Basel_Risk_Banking_SSRN-id2060756.pdf

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Running Head: Basel III and Risk Management 1

Basel III and Risk Management in Banking

Baitshepi Tebogo

Institute of Development Management, Botswana

[email protected]

Abstract

This paper limits itself to the examination of the necessity of Basel III and its

abilities in bringing about prudent risk management among banks and other financial

institutions. The paper gives an overview of the Basel III framework and its efforts

towards improving risk management initiatives. The paper further examines the role of

Basel III accord in controlling liquidity risk exposures, and analyses the strengths and

shortcomings of the system. Lastly, it concludes by giving a recommendation regarding

the necessity of Basel III in bringing prudent risk management in the banking industry.

The Basel III agreement does provide strategies for increasing the quantity and quality

of capital among banking institutions. The framework is also fundamental in bringing

stabilities in the financial system. However, failures in proposing measures against

account manipulation, corporate governance, roles of credit rating agencies and

strategies for monitoring the financial system limits the efficacy of Basel III in bringing

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Electronic copy available at: http://ssrn.com/abstract=2060756

Basel III and Risk Management 2

prudency in risk management; despite these factors having contributed to the events

attendant to the financial crisis. While the paper acknowledges achievements of the

Basel III framework, findings from the analysis shows that there are still some concerns,

which must be addressed in order to bring prudency in risk management behaviours of

banks. The paper concludes by offering possible recommendations to strengthen the

policy framework of Basel III.

Keywords: Basel III, risk management, banking supervision, financial crisis, leverage,

liquidity, systemic risk, moral hazard

May 2012


Introduction

There is little doubt that the banking events attendant to the financial crisis of

2007-2011 provided the immediate spark for what has been referred to as the worst

financial crisis since the Great Depression of the early 1930s. The effects of the crisis did

unveil a plethora of shortcomings in the process of regulating systemic risks in addition

to exposing the moral hazards of the systemic importance of financial institutions (Co-

Pierre, 2011). As Co-Pierre (2011) puts it, the fear of unforeseeable consequences

resulting from the failure of important financial institutions forced governments to

resort to bailouts as measures for saving Systemically Important Financial Institutions

(SIFIs). An assessment of causes that led to the failure of financial institutions revealed

huge inadequacies in the capital portfolios of several financial institutions. Varotto

(2011, p. 136) argues that banks suffered greater losses in their trading books, with such

losses exceeding their minimum capital requirements.

In essence, several banking activities have proven insufficient in mitigating

financial risks. Rees-Mogg (2011) argued that the reported loss of $2 billion by the Swiss

Bank, UBS, should be seen as an absolute outrage because, at the very least, the rogue

trading behaviour demonstrated the lack of adequate risk management measures

within UBS. This incident was, therefore, a poster child of how banks overrode prudent

risk management rules before and during the financial crisis. Were it not for rescue

measures by Swiss authorities in 2008, UBS could have possibly collapsed. Failure in the

regulation of speculative risks was also evident during the collapse of the Lehman

Brothers in the United States. Many banks were also closed during the Great Depression


of 1929 and the bank panic of 1933, events that can be related to the banking crisis of

2007-2011. While banks are supposed to be the safe custodians of securities and other

funds, the recent revelations in the banking industry have shown that they are playing a

miniscule role in mitigating risks.

The experiences of the financial crisis of 2007-2011 and its aftermath raised the

need for a review of international banking regulations. Consequently, banking

regulations have been beefed up following the 2007-2011 financial crisis, and so has

government intervention in banking activities (Calomiris, 2009). Banks are now viewed

as delicate financial institutions that must be supported in order to develop robust

financial markets. According to Rochet (2008), moral hazards among depositors and

owners, incomplete financial markets, and a myriad of other negative externalities are

examples of factors that contribute to the level of fragility in financial institutions. For

this reason, supervisory and regulatory measures have been implemented to enhance

capital adequacies and creation of sufficient capital to withstand future financial crisis

(Varotto, 2011, p. 134).

