In most countries, the government appoints a regulatory authority and grants it the mandate to monitor and control the operations of commercial banks in a country. Banking regulation has evolved significantly. For instance, in the 1970s the regulation focused on controlling both the borrowing and lending rates and structures of the commercial banks. In recent years, the regulations focus on market variables. Thus, regulations act as a response to market failures that are being experienced in recent years (Biggar & Heimler 2005).
Generally, regulation within the commercial banking system reduces the risk that the bank depositors and the banks are exposed to. The banking sector and the economies of various countries are emerging from the global financial crisis that began in 2008. The banking sector is recovering at a slower pace than the other sectors in the economy.
This can be attributed to the loss of consumer confidence. The global financial crisis necessitated the regulators to change the regulatory framework for financial institutions. Regulators across the world have tightened the regulation of commercial banks. The global crisis and other factors led to the creation of Basel III (capital adequacy framework). Basel III focuses on four key areas these are, capital requirement, leverage ratio, liquidity ratio, governance, and sanctions.
The general implications of Basel III are increased quality and quantity of capital, reduced leverage ratio, enhanced short-term liquidity coverage, enhanced stable and long-term funding of balance sheet, and reinforced risk capture. These new regulations exert a lot of pressure on the operations and profitability of the commercial banks because they reduce the ability of the commercial banks to offer credit facilities and earn profit. The paper seeks to evaluate the impact Basel III framework on the internal control processes of financial institutions.
Components of capital/capital buffers
Basel III outlines the various changes in the components of capital and capital buffers. The first requirement stipulated in the new framework is that common equity and retained earnings need to be the main constituent of Tier 1 capital. This new regulation will require banks to reorganize the books of account so that items such as debt-like instruments that were initially in this category are eliminated. The second requirement is that Tier 2 capital should be harmonized and simplified. Further, components of capital that have a loss-absorption capacity should be entirely removed. Further, the components of hybrid Tier 1 should be gradually eliminated. In terms of quantity, the framework requires banks to increase the percentage of common equity in Tier 1 from 2.0% to 4.5%. The capital conservation buffer should be 2.5%.
Thus, the common equity requirement should total 7.0% (Accenture 2011). Apart from common equity, the percentage of total capital was increased from 8.0% to 10.5%. The value is inclusive of the conservation buffer. The changes in capital requirements are supposed to be implemented by banks gradually. These changes will require banks to raise additional capital in the form of common equity. This necessitates banks to improve efficiency and financial performance so that they may become more appealing to investors. Besides, the changes may result in a reduction of dividends paid by banks and an increase in retained earnings (Robert, Canner, Mok & Sokolov 2005).
In general, the changes will result in an increase in the minimal capital ratio for the banks. Besides, the requirements will require banks to increase the equity ratio by a significant amount. From an internal control point of view, the banks will have to clean their books as soon as possible so that the various capital components are recorded in the right category (Accenture 2012).
Counterparty Credit risk
The Basel III framework aims at ensuring that risks in the Pillar 1 structure are completely covered. Thus, “this framework seeks to alter the handling of exposures to financial organizations and the counterparty risks on derivative exposures” (KPMG LLP 2011). The first change proposed in this category is that counterparty credit risk should be calibrated based on the stress points. Secondly, the counterparty risk management standards should be improved. Some of the areas that require upgrading are stress-testing and collateral management. Further, strong standards for central counterparties should be developed.
Finally, a capital charge for potential mark-to-market losses and Credit Valuation Adjustments should be introduced. These changes will have the effect of reducing the volume of intra-financial sector business due to increased charges (PricewaterhouseCoopers LLP 2012). Further, “the banks will have to review their business models because the costs of dealing with counterparties will have to be incorporated into the normal operations of the business” (KPMG LLP 2011). This will reduce risk when dealing with counterparties.
The aim of Basel III in this category is to reduce the risk of building up too much leverage in financial institutions. The first change in the internal control process is that financial institutions will have to maintain a new leverage limit of 3%. This implies that the total assets of a bank should not exceed 33 times the capital of the banks. While estimating the ratio, both on and off-balance sheet items should be included. The ratio is put in place to complement the risk-based measures of capital that were initially being used by banks (Latham & Watkins LLP 2011).
