Essay The Relevance of Basel II Capital Adequacy Framework in The Aftermath of Global Financial Crisis - WWW - Topgradepapers

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The relevance of Basel. II capital adequacy framework in the aftermath of Global Financial Crisis
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The Relevance of Basel II Capital Adequacy Framework in the Aftermath of Global Financial Crisis
This report consists on Basel II and its connection to Global Financial Crisis. The Basel II capital adequacy framework describes the rules and requirements for banking that are of international
nature. Banking is a saving channel and it provides credit, hence its importance is vital. It is necessary to regulate the banks to add value to banking system, financial system and at a broader
the objective of adequate supervision of every internationally active bank. This committee first introduced Basel I, which was an achievement as it helped to understand capital definition, capital adequacy and capital regulatory adequacy. That was simple to apply and also addressed
Basel II is modified and amended rules for international banking and it is committed by more than 100 countries. Basel II includes three pillars. Banking industry developing culture of risk effective supervision (Pillar II)2. Market has clear rules for disclosure and moving to greater transparency (Pillar III)3. The proper implication of Basel II ensures improved safety and management (Pillar I)1. Effective supervision exists, compliance with Basel Core Principles for
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soundness, improved governance, risk management and forward looking etc. The Basel II was implemented in September 2008 just before the Global Financial Crisis. This report highlights what the Base II is and whether it contributed to Global financial Crisis or not, what problems Basel II is facing and what improvements are suggested in Basel II. The Basel II was in its infancy stage and it was unable to handle the bubble of Financial Crisis that was evolving since a decade. Now the past is done, what will be the future of Basel II? Further this report incorporates the suggested improvements and changes to Basel II and also the impact which these improvements and changes will leave on financial System.
Pillar I: Defined under WHAT IS BASEL.II CAPITAL ADEQUACY FRAMEWORK? Pillar II: Defined under WHAT IS BASEL.II CAPITAL ADEQUACY FRAMEWORK? 3 Pillar III: Defined under WHAT IS BASEL.II CAPITAL ADEQUACY FRAMEWORK?
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risk management orientation. The outcome was that Basel I adopted in over 100 countries. The
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level to entire economy. The Basel Committee on Banking Supervision was found in 1974 with
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SYNOPSIS:
WHAT IS BASEL.II CAPITAL ADEQUACY FRAMEWORK?

According to the rules and regulations of capital requirements, credit institutions e.g. banks, should maintain the stated minimum amount of the financial capital in order to avoid the risks. The aim is to ensure the soundness of these institutions and also to maintain customer satisfaction for its rights in the institution and at a larger point of view to ensure the stability of
financial system. These rules also give defensive shield to depositors against losses. The committee named Basel Committee on Banking Supervision was formed in 1974 to handle the
banking supervisory matters. The committee representatives of the Basel Committee comes from the countries Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherlands, Spain,
Sweden, Switzerland, UK and US. After Basel I, in 1999 the committee issued a suggestion for a new framework and after widespread communication with banks and industry groups. The modified framework was issued in the year 2004. Some of the main requirements of Basel II are to recognize credit risk, market risk and operational risk and then assigning sufficient capital to cover up potential losses (Susan McKiernan, John Salmon, 2008). The main objective of this framework - Basel II, is to renew the existing capital requirements framework so that more risk could be avoided.
The Basel II framework consists of three main parts: Pillar I: The first part talks about the minimum capital requirements, which the firms will be required to meet in order to cover credit risk, market risk and operational risk. Pillar II: The second part focuses on new supervisory review process. This thing involves financial institutions to have their own system to judge their overall capital adequacy with regard to their risk profile.
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Pillar III: The third main part basically integrates part one and part two. It primarily focuses on how to improve market discipline, capital and risk management.
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THE CAPITAL MANAGEMENT OF BANKS AND BASEL II
Basel II requirements. It helps to increase operational efficiencies and to lower the cost of capital (Bernanke, B.S, 2008).
Products & Features: The credit regulatory body for banks calculates Basel II capital ratios, and to support compliance requirements of the first main part of Basel II. It also processes
information from the multiple resources. Credit Management for Banks proposes flexible product coverage and the tools of managing data.
Benefits: Capital management enables the function of more advanced approaches to Basel II. This framework illustrates a complete measure and minimum standard for capital sufficiency. It
banks face.
As a result, it is intended to be more flexible and better able to evolve with advances in markets and risk management practices (Algo Access Portal, 2009).
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According to the experts, the main reason for the current financial crisis is Basel II. It has been failed to prevent the financial disaster. Some of the industry practitioners have demanded for its replacement. But all this bubble was evaluating since decade and Basel II came into existence just at the beginning of 2008. The three major indicators for financial crisis are analysis of financial markets (stock exchange), exchange rates, and commodity prices. By monitoring these indicators one can easily help to understand the likeliness going to be
happening. By monitoring financial institutes the trends and growth or fall can be seen. Monitoring of exchange rates gives a better insight for understanding global economy and by monitoring commodity prices; the situation of trade as well as trade within a country can be easily evaluated. (AfDB 2008) 4
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LEADING INDICATORS OF GLOBAL FINANCIAL CRISIS
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seeks to improve on the offered rules by supporting capital requirements deeply for the risks that
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Credit Regulatory Capital solution helps financial institutions to go further than just meeting
CONTRIBUTING FACTORS TO GLOBAL FINANCIAL CRISIS