When faced with disasters typical of the financial crisis, and pressures emanating

from the sense of urgency in preventing a repeat of similar occurrence; officials and

financial regulators have resorted to designing preventive rules and regulations. A clear

case is the 2010 publishing of the Basel III rules by the Basel Committee on Banking

Supervision to be effected as from 2013 (Schwerter, 2011, p. 338).

The rest of the paper is organised as follows: The paper examines the necessity of

Basel III regulatory frameworks and its ability in helping the banking and financial


market to adopt prudent risk behaviours in their trading activities. It gives an overview

of the framework and its efforts in improving risk management initiatives, as well as

the roles of the framework in controlling liquidity risk exposures. Finally, the paper

analyses the strengths and shortcomings of the system, and delivers a conclusion

regarding the necessity of Basel III in bringing prudent risk management in the banking

industry.

Basel III

The Basel Committee on Banking Supervision (BCBS) agreed upon the Basel III

Accord in 2010 in a move aimed at increasing the quantity and quality of capital among

banking institutions. Another aim of the accord was to provide a macro-prudential

strategy for addressing what Thornton and Giustiniani (2011, p. 324) refers to as

systemic risks and pro-cyclicality. Thornton and Giustiniani (2011, p.324) also state that

the new Basel III agreement was aimed at introducing internationally harmonized

standards of regulation to govern the levels of liquidity in banks. Basel III was adopted

as an improvement to several facets of its earlier predecessor, Basel II agreement that

many an analyst consider to have played a fundamental role contributing to the credit

bubble (Basel Committee on Banking Supervision, BCBS, 2010). As such, several

changes relating to capital requirements, risk coverage, and measures on the leverage

ratios were proposed on the new Basel III agreement.

The major capital requirements on the new Basel III agreement require banks to

maintain a 4.5% common equity of risk-weighted assets among the introduction of


other capital buffers. This includes a discretionary countercyclical buffer of 2.5 % that

controls capital in high credit durations and a mandatory buffer of 2.5% for conserving

capital. Regarding the leverage ratio, a minimum leverage ratio of 3% was introduced

on top of other two liquidity ratios covering the total net volume of cash outflows and

the ratio of net stable funding (Basel Committee on Banking Supervision, BCBS, 2010).

In order to ascertain the ability of this accord in bringing prudent risk

management behaviours in the banking industry, it is emphatically crucial that the

applicability of its regulatory parameters be examined. This entails conducting an

analysis of the prudential regulation in the form of capital adequacy and liquidity

management, the integration of prudential policies on a macro-level, implementation of

moral and systemic hazards among financial institutions, and the manner with which

the policies contained in the agreement will be implemented.

Basel IIIs ability to reduce systemic risk

Systemic risks entails distress risks within the financial system brought about by

failure of a significant part of the system or caused by imbalances of the system, both of

which are likely to bring negative economic consequences (Schwerter, 2011, p. 338).

Financial shocks are capable of triggering systemic crises through different spill-over

effects. In an attempt to minimize the drawbacks associated with Basel II regulatory

frameworks in controlling systemic risks, designers of Basel III agreement included

effective and target-aimed incentives to guide banks and financial institutions in

realizing increased stabilities.


Capital adequacy and management

As Lastra (2004, p. 225) puts it, capital adequacy is not only a core part in

contemporary banking regulation but it also forms a major strategic theme that

warrants increased regulation and control. Capital regulation is aimed at ensuring that

credit institutions hold enough capacities to cushion against unforeseen losses

(Thornton and Giustiniani (2011, p.324). Similarly, the extent of a bank’s capital

adequacy is influenced by the risk profile and loss absorption capacities. Undeniably,

the 2007-2011 credit crunches did expose deep-rooted flaws in capital and risk

measurement and management among capital institutions. Based on such flaws, the

Basel Committee on Banking Standards (BCBS) implemented several dimensions aimed

at strengthening minimum capital standards in the Basel III agreement. Tightening of

common equity to 4.5% and expounding on definitions of equity dimensions, coupled

with the increase in Tier 1 capital requirement is indeed a factor that improved the

quality and sustainability of capital among financial institutions (“Basel III and IFRS 9 A

tightening of the regulation, 2011).

