some of the areas. First of all is the observation of certain elements of Basel III. There is a published rule text provides for an "observation period" that will enable supervisors to obtain more robust reporting over this period. The aim is to evaluate the impact of the new standards on individual banks, the banking sector and the broader markets. Second is the further development of supervisory standards. The Committee will be taking a very close look at how banks arrive at their measures of exposure, how they risk-weight their assets, and how they engage in risk mitigation activities. The focus should be on building sound business models which is supported by adequate capital and liquidity. Last but not least, there is a need of efforts to improve supervisory practices and cross-border bank resolution practices. The third broad area of focus relates to supervisory practices and cross-border bank resolution. While many efforts focus on the prevention of crises, there is still a need to continue working on cross-border bank resolution (Basel III and Beyond, 2011).
Related paper discussion on the changes in the indicator, along the development of Basel I to II to III
In Basel I, the limitation of Basel I is the risk classifications are very broad which lead inaccurate assessments of borrower risk and also the capital requirements. Moreover, estimates are retrospective rather than prospective and it does not adequately reflect the risk of borrowers who are current on loans today but who could default in the future. The regulatory capital requirement has been in conflict with increasingly sophisticated internal measures of economic capital. The simple bucket approach with a flat 8% charge for claims on the private sector has given banks an incentive to move high quality assets off the balance sheet, thus reducing the average quality of bank loan portfolios. In addition, the 1988 Accord does not sufficiently recognize credit risk mitigation techniques, such as collateral and guarantees. The next limitation of Basel I is which do not account for regulatory changes, lending practices and economic cyclicality. These limitations could influence both level of loan loss and borrower default risk in the future.
In order to take care of the limitations of Basel I as discussed above, Basel Committee on Banking Supervision (BCBS), after a world-wide consultative process and several impact assessment studies, evolved a new capital regulation framework, widely known as Basel II framework ("International Convergence of Capital Measurement and Capital Standards: A Revised Framework").
There a few positive indicator of the Basel II is that the adoption of three pillars on the identification, quantification and management of risk and public disclosure. In Pillar 1 requires banks to maintain minimum requirements such as addressing risk. The new framework provides a spectrum of approaches for banks of different levels of sophistication, depending on their internal risk management capabilities and complexity of operations, to calculate their minimum capital requirement. While in Pillar 2 requires banks to have supervisory review. The banks' capital adequacy and internal assessment process will also be reviewed for ensuring that capital above the minimum level is held where appropriate. Also, in Pillar 3 requires promoting greater stability in the financial system. As a general rule, different banks with different levels of sophistication and risk exposures will be subject to different disclosure requirements (Key features of Basel II and its benefits to the economy, n.d.).
Basel II will provide incentives to banks to adopt the latest advances in the field of risk management. Those banks which adopt the best practices in the management of risk will be awarded with lower capital requirements. However, in order to help in boost the development of the banking industry, also those banks has enhanced risk management will improve banks' ability to offer more sophisticated products to customers. It will also enhance banks' ability to assess lending to sectors such as the small and medium-sized enterprises (SMEs), and allow for better risk-adjusted pricing.
However, Münstermann (2005) indicated that a Credit Research state that of weakness of Basel II is that major banking risks not reflected in Pillar 1 such as interest rate risk in the banking book, concentration risk, strategic business risk, reputation risk while the structural interest rate risk not covered by capital requirements, but included in Pillar II. Besides that, Basel 2 also differences in view of relative riskiness of certain business lines are high-risk corporate, mortgage banking, consumer lending and so on. In Pillar 3 disclosure exercise is time-consuming, costly and unlikely to yield any real benefits for regulators, banks and market participants alike. The ongoing reform of the Pillar 3 regime will increase the amount of information available, but it does not appear to address any of the regime's limitations whilst it is likely to increase banks' compliance costs.
Another issue on Basel II is related to the "pro-cyclicality". The researchers argue that the operation of the new Capital Accord will lead to more pronounced business cycles. The arguments suggest that in times of recession when a bank's capital base is likely being eroded by loan losses, its existing (non-defaulted) borrowers will be downgraded by the relevant credit-risk models, forcing the bank to hold more capital against its current loan portfolio. To the extent that it is difficult or costly for the bank to raise fresh external capital in bad times, it will be forced to cut back on its lending activity, thereby contributing to a worsening of the initial downturn. (Kashyap and Stein, 2004). Moreover, another researcher argue that pro-cyclicality of the Basel II framework may give rise to pro-cyclical effects due to the fact that the three main components of the IRB system are themselves influenced by cyclical movements. In particular, the higher risk sensitivity of banks' ratings systems may lead to increases in regulatory capital requirements in an economic downturn. However, such concerns have been addressed and pro-cyclicality has been significantly reduced in the latest proposals (Vanoli, 2007).