The global financial crisis was worsened by many contributors like Bad Loans. The Basel II has
emphasized rules and requirements for advancing a loan but the financial crisis was not stopped by Basel II because its appearance was too late to manage a bubble that was growing since a nonperforming asset doesnt generate any income to the lender.
decade. These bad loans become a severe reason for the Global financial Crisis. The
The conditions of financial markets also lead to the Global Financial crisis. The dynamic changes in the market in late 2007 created problems for global economy and it has its role in Global Financial Crisis as it lost the confidence of investors and they were to bear huge losses
It is a structured finance process that is used to distribute risk by aggregating debt instruments in a pool and then issues new securities backed by the pool. This term is named as securitization
from the investors is securities. It gives many advantages to issuer like as it reduces fund costs, reduces asset liability and lowers capital requirements etc. (Raynes, Sylvain and Ann Rutledge,
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2003).
ATTITUDE OF REGULATORS US FEDERAL RESERVE, BANK OF ENGLAND
Basel II is regulated by authorities like US federal reserve and Bank of England. These are responsible for the proper implementation of Basel II rules and any amendments made to these rules and requirements. The US Federal Reserve and Bank of England are making great contributions toward betterment and improvement of the rules and for this purpose they conduct researches and keep in touch in other countries leading banks.
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because it is derived from the fact that the form of financial instruments used to obtain funds
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and all the leading financial markets has to crash.
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HOW THE GLOBAL FINANCIAL CRISIS IS BEING MANAGED
financial crisis. For this purpose many suggestions have been presented and still the work is on.
Some of the areas identified for managing this crisis and to avoid it in future are likely to be; deposit insurance, bailouts, and bankruptcies (Nicholas bliss, 2007).
Deposit Insurance: It is a measure implemented in many countries to protect bank deposits whether in full or in part, from losses caused by a banks inability to pay its debts when due. It is a component of financial system safety net that ensures financial stability. Bailouts: it is an act of giving capital to such a company that is in danger of failing in an attempt
to save itself from bankruptcy, insolvency or total liquidation. Bailout is a matter of
Bankruptcies: it is legal proceeding involving a business that is unable to repay outstanding debts. When companies were suffering in global financial crisis, the cases of bankruptcy evolved
creditors.
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In collaboration with the giant banks, Federal Reserve has produced the greatest financial crisis of the world. The underlying factors of the crisis like, unlimited amounts of money and credit, created an artificial wealth environment. Federal Reserve printed massive Dollars, the hidden buying up of deadly assets, behind the scenes deals with the biggest banks, secret currency swap deals with foreign Central Banks, and forced the FASB to change accounting rules to allow banks to fraudulently value bad loans. Therefore, regulators are responsible for this global financial crisis. The Federal Reserve cannot face the extreme behaviors of investors. The Federal Reserve authorization of long-term interest rates has not been met (Susan McKiernan, John
Salmon, 2008).
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at stage. Many companies came to court for being bankrupt whether by the debtor or on behalf of
ROLE OF REGULATORS IN RESPONDING TO GLOBAL FINANCIAL CRISIS
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What the loss is to be bear is born. Now there comes the question of managing the aftermaths of
PROBLEMS WITH BASEL II; LESSONS FROM GLOBAL FINANCIAL CRISIS