Expanding the range of risk-weighted assets, the inclusion of additional capital

buffers, and the complementation of new tier 1 leverage ratio are other measures

implemented to strengthen the capital sustainability in financial institutions. Primarily,

the revision of the tier 1 leverage ratios performs important objectives such as providing

an avenue for assessing the potential scale of risks and expansion of balance sheets

during periods of economic upturns.


With regard to the performance of Basel IIIs capital adequacy concept, several

challenges are already being foreseen in its application. Identified problems relate to the

valuation of risks in terms of developing a formula that will ascertain the level of risk in

a timely, accurate, and comprehensive manner. Equally, the risk weighing system is

subject to numerous challenges regarding the assumptions of particular portfolios

because nearly all banks are yet to alter their risk weighing systems (Haldane, and May,

2011). For this reason, banks still identify aspects of their common equity from some of

their risk-weighted assets. This move can provide incentives for financial institutions to

engage in capital arbitrages.

Liquidity Management

The aftermath of the financial crisis also showed that financial institutions had

numerous loopholes in their funding strategies and asset management procedures.

Many financial institutions relied on short-term wholesale markets and in the event of

lack of liquidity in interbank transfers, most banks found themselves illiquid. This move

shows the dangers associated with increased focus on solvency and quality of assets

rather than placing much emphasis on the level of liquidity.

In implementing the Basel III agreement, the net funding ratio and liquidity ratio

were introduced as a measure of gauging the level of liquid assets, as well as having a

minimum funding amount that can maintain funding over a one-year continued stress

within the financial system. So far, this issue has been a subject of debate in many

conversations because academics and analysts have argued over the possibility of a


bank undertaking an optimal level of transforming its maturity without hampering

other productive activities.

Enhanced Supervision

The laxity in enforcing and implementing the prevailing financial regulations

contributed to the financial crisis because many regulatory authorities failed to

undertake their assessment programs and check for non-compliance among banking

institutions (Kay, 2009). If the effects of the financial crisis are anything to learn from,

the criticality of supervisory objectives is among the key lesson that could be drawn

from the entire situation. For this reason, the implementation of Basel III will consider

setting certain standards to ensure that supervisory authorities conduct themselves

diligently when undertaking their tasks. The supervision agenda was thus adopted to

act as a key tool in bringing about financial reforms even though, very little progress

has been realized to date.

Integration of prudential components in Basel III also served a similar purpose of

restructuring and revamping the nature of supervision within the financial systems.

Thornton and Giustiniani (2011, p.328) view the setting up of European System of

Financial Supervision (ESFS) and Financial Policy Committee (FPC) as moves aimed at

instituting enhanced legal powers and mandate for detecting risks in the European

financial system. In the same vein, the Financial Stability Oversight Council (FSOC) was

created in the US to utilize the experiences of insurance experts and federal financial

regulators to control the process of realising macro-prudential goals. While the FPC is


capable of passing judgment in situations of financial misdemeanours by financial

institutions, the FSOC and ESRB lack direct enforcement powers and as such, their

mandates is limited to the issuance of recommendations and warnings to banking

regulations’ transgressors (Thornton and Giustiniani, 2011, p.324).

Cross-border financial transactions were very high prior to the banking crisis and

the majority of these were not supervised. Equally, poor coordination and cooperation

existed between supervisors from both the home and international platform. It is with

reason, therefore, that a model for monitoring international progress was developed

within the Basel III system to enhance supervisory challenges from a global perspective.

However, several challenges are still encountered while implementing this model

because there have been cases of clashes regarding the level of information to be shared

amongst supervisory authorities. This has acted as an impediment for enhancing the

joint monitoring process for risk assessment in the international financial system.

Prudency in Risk position and policies

The poor risk position of financial institutions and lack of prudential policies for

government interventions provides little guidance in determining the right procedure

to follow in choosing appropriate regulations. Difficulties in assessing the behaviour of

financial institutions and its response to several policy interventions contribute to the

increasing challenges of estimating the right prudential regulations to adopt. As earlier

mentioned, the creation of ESRB in the European Union, the FSC in the United

Kingdom, and the FSOC in the United States are examples of some of the objectives


aimed at improving the process of controlling prudent behaviours among players in the

financial system.

