Capital Market Essay

Part A

History Behind the Development of the Basel (I to II to III) Accords

Basel I

In the 1970s and 80s, such events and circumstances as increased volatility on financial markets, globalization, debt crises, deregulation, as well as innovative instruments were much prevalent and had significant impacts on banking institutions. To be precise, the occurrence of such events and circumstances gave rise to the erosion of capital base of banking institutions, especially those that were large in their attributes, across the world. As a result, the BCBS became concerned and, according to Reuters (2011), this is when the motivation to create and publish the very first international agreement on capital requirements for banking institutions started. This agreement was labeled Basel I, and its design was aimed at introducing a new uniform manner of calculating the adequacy of capital towards the strengthening of financial stability.

Basel II

Basel I accord was based on a particularly simplified model of measuring capital. Considering the contemporary world, the meaningfulness of an approach adopted by the first Basel is almost negligible for a majority of financial banking institutions. These became the justification for creation of another Basel, which would allow for a more detailed approach towards calculating capital. In addition to this, there was a need to improve the internal processes, as well as, more appropriate risk management practices. Indeed, it became apparent that the first Basel was unable to cope with the pace considering the advances in sound practices of risk management. Back to the drawing board, the BCBS started another journey towards designing a regulatory framework that would meet these concerns. This became the onset of the Basel II accord.

Basel III

Basel III accord was introduced following the shortcomings of Basel II and following the financial crisis, which hit the world in 2008. Just before the onset of the crisis, a period of liquidity became widespread and following this, liquidity risks emerged. After the excess liquidity was contained, many banks came to realize that they did not have sufficient liquidity reserves capable of meeting their obligations.

In addition, the capital formula of Basel II for credit risk was claimed to be procylical. Combining this weakness with the diminishing roles of the banks, the BCBS saw it noble to initiate the process of developing a new Basel that would straighten these discrepancies. This was the birth of Basel III.

Key Changes that Would be Made to the Regulatory Capital Base in Basel III and Their Benefits

In 2010 it was proposed that there were several changes to Basel III that would be initiated. Among these changes were also those related to the capital base. There were three proposed changes to the regulatory capital base of the Basel III. These included the Tier 1 capital and the Tier 3 capital.

Tier 1 Capital

This refers to the core measure of financial strength of any particular baking institution from the perspectives of a regulator. Tier 1 capital is described by Iqbal and Shah (2009) as composed of core capital, which is, in turn, comprised of common stock, as well as disclosed reserves. However, it may be inclusive of preferred stock, which is neither cumulative nor redeemable. The major change that would be inflicted on Tier 1 capital was that the seemingly predominant form of Tier 1 capital ought to be retained earnings, in addition to common shares.

Tier 2 Capital

Commonly acknowledged as supplementary capital, Tier 2 capital is constituted of a significant number of essential, as well as, legitimate constituents of the capital base of any particular banking institution. For this particular tier, the proposed change was the harmonization of the tier 2 capital instruments.

Tier 3 Capital

This particular term is used to refer to the capital that is held by financial banking institutions mainly to cover particular risk classes. Such include foreign currency exchange risks, as well as, commodity risks. The tier 3 capital was set by Basel II accord and may be constituted of short-term subordinated debt, however to a maximum of 250% of the Tier 1 capital held by a banking institution. Further, the tier is subject to other various restrictions. The proposed change to this tier was to eliminate it completely and entirely.

These changes, according to Systems Harvard Law School (2005), are fundamentally essential, as they would lead up to a situation where quality, consistency, as well as, transparency of the regulatory capital base is raised.

Potential Challenges in Implementing the Countercyclical Capital Buffer

Abbreviated as CCB, the countercyclical capital buffer mainly aims at achieving the broader macro-prudential objective of rendering protection to the financial baking sector from periods characterized by excess aggregate credit growth, which are acknowledged by Reuters (2011) as mainly associated with the build-up of system wide risks. In an attempt to address this basic objective, the countercyclical capital buffer may also prove to be ideal in helping lean against the build-up stage of the cycle in the first place. This is particularly by way of raising the costs of credit and as a result, dampening its demand. While it is acknowledged as invaluable, the implementation of the countercyclical capital buffer is usually faced by several challenges.