From a profitability point of view, the change will reduce the ability of banks to lend. This will reduce the ability of banks to generate more profit. Besides, it will enable financial institutions to improve their capital base. However, it may encourage banks to sell assets that have a low margin (KPMG LLP 2011).
Such assets have the potential of lowering the value of the asset base of the financial institutions. It is worth mentioning that estimation of the leverage risk will not take into account the risks that are related to the asset base of the institution. However, this new ratio may contradict the requirement of the market and rating agencies. “The agencies may require the financial institutions to maintain a higher leverage ratio than the requirements outlined by the regulator” (KPMG LLP 2011). The second change is that a new template for reporting will be developed and the regulators will monitor the leverage ratio on a periodic basis.
From the internal operations perspective, the financial institutions will be required to fill in and submit the new template as stipulated. Also, the regulator will closely monitor the leverage level of the financial institutions. However, closer monitoring may encourage banks to lend at higher rates so as to maximize returns (KPMG LLP 2013).
Global Liquidity Standard – Liquidity Ratio and Monitoring tools
Under this category, Basel III seeks to increase liquidity coverage. First, the 30-day Liquidity Coverage Ratio will be introduced. The new ratio is expected to improve banks’ resilience to the likelihood of liquidity disturbance. Further, banks will need to maintain adequate liquid assets which are of high quality. These changes will improve the stability in liquidity of financial institutions. Besides, it will lessen the risks arising from the possibility of a bank run. Also, the change is likely to reduce the profitability of banks because they will have to keep highly liquid assets that yield dismal returns (KPMG LLP 2013).
The second change is that a net stable funding ratio will be introduced. This change will encourage banks to reduce the usage of short-term funds and seek stable funding. It will also require banks to increase the proportion of deposits with longer maturities. The introduction of a common set of monitoring tools seeks to enhance global consistency in the supervision of liquidity risk. Some of the monetary tools that were recommended in Basel III are contractual maturity mismatch, the concentration of funding, available unencumbered assets, Liquidity Coverage Ratio by significant currency, and market-related monetary tools. These monitoring tools will change the internal operations of financial institutions because they will be required to comply with the new monitoring tools. This will also change the reports that have to be prepared and submitted to the regulatory authorities (Dow Jones & Company, Inc. 2013).
Enhanced Governance and Sanctions
The changes proposed in Basel III seek to improve the shortcomings in the corporate governance setup. The changes put more emphasis on the risk management function in organizations. Thus, the recommendations seek to change the internal processes that relate to risk management. First, the oversight role that is provided by the board on risk management will be improved. This will be achieved by increasing the amount of time committed to the risk management function, requiring the employees and the board members to possess relevant and practical knowledge, and increasing the diversity in the arrangement of the board.
Further, the board should be sufficiently involved in the general risk strategy of the institution. Also, more weight should be allocated to the risk management function in financial institutions. These changes in the internal processes will enhance the efficiency of the risk oversight board, improve risk management function, and enhanced monitoring. This will strengthen the internal control of the institutions (Hull 2012).
Basel III seeks to improve the levels of administrative monetary sanctions. Thus, financial institutions will need to put in place operative, balanced and preventive sanctions. These changes will alter the internal control processes of an entity. Specifically, the banks will have to align their internal processes and operations with the minimum common rules and maximum level of monetary administrative sanctions that are put in place by the regulatory authority. Further, the banks will have to take into account the factors that have to be considered when determining the sanctions (KPMG LLP 2011).
The paper carried out an evaluation of the impact Basel III framework on the internal control processes of financial institutions. From the analysis, it is evident that Basel III will affect the internal processes of capital and capital buffers, counterparty credit risk, leverage ratio, global liquidity standard, and governance & sanctions of financial institutions. These changes are aimed at improving the operations of financial institutions. They also seek to reduce the degree of the negative impact of a possible collapse of financial institutions on the economy.
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