Critical Assessment

Perhaps, the Basel III agreement does provide an avenue for solving serious

flaws in the financial system as evidenced from the high measures put in place to

ensure stability in activities among financial institutions. To begin with, the

implementation of measures aimed at the restoration of a strengthened equity bases

coupled with the adoption of strict standards is an expert move geared towards the

realisation of financial stability (Shwerter 2011, p. 348). The stricter regulations also

seem to favour the stabilisation of the system because the adjustments of measures

governing the asset value have an effect of reducing exposure of financial institutions to

continued risks. The changes made on capital buffers offer increased flexibilities and

incentives to financial institutions with regard to the strengthening of their capital

bases.

Adjustments made on the liquidity standards are well thought as they seem to be

the most likely step that will guide many economies to adopt prudent behaviours in

their financial activities. Monitoring measures adopted in the Basel III agreement seems

to be efficient in providing critical information for monitoring risks and levels of

liquidity among financial institutions.


Other than the above listed points, the Basel III committee still needs to

undertake some considerable work if the framework is to achieve its fundamental goals

in bringing prudency in the behaviours of financial institutions. Several authors and

financial analysts have criticized the applicability of the Basel III framework by citing

limitations and suggesting regulatory reform measures. For instance, the criteria of

treating leverage ratio has been subjected to varied criticisms because it undermines the

Basel II approach that many feel to be efficient in managing risk-weighted regulations.

The current Basel III leverage ratio can be affected by an increase in competitive

pressures within the financial market because such a situation might force financial

institutions to keep high-risk assets and trade in low risk assets as a move towards

meeting the ratio requirements (Petrou, 2010).

Differences in banking models in different regions, particularly the European

Union, have made it difficult for regulatory frameworks to undertake their goals. This

makes it difficult to use a uniform financial control mechanism in several nations.

Another area that needs significant review is the aspect of non-existent pricing of

systemic risks, a factor that has failed to internalize all the negative externalities arising

from the systemic risks. The behaviour of G20 countries in offering financial bailouts to

large financial institutions creates a moral hazard in addition to eroding the market

discipline within financial markets. This move undermines the idea of using an

accepted framework to protect money markets, interbank markets, and large value

payment systems in favour of protecting individual banks or systemically important

financial institutions (SIFIs) (Petrou, 2010).


The lack of uniformity in the financial system was not considered in Basel III

agreement. Most likely, increased regulations in the banking sector can encourage

regulatory arbitrage whereby banks can invest huge sums of capital in uncontrolled

markets (particularly the shadow banking sectors) due to the increased costs in the

regulated sector. Equally, banks have the likelihood of taking risks viewed to maximise

returns and hence, the attempted regulatory frameworks aimed at capturing risks might

be jeopardised in situations where banks might be willing to create new sets of risks.

The activities of credit rating agencies during the financial crisis is also a matter

that warrants discussion because poor credit rating formulas led to the award of AAA

ratings to certain institutions that did not deserve such ratings. Even though credit

rating agencies did contribute in causing the financial crisis, the Basel III framework

failed to address the issue of managing credit rating agencies. Measures must be put in

place to reduce the increased reliance of external credit rating agencies. Closely related

to the issue of credit rating agencies are the shortcomings associated with risk

management, establishment of market transparency, and quality of supervision of

financial institutions before the financial crisis. Many moral hazards and ethical issues

can be raised regarding the roles played by auditors and financial regulators in events

leading to the collapse of key financial institutions such as the Lehman Brothers. The

analysis of Basel III framework reveals that no provisions have been made to oversee

the activities of players in the shadow-banking sector even though such players

contribute heavily in expanding the credit system.


The concept of imposing additional requirements in capital is still a subject that

needs review. Practically, it is quite difficult to change the systemic importance of a

financial institution because of its highly volatile quantity of capital. Achieving a high

systemic importance in banking capital might require that banks hold a large volume of

the banking capital in order to fulfil the capital requirement (Lehar, 2005). Therefore, it

becomes quite difficult for regulatory authorities to justify the need for having

additional capitals requirements.