According to Schemer and Mathison (1996), the most appropriate time to activate the buffer is usually a complicated task and necessitates identification, as well as monitoring of both stress indicators and the systematic risks. The most prevalent problem or challenge is to know the most appropriate time to activate the buffer. In his research study, Reuters (2011) identified that a good timing usually lies at the heart of the tool. Iqbal and Shah (2009) further added that resorting into activation when it is too late is of concern to responsible bodies. Usually, it requires a minimum of one year for the implementation of the buffer, from the time activation takes place, placing greater extent of pressure on both, in addition to, accurate identification of systematic risks. According to Schemer and Mathison (1996), the size of the buffer ought to reflect the potential of a late activation. Harvard Law School (2005) further cautions that it would be of particular importance to err on the side of caution and opt to select a larger capital requirement.

In a similar manner, where stress emerges in the economy and a banking financial institution wishes to implement the buffer, doing so too early also poses dangers in significant amounts. Where there is a premature release, the risk of banks using the capital for dividend settlements rather than for lending purposes becomes imminent. It is advisable that authorities seek ways in which this form of an action will be prohibited from happening.

Another major challenge, according to Reuters (2011), is inaction that is opting not to implement. Usually, the cost associated with using the buffer is not only observable but immediate, as well. In addition, the benefits usually accrue at a point in the future, which is not necessarily specific.

The Risk Sensitive Framework of Basel II as the Cause of the Recent Crisis

Indeed, certain literature advances that actually it was the risk sensitive framework of Basel II that led to the crisis. In an own point of view, the claim is valid, but to some extent. This can be argued on the basis of several dimensions. Foremost, one ought to ask him or herself this particular question; what was the paradigm shift from Basel I to Basel II? As a matter of fact, the shift was that while Basel I adopted an approach that Iqbal and Shah (2009) recognize as "one size fits all", Basel II introduced capital regulations that were risk sensitive in nature. The main charge held against Basel II was that precisely it was this risk sensitivity that made it blatantly procyclical. Usually when times are seemingly good, the financial institutions usually do exemplary and the markets are always willing to invest capital in those institutions. Basel II is believed not to impose any significant additional capital requirements on financial banking institutions. On the other hand, in times where stress prevails, Reuters (2011) indicates that banks are in need of additional capital. In addition to this, the markets are wary of supplying or rendering the capital to these institutions. However, Basel II requires banks to bring in more capital during the stress periods. As it was evident during the crisis, it was indeed the inability to bring in capital while under pressure that made significant international financial banking institutions get into a vicious cycle of what Iqbal and Shah (2009) call deleveraging. As a result, it hurtled the global financial markets into seizure. In addition to this, almost every economy around the world was forced into recession.

In addition, though Basel II made capital regulation more risk sensitive, it was not adequate in bringing in the necessary correspondent changes in both the definition, as well as, composition of the regulatory capital in order to reflect the changing market dynamics. According to Roh (2002), there was a miserable failure on the part of market risks. This was particularly noted in its attempt to factor in the market risk from the complex derivative products, which were said to be coming on the market in an extraordinarily huge manner. Harvard Law School (2005) indicates that these models demanded less capital against trading exposures based on the postulations that trading book exposures could be readily and easily sold and the unwinding of positions would be done in an extremely easy manner. As a result, banks were provided with a perverse incentive to park banking book exposures in the trading book in order to optimize the capital. As it is apparent now, a majority of the toxic assets, as well as, their scrutinized derivatives that were perceived as the epicenter of the financial crisis were parked in the trading books of the banking financial institutions. Therefore, even if the Basel II was purportedly risk sensitive, it failed miserably in promoting modeling frameworks, which were necessary for accurate risk measurement and for demanding sufficient loss absorbing capital necessary to mitigate that particular risk.

Effect of Basel III on the Profitability of Banks

According to Van Deventer and Imai (2003), Basel III requires not only higher but also better quality capital. This is a clear implication that the cost associated with equity capital is extremely higher. In addition to this, there is a huge likelihood that the requirements of absorbency of the non-equity regulatory capital will lead to an increase in its costs. In the last three years, Harvard Law School (2005) indicates that the average Return on Equity in the world banking system has been approximately 15%. Following the implementation of Basel III, it is perceived that it will cause a decline in the ROE of the world banking sector in the short term. The expected benefits, which arise out of a stronger and more stable world banking system, however, will be used to offset the negative effects surfaced by a lower ROE in the medium to the long term. Moreover, it is worthwhile to make assumptions that investors will perceive the benefits arising out of harboring less risky, as well as, more stable banking institutions and as a result, they will be much willing to trade in higher returns for lower risks. A much relevant question is whether financial banking institutions will be up to the task in bearing the increased cost of capital themselves or transfer it to their depositors, as well as, borrowers. It is necessary that such a trade-off is assessed in the context of the relatively higher level of what Cornford (2006) refers to as Net Interest Margins of the world financial institutions, of approximately 3%. A higher Net Interest Margin is an implication that there is a scope for financial banking institutions to up their efficiency, lower the costs associated with intermediation and at the same time ensure that returns are not overly compromised irrespective of whether the costs of capital may increase or not.