The fundamental problem with the Basel II framework was that it created perverse incentives to underestimate credit risk. The regulators had allowed large banks with sophisticated and refined risk management systems to form risk assessment that are their own frameworks. The regulator did not realize that the internal risk models of many banks could perform poorly and seriously under-estimated risk exposure of the borrower. In recent crisis banks had relaxed their lending
policies to great extent not keeping in mind the pay back ability of the borrower and extended
loans to such borrowers who didnt had capacity to pay interest payments and principal if something goes wrong. Banks justified their practices by showing on their risk assessment sheets
that they had enough collateral in the form of property or borrowers home but again their risk models could realize the important fact that if things go badly wrong, how they would be able to liquidate those collateral to get their money back. In recent crisis banks had extended more than US $5 trillion and when recession hit US and people started losing their job, it created such a panic in the market that people were unable to pay their interest and principal back, it forced banks to liquidate their collaterals and severely caused US home market to go down and forced banks to reassess and re-price credit risk (Elliot, Larry, 2008). Due to this the worlds largest
to other bank. The lessons bank regulators learnt from this turmoil is that central banks should devise a policy about the risk exposure and assessment of all the banks in a country and make
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every necessary step to implement it and hold a tight control over the banking system rather than allow every single bank to devise their own risk management. Central bank should make sure that every bank has state of the art risk assessment time and credit risk department and it should audit banks credit risk system on a regular basis.
WHAT IMPROVEMENTS IN BASEL. II AND REGULATION CAN BE SUGGESTED IN MANAGING FUTURE FINANCIAL CRISIS
Now it is the responsibility of the committee to take some concerete steps in managing the future financial crisis. The committee should learn the lesson and be careful for such type of situation in the future. Basel II should be reviewed by the committee again and work on its three major parts. They should design the capital requirements in a way that have no bad impact on the society and 7
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banks either went under bankruptcy like Lehman brothers or they were sold at a very cheap price
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as well as on the world economy. And what they will propose or plan, it should be implemented with complete transparency and efficiently. In order to manage future financial crisis, the committee announced to enhance the three major components of Basel II. It is focusing on some
the recommendation that in future banks should follow more rigorous process in their credit
analysis. The improvement in the market discipline includes strengthening disclosure
requirements for securitization, trading activities and off-balance sheet exposures. These things will help to reduce market uncertainties (John M. Pachkowski, 2009). It is the expectation that the banks and supervisors begins the implementation of the second major part of Basel II immediately. The Committee of Basel II has decided that the first and third part of the Basel II
should be implemented with no later than 31st December, 2010. It has been also approved in the Committee that the floor limit should keep in place even beyond the end of the year 2009.
WHY WESTERN BANKS WERE MORE INVOLVED IN GLOBAL FINANCIAL CRISIS