Conclusions and Recommendations

While several proposals and counter-proposals on financial sector reforms have

been presented by financial experts and authors, the Basel III framework still manages

to capture a central position in managing the challenges faced by the financial system

during the financial crisis. The most important aspects of the Basel III framework

include its strengthened abilities in dampening systemic risks (Haldane, and May,

2011). Undoubtedly, the financial crisis was caused by a mixture of factors such as

excess leverage ratios, lack of capital adequacies, and excess liquidities. Other

shortcomings evidenced included poor corporate governance and imbalances in risk

management procedures. Much of such shortcomings appeared to have been addressed

by the Basel III framework. In order to achieve its aims and objectives in addition to

bringing efficacy in risk regulation, the aforementioned challenges, and shortcomings of

the Basel III agreement must be addressed. There is likelihood that these shortcomings

will create instabilities in future if they re-emerge.


Basel III system was necessary in improving many aspects of the financial crisis

even though its abilities in bringing prudent risk management behaviours are still

questionable. This is in part due to its failures in addressing factors that contributed to

the financial crisis, as well as in addressing subsequent problems in Basel I and Basel II

frameworks. It is also apparent that failures to make alterations in the risk weighing

regime exposes it to portfolio invariances because financial institutions are in a

quagmire, trying to identify common equity from their risk weighted assets (Blundell-

Wignall, & Atkinson, 2010). There is still a need to address issues to do with account

manipulation, corporate governance, roles of credit rating agencies and strategies for

monitoring the financial system (Blundell-Wignall, & Atkinson, 2010). Measures and

policies that can be adopted to improve the process include frequent monitoring and

regulation of the financial system, examination of shadow banking activities, and

putting stronger measures to bring compliance instead of relying on credit rating

agencies.


References

“Basel III and IFRS 9 A tightening of the regulations” (2011). Risk. 24 (4): 23-25. Retrieved from Business Source Premier on EBSCOhost Basel Committee on Banking Supervision, BCBS. (2010). Basel III and financial stability. Bank for International Settlement Blundell-Wignall, A., & Atkinson, P. (2010). Thinking Beyond Basel III: Necessary solutions for capital and liquidity. Financial Markets Trends 10 (1). Calomiris, C.W. (2009). “Financial innovation, regulation, and reform,” Cato Journal, 29 (1): 65-91 Co-Pierre, G. (2011). Basel III and Systemic Risk Regulation-What Way Forward? Working Paper No 17 Haldane, A.G., and May, R.M., 2011. “Systemic risk in banking ecosystems”. Nature 469, 351–355. Kay, J. (2009). Narrow Banking: The Reform of Banking Regulation, Center for the Study of Financial Regulation, London Lastra, R., M. (2004),"Risk-based capital requirements and their impact upon the banking industry: Basel II and CAD III", Journal of Financial Regulation and Compliance, 12 (3): 225 – 239 Lehar, A. (2005), “Measuring systemic risk: a risk management approach”, Journal of Banking & Finance, 29 (10): 2577-603. Petrou, K. S. (2010). “Basel III + Dodd-Frank=Little Leeway on Capital”. The American Banker. 175 (127). Retrieved from Business Source Premier on EBSCOhost Rees-Mogg, W. (2011). “Banks are now the danger, not the safety net.” The Times. Retrieved from Newspaper Source at EbscoHost.com Rochet, J.-C. (2008). Why Are There So Many Banking Crises? The Politics and Policy of Banking Regulation, Princeton University Press, Princeton, NJ.


Schwerter, S. (2011),"Basel III's ability to mitigate systemic risk,” Journal of Financial Regulation and Compliance,19 (4): 337 – 354 Thornton, J. and Giustiniani, JA. (2011),"Post-crisis financial reform: where do we stand?", Journal of Financial Regulation and Compliance, 19 (4): 323 – 336 Varotto, S. (2011),"Liquidity risk, credit risk, market risk and bank capital,” International Journal of Managerial Finance. 7 (2): 134 – 152

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