Other Major Weaknesses in Basel III

Many researchers have identified that the importance of Basel III is invaluable. However, it has been acknowledged as not sufficient. As such, there is a necessity for it to be complemented by other measures in order to adequately deliver the sort of financial stability outcomes that many individuals within the global society expect. This is a general statement of weakness. However, this particular weakness is brought about by three specific weaknesses. Foremost, the full set of policy reforms is yet to be completed. The Basel committee has a significantly full policy agenda to complete before it can be declared that the overhaul of the regulatory framework has incorporated each and every lesson derived from the crisis. To be precise, there is a need to complete the work associated with liquidity and embark on a fundamental review of the rules relative to trading book.

The second weakness is an inadequacy in ensuring robust implementation. A robust implementation implies more than just having a set of local rules characterizing the Basel III. In order to ensure that the objectives of policy reform are attained, there is a necessity to ensure that the reforms are implemented by national authorities in not only a full but also a consistent and timely manner. It is only after this is done that the full benefits of healthier banks, in addition to, financial systems bear desirable fruits.

The third weakness pertains to the rules. According to Schemer and Mathison (1996), no matter how well written and also how consistently implemented, Basel III will not be adequate in delivering both the financial stability, as well as, financial health in the most desirable banking system. The fitness regimes have been designed and initiatives towards ensuring that the regime is appropriately translated into local languages have been made. However, in the absence of supervisors who will encourage, coax and cajole banks to adhere to the program and, according to Jones (2000), reprimand the laggards occasionally will render the goals unachievable.

There have been calls for Basel IV. However, an array of researchers simply claims that if we get things right with regard to Basel III, then there is no need for Basel IV. To do this, emphasis should be on strong capital for each and every financial banking institution.

The Likely Impact of Basel III on Economic Growth

Roh (2002) claims that Basel III is likely to hurt the economic growth. Even though there are not precise quantitative estimates of the impacts on economic growth, there is a major concern attributed to the accord. As such, the high capital requirements under the accord will kick at a time when credit demand in the economy will be on a rise. In their research, Schemer and Mathison (1996) indicate that in a structurally transforming economy, characterized by a rapid upward mobility, the demand for credit will expand at a faster rate than the Gross Domestic Product. To explain such a state of affairs, there is the likelihood that the world economy will shift from services to manufacturers in an increasing manner. In addition to this, the intensity of credit for manufacturing is higher per unit of the Gross Domestic Product as compared to that for services. The second explanation is that there is a need for economies to double their investment in their infrastructure and this will indeed place enormous demands for credits. These two reasons imply that there is a possibility of the imposition of higher capital requirements on banks as per Basel III at a point in which there will an extended and an expanded credit demand, which will occur in a rapid manner. At its core, Chami and Cosimano (2005) define this as boiling down to the tension between short-term compulsions, as well as growth prospects in the long term.

Is There a Need for Basel III?

There have been mixed views regarding the need for Basel III with reference to the fact that Australia was the least affected among the most developed economies. On the one hand, it is argued that Australia does not need to adopt the accord. On the other hand, others feel that Australia should adopt only a diluted version of the Basel accord necessarily to balance the benefits against the putative costs. In an effort towards buttressing this particular view, Roh (2002) argues that the accord is designed as a corrective for banks in the advanced economies such as Australia, which are perceived to have gone astray oftentimes seizing the opportunity of the regulatory gaps, in addition to the regulatory looseness, and that financial banking institutions in Australia, which remained sound through the crisis, ought not to be burdened by the accord's onerous obligations.

However, Van Deventer and Imai (2003) are not convinced by this view. According to the researcher, Australia needs to transit to the accord owing to the fact that as Australia integrates to the rest of the world, as increasingly Australian financial banking, institutions go overseas and foreign institutions enter the country, Australia cannot afford to have a regulatory deviation from the set world standards. Jones (2000) further indicates that any form of deviation will definitely hurt the Australian economy not only by way of perception but in actual practice, as well.

Moreover, it is perceived that the views of a lower standard regime will necessarily put Australian banking institutions at a disadvantage in world competition. This is particularly due to the fact that implementation of the accord is subject to a peer group review, whose findings, according to Roh (2002), will be in the public domain.