The banking industry is one of the industries that are under strict control from both the national government and international bodies based on their importance in the stability of national and international trade and economies. The enforcement of the regulations is a priority of many organizations. As Nowak reveals, in cases where the regulations have failed, global crises have resulted, with the national governments being forced to bail the banks out to prevent national and global economic failure as witnessed in the most recent global financial crisis. One of the regulations to this effect is the creation of capital requirements, meaning that banks have a specified manner of handling their capital that is relative to their assets. Internationally, several bodies exist that influence the capital requirements in many countries. One such body is the Basel Committee on Banking Supervision. This research paper looks at capital adequacy regulation and in particular, the role of the Basil Committee on Banking Supervision and the capital measurement systems that it has introduced over the years in the form of Basel Capital Accords.
A lot of literature exists on capital adequacy regulation highlighting the importance of the topic in the finance sector. Several financial analysts and researchers have also advanced many theories and ideas about the topic. This section highlights some of the important ones together with developments in the field over time. As indicated above, several bank regulatory authorities have been established in many nations, with international bodies existing to that effect. This measure is meant to ensure banking systems maintain stability nationally and internationally. The Basle Capital Accord of 1988 has attracted interest, as Zicchino reveals, with several authors discussing it in detail and stating that it was an attempt to set minimum capital standards to which banks in the signatory countries could adhere. According to George Sheldon, the Accord uses estimated risks of bank portfolios to assess capital requirements, which is different from the use of simple leverage ratios.
Sheldon also states that the Accord was originally for credit risks only although it later extended to include coverage of market risks with planned operational risks (2001, p. 2). Over 100 countries around the world have implemented the guidelines of the Accord. In Switzerland, Rime confirms how the implementation led to several revisions of the country’s capital regulation for banks. There have been increased activities in recent times as regards capital adequacy regulation. Nevertheless, little documentation is available on the benefits or costs that such regulations have.
Some authors claim that the control of bank capital is an important area in the financial markets. Although organizations that offer the services enjoy monopoly, there is much more to be done. The provision of capital adequacy requirements in the banking sector is pivotal to the stability of national banking institutions. They cushion banks from the probability of failure. According to Sheldon, there exist a number of negative externalities, which are potential risks in the banking industry. Some of the risks in the industry result from the interdependence of financial institutions, which allow the fortunes of one institution to influence those of other related institutions. Sheldon also states that different forms of deposit insurance such as the implicit (too big to fail) and explicit forms allow players in this industry to pass on the effects of their actions onto third parties. It, therefore, means that the industry players are at liberty to exercise their peculiar decision-making in the absence of capital adequacy regulations, and hence their requirement.
Barrios and Blanco describe capital as being a major part of public trustworthiness in the banking industry despite its tiny proportion compared to other parts of investments in banking. They continue to state that, in the presence of a crisis, the ability of a bank to pay its debts is dependent on the leverage ratio, and that a low leverage ratio is undesirable. This represents the other reason for the existence of capital adequacy regulations: avoiding bankruptcies. Several authors have however observed that banks have often responded by increasing their risk exposure as Kim and Santomero confirm, with other studies stating that the development of tight regulations in the industry may result in banks cutting their credit offer and fall as a result in the productive investment as Santomero and Watson point out.
Barrios and Blanco had other contributions in banking. These took the form of hypothetical models serving as enlightenment for the criteria followed in the formulation of capital to asset share especially for regions with strict sanctions. In the foremost model, also called the market plan, the financial institutions were allowed to hold capital to asset ratio well above that, which was acceptable or synchronized. The second model that they proposed was the regulatory model. In this model, banks had an optimal capital ratio below the minimally accepted one. A conclusion was consequently made that, for Spain, which was the country of reference, there exists a number of factors determining capital augmentation. Apart from the regulatory constraint in the form of capital adequacy regulation, the other important factor is the pressure of market forces.