One of the reasons that pushed the western banks to be involved in Subprime Mortgage loans is, population of western countries was increased because of people coming from other countries like Asia, Africa. People migrated in abundance from War Targeted areas i.e. Afghanistan, Pakistan, and Iraq (Office of the Superintendent of Bankruptcy Industry Canada, 2006). And
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they didn't have to leave the western countries because of Attractive Income Opportunities and bad conditions of their countries. And other foreigners were also there to get money, peace and other modern facilities. All these factors made the landlords to increase the rent of land. This caused migrated people to get their own house. So they went to banks for loans. Banks due to increased demand accepted them. Houses were bought, then because of low income or to handle pressure of bank payments, they mortgaged the lands. So this is one of the reasons of more involvement of western banks in this process lead to Financial Crisis (Dirk Willem te Velde,
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securitizations which is related to minimum capital requirements. The committee has proposed
CONCLUSION
It is concluded that Banks have a significant position in the financial sector of the world economy and if anything goes wrong with them, its effects could be seen everywhere in the world. The present financial crisis is due to the inefficiencies of Basel II. But instead of wasting time on criticizing it, its a time to think about the improvements in Basel II that could bring change in the financial system.
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REFERENCES:
1. Algo ACCESS Portal (2009), Credit Regulatory Capital Management for Banks,
07/09/09
2. Nicholas bliss (2007), Basel II: capital management Strategies, available at http://www.freshfields.com/publications/pdfs/2007/mar14/17464.pdf, 05/09/09 accessed at
3. Susan McKiernan, John Salmon (2008), Basel II: an introduction to the new Capital Adequacy Rules, available at http://www.out-law.com/page-7096, accessed at 09/09/09
4. Dirk Willem te Velde (2008), The global financial crisis and developing countries, available at http://www.odi.org.uk/resources/download/2462.pdf, accessed at 10/09/09
5. John M. Pachkowski, J.D. (2009), Improvements to Basel II Approved available on http://www.financialcrisisupdate.com/2009/07/improvements-to-basel-ii-approved.html, accessed at 11/09/09
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6. AfDB (2008),
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crisis/indicators/, accessed at 04/09/09
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7. Elliott, Larry (2008), "Credit crisis
http://www.guardian.co.uk/business/2008/aug/05/northernrock.banking,
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- how it all began", The Guardian, retrieved 10
available at http://www.algorithmics.com/EN/solutions/regulatorycapital, reviewed at
8. Bernanke, B. S. (2008) The Future of Mortgage Finance in the United States. Speech given at the UC Berkeley/UCLA
9. Raynes, Sylvain and Ann Rutledge (2003), The Analysis of Structured Securities, Oxford U Press, p. 103.
10. "Insolvency in Canada in 2006": Office of the Superintendent of Bankruptcy (Industry Canada). Retrieved 09/09/09
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WHAT IS BASEL.II CAPITAL ADEQUACY FRAMEWORK?

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THE CAPITAL MANAGEMENT OF BANKS AND BASEL II

LEADING INDICATORS OF GLOBAL FINANCIAL CRISIS

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CONTRIBUTING FACTORS TO GLOBAL FINANCIAL CRISIS

ATTITUDE OF REGULATORS US FEDERAL RESERVE, BANK OF ENGLAND

and all the leading financial markets has to crash.

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HOW THE GLOBAL FINANCIAL CRISIS IS BEING MANAGED

to save itself from bankruptcy, insolvency or total liquidation. Bailout is a matter of

ROLE OF REGULATORS IN RESPONDING TO GLOBAL FINANCIAL CRISIS

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PROBLEMS WITH BASEL II; LESSONS FROM GLOBAL FINANCIAL CRISIS

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analysis. The improvement in the market discipline includes strengthening disclosure

WHY WESTERN BANKS WERE MORE INVOLVED IN GLOBAL FINANCIAL CRISIS

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crisis/indicators/, accessed at 04/09/09

7. Elliott, Larry (2008), "Credit crisis

available at http://www.algorithmics.com/EN/solutions/regulatorycapital, reviewed at

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