As we know that Basel II introduces two methods for the estimation of the minimum capital for risk assets, one is the standard approach and Internal Rating-Based approach (IRB). However, these two methods have its' own limitation. Firstly, the limitation displayed by the standard method is that the minimum capital will be greater than with IRB method, since it operates as an incentive for banks to choose the second approach in order to obtain a more efficient risk management. Secondly, the IRB approach hints a high implementation cost, given its complexity, which would make it necessary to train employees, technology updating. Besides that, another limitation is the one of supervision difficulty, since the supervising authority, in charge of validating and controlling the models, would need to count on highly skilled staff in order to understand and evaluate banks' credit risk systems. Findings from Vanoli (2007) indicate that major banks compel Less-Developed Countries´ (LDC) to adopt IRB in order to reduce capital and to have comparative advantages derived from the use of expensive internal models. ().
In addition, another limitation of Basel II is the impact on individual banks capital levels and bonds remains difficult, given different portfolio mixes as well as the expected reliance of most major banks on internal systems and risk models to determine risk-weights, rather than standard risk weights. In other words, under the advanced internal risk measurement approaches, the formulas applied by the banks to different asset classes will be the same, but the inputs to these formulas will depend on the individual banks' internal data. It is therefore possible, at least in theory, that different banks could calculate different capital requirements for the same asset. In practice, however, we expect the regulators to ensure that such variations are limited.
The reasons for updating from Basel I to Basel II are due to the factors which include globalization, technological advances, and financial engineering. Firstly, the globalization, this is due to the result of the rapid increases in international trade, investment and financing flows, the limitations imposed by physical borders and geography are having less of an effect on the flow of money. Secondly, the technological advances such as the breathtaking advances in computing speeds, storage capacity, networks and communication are enabling advances and changes in virtually every facet of everyday life. Last factor is that the financial engineering. In this factor is due to the increasingly complex financial products are being developed to cater for more detailed and complex needs.
Since that the limitation of Basel I to Basel II it is not yet fully being improved and solved, thus the new adoption of Basel III into our Basel Accords.
Conclusion due to scarcity of data or information
Based on the researchers research, Basel I, II, and III is response to be better the banking sector. As a conclusion, the Basel Committee has continuously strengthened global capital and liquidity regulations with the goal of promoting a more resilient banking sector. The objective of the Basel Committee's reform package is to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spill over from the financial sector to the real economy. Basel I, II and III have shown significant improvement after one another. Each new Basel proposes many new capital, leverage and liquidity standards to strengthen the regulation, supervision and risk management of the banking sector. The capital standards and new capital buffers will require banks to hold more capital and higher quality of capital than previous Basel rules. Each new leverage and liquidity ratios introduce a non-risk based measure to supplement the risk-based minimum capital requirements and measures to ensure that adequate funding is maintained in case of crisis. It is obvious that each new improved Basel has the same purpose that is to improve the banking sector regulation.
Conclusion
In Basel I. it is the first of the Basel Accords and published a set of minimal capital requirements for banks. Basel I is now widely viewed as outmoded. Indeed, the world has changed as financial conglomerates, financial innovation and risk management have developed.
Therefore, a more comprehensive set of guidelines, known as Basel II are in the process of implementation by several countries. The purpose of Basel II, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.
Basel III is third of the Basel Accords and new global regulatory standard on bank capital adequacy and liquidity agreed by the members of the Basel Committee on Banking Supervision. It was developed in a response to the deficiencies in financial regulation revealed by the Global Financial Crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. The Organization for Economic Co-operation and Development (OECD) estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.
As a conclusion, Basel III was designed to address the weaknesses of the past crisis; main intent was to prepare banks and banking sector for next crisis. This Basel III with the combination of globalization and ever more rapid financial innovation means that all countries need to higher capital and liquidity buffer to protect the banking system and economy from unexpected risks. The framework includes firm specific approaches but also incorporates marcoprudential measures to help address systemic risk and interconnectedness. Basel III improved the quality and quantity of capital, with a much greater focus on common equity to absorb losses. It also helps banking sector to achieve more comprehensive coverage of the risks, especially related to capital markets activities. Basel III also introduced stronger supervision, risk management and disclosure standards.
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