The institution of the Basle Commission
Basel committee came into being in the early 1970s, with the initial ten members having their central bank governors as their representatives who organized yearly meetings. The creation of the committee was prompted by the disturbances that existed in the global banking markets and the international currency, with the main incident being the failure of the West German Bankhaus Herstatt as Maes reveals. The assembly that led to the creation of the committee has been followed by a series of meetings, with the first one being held the following year after its establishment.
The committee now boasts of over 100 members, with the intention of creating banking regulations besides ensuring strict supervision of the banking industry in the member countries and internationally. The representation is in the form of a member’s central bank or any other authority where the central bank is not a member. The committee also had the goal of international banking industry collaboration, which was meant to be a source of standards in the banking industry and a source of mutual understanding in the same industry. It did not however have the supervisory authority over its member countries. It only enacts supervisory standards and guidelines with the hope that the member countries would implement them as recommended in a detailed arrangement.
The failure of the Bakhaus Herstatt in 1974 proved the importance of international cooperation in the banking industry. The expansion that was witnessed in 2009 was one of the ways of achieving this role of international cooperation as envisioned in the original committee meeting. BCBS functions to establish a meeting point towards common standards and approaches. It has no treaty signed to create it serving rather as an informal establishment. Four subdivisions or subgroups constitute BCBS. These facilitate the activities of the committee in various areas of the banking industry, with each having a different head among the central bank governors.
The Objectives of the Basle Committee
The Basle committee was created with the mandate of providing a forum where governments and international banking institutions could have regular cooperation. It was also mandated with the improvement of global banking supervision. Some of the measures to this effect include the rapid expansion that it was able to achieve, the creation of the Basel Consultative Group, the regular international conferences attended by banking supervisors of the respective countries, and the creation of a Financial Stability Institute.
Some of the other objectives of the Committee include the promotion of greater banking resilience. As stated above, the banking industry, though vital to the economies worldwide, is susceptible to a number of intrinsic and extrinsic threats. The committee, therefore, has a role in ensuring that the industry’s threats are kept at a minimum to avoid some of the financial crises that have been witnessed in the past. The question that comes in is whether the measures put in place have been enough to prevent such crises in light of the recent global financial crisis of 2008.
The other objective is the achievement of maximum sustainable economic growth through the enactment of measures that members can use to ensure the profitability of their institutions. This measure is important as it ensures that the banking industry is constantly available for borrowing for the member countries without adverse effects. The committee also has the objective of empowering the member nations and their banks to withstand future crises. Banks and financial institutions should be able to withstand financial crises whenever they occur without experiencing losses and bankruptcy. In fact, some of the crises are unpredictable and from different sources away from the control of the committee and other global financial institutions. The last objective is the creation of a level playing field in the international platform by the implementation of standards.
The Historical Significance and Evolution of the Basle Requirements
Based on the above-listed objectives of the Basel Committee on Banking Supervision, several requirements for the member countries were set with the desire to improve banking safety and/or create a level playing field internationally. The first of these requirements was Basel I which was introduced in 1988 with the main goal of setting a minimum capital requirement rule. The initial goal for which it was created was achieved with praise from the key industry players. However, critics cited the low-risk sensitiveness that was potentiated by Basel I in its capital requirements, which they stated would lead to banks taking greater risks and regulatory capital arbitrage as Jones confirms. Originally known as the 1988 Basel Accord, Basel I was implemented in the countries that were members of the committee at the time in their respective countries by1992.
Basel, became irrelevant after a period of years, thus leading to the creation of other regulations to make the banking industry safer. The successor was Basel II, which represented a rather improved version of Basel. This version even had three pillars upon which its operations were organized. Basel II was published in 2004. One of the major roles apart from the control of the capital for banks was to eliminate inequality gradually in the international banking system.
After the global financial crisis of 2008, plans emerged for the creation of Basel III after Basel II displayed weaknesses in the prevention of the crisis of such magnitude. In the period of 2010-11, members of the committee agreed on a global regulatory standard in response to the financial regulation deficiency displayed by the last financial crisis. According to Gatzert and Wesker (2012), this requirement is meant, “to strengthen capital requirements by the bank, with the introduction of new regulatory requirements on bank leverage and liquidity”.
The Development of Basle I, Basle II, and Basle III Requirements
In 1988, governors of the central banks of the G10 member countries, which constituted the committee, approved the Basel Capital Accord.
The main capital requirements in Basel I was to be implemented by the end of 1992. A report to the assembly confirmed the same for the member countries. The requirements have also been met with optimism over time in some of the countries that did not participate in the original agreement. This has resulted in the increased international presence of banks in global trade due to the reduced risks. The target was for banks to achieve and hold capital equivalent to 8% of the risk-weighted assets if they were to be active on the international front. According to Zicchino, the credit risk was also divided into 5 categories percentage-wise, which were“0%, 10%, 20%, 50%, and 100%, with the highest risk of 100% constituting of things such as commercial loans.”
There were also several liquidity requirements included in Basel I, although these were initially not present. They were only included with time. These have also been adopted in the member countries, with the original members of the G10 being at the forefront of their implementation. The other members joining the committee after 1992 have also adopted these requirements, with some doing it by name and others implementing them.
Basel II Capital Requirements
Basel II was a revision of the capital requirement initially spelled in Basel I. It constituted a major reason for the overhaul of Basel I to Basel II. The calculation of the minimum capital requirement can be summarized by the equation:
The liquidity requirements in Basel II were stricter compared to Basel I. They were aimed at promoting the security of the banking industry on the international front. Some of the requirements included the new methods of evaluating the operational risk that was introduced with time.
The most recent of the Basel accords, which is Basel III, was constructed after the global financial crisis of 2008. The realization was that, even with the capital and liquidity requirements existing in previous versions, there was still a lot to be done to ensure the stability of the banking sector and to prevent further crises. There was also the importance of ensuring that the banks do not succumb to the effects of such a crisis it was to occur again in the future.
The design of Basel III necessitated the redefinition of capital, with more focus on common equity. Common equity under this arrangement was recognized as an important component of a bank’s capital. In Basel III, “Common Equity Tier 1 was set to be at least 4.5% of risk-weighted assets.” Tier 1 Capital was also set to be at least 6.0% of risk-weighted assets with the Total Capital (constituting of the sum of Tier 1 and Tier 2 Capitals) set to be at least 8.0% of risk-weighted assets.
In Basil III, there is the introduction of a liquidity coverage ratio to promote the resilience of banks to disruptions that may occur in liquidity. The ratio was created with the intention of creating high-quality liquid assets that would be sufficient to offset outflows in cash in the event of a crisis. A net stable funding ratio is also a component of Basel III, with a number of monitoring tools being used to this effect.
The Fundamental Differences between Basle I, Basle II, and Basle III
There are major differences in the three Basel agreements other than the period within which they were instituted. Since Basel III is an improvement of the previous agreements under Basel I and II, it stands to be more superior to the previous ones, on most of the considerations and areas. One of the differences between the three is the quality of capital under each of the agreements. Basel III, as stated above has a better and stricter definition of capital, and hence a major advantage over the previous versions. In fact, better quality capital and definition mean that banks now have a better chance of absorbing shock in times of crises, protecting them, and making them stronger.
Another major feature of Basel III is the introduction of a capital conservation buffer, which is set at 2.5% under this agreement. Previous Basel agreements did not have this feature. In addition to better capital, it will help banks in periods of losses such as major crises. Another element of Basel III is the countercyclical buffer that was introduced to alter capital requirements depending on the fortunes of banks. This buffer will ensure that the industry is relatively risk-free, with coverage of the potential risk. In good industry performance, the capital requirement will increase and consequently decrease in bad times, with this acting as a buffer mechanism for the banks.
Basel III also has the characteristic of increased common equity requirement that is least allowed in a banking industry. There is also an accelerated effort under Basel III to raise the Tier 1 capital requirement from the existing minimum of 4% to a figure of 6%. The similarity in the three is that the minimum capital requirement has not changed, remaining at the original 8%. However, Basel III allows for upward change with the addition of the conservation buffer to a maximum of 10.5%.
The other new inclusions in Basel III are a leverage ratio, which is not risk-weighed. It will be implemented in the years following the global financial crisis. Other differences can be found in the liquidity ratio that is to be created under Basel III. The comparison proves that Basel III is superior to its predecessor. Many measures could be used to assess this power. However, it remains to be seen whether Basel III will be adequate to prevent a global financial crisis as witnessed recently.
The Effectiveness of Basle Committee Requirements
The global financial crisis of 2007-10 was a revelation that can be used to gauge the effectiveness of the committee’s requirements. Robert Andreas Nowak conducted a study to establish the effectiveness of global financial regulation with resultant conclusions on the same. The first conclusion that he made was that global financial regulations as in the case of Basel I, II, and III are not binding, but constraining. The introduction of limits in the banking industry limits the degree of risk-taking, which is a major component of strong financial institutions.
At the time of the study, Nowak also concluded the existing financial regulations were effective in the potential mitigation of any bank failures (2011, p. 27). This means that, if a financial crisis were to occur now, banks and countries that have adopted the proposition of the committee would be successful at avoiding collapse and surviving the event. This may also explain the reduction in the severity of the latest crisis as compared to the ones that preceded them. Despite the findings of resilience in the case of a crisis, Nowak concluded that two of the ratios in the global financing regulations, the common equity ratio, and the net stable funding ratio, have the potential to fail in the case of a crisis.
In conclusion, the banking industry is an important one to any country or market. The strict ruling is therefore important to ensure its protection from manipulation from external and internal forces. Capital adequacy regulation is an apt way of accomplishing this mission. Several measures put by the Basle committee have proven to be effective in the past. The latest measure to be implemented Basle III has potential benefits for the global banking industry, based on the strengths that it has against the previous such installations. Based on the studies that have been reviewed, there have been benefits from the existence of the Basel regulations. This has attracted a membership of the committee from the original 10 members to over 100 members. The banking industry will require the implementation of the requirements as set by the Basel Committee. The future crisis will be dealt with in a better way. The implementation should however be universal with all the internationally active countries participating.
Barrios, Victor, and Juan Blanco. “The effectiveness of bank capital adequacy regulation: A theoretical and empirical approach.” Journal Of Banking & Finance 27, no. 10 (2003): 1935.
Gatzert, Nadine, and Hannah Wesker.“A Comparative Assessment of Basel II/III and Solvency II.”Geneva Papers On Risk & Insurance – Issues & Practice 37, no. 3(2012): 539-570.
Jones, David. “Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues.”Journal of Banking and Finance 24, no. 1(2000): 35-58.
Kim, Daesik, and Anthony Santomero.”Risk in Banking and Capital Regulation.”The Journal of Finance 43, no. 5 (1988): 1219-1233.
Maes, Ivo. “The Basel Committee on Banking Supervision: The History of the Early Years.” Financial History Review 19, no. 3 (2012): 365-368.
Nowak, Andreas. How Effective is Global Financial Regulation? The Basel Accords’ Role in Mitigating Banking Crises. North Carolina: University Durham, 2011.
Rime, Bertrand. Capital Requirements and Bank Behavior: Empirical Evidence for Switzerland. Swiss National Bank: Banking Studies Section, 2000.
Santomero, Anthony, and Ronald Watson.“Determining an Optimal Capital Standard for the Banking Industry.”The Journal of Finance 32, no. 4 (1977): 1267-1282.
Sheldon, George. Costs and Benefits of Capital Adequacy Requirements: An Empirical Analysis for Switzerland. Switzerland: Labor Market and Industrial Organization Research Unit (FAI) University of Basle, 2001.
Zicchino, Lea. “A Model of Bank Capital, Lending and the Macroeconomy: Basel I versus Basel II.” Manchester School (14636786) 74, no. 1 (2006): 50-77.