It is apparent that the spiral effect of the current financial crisis is steadily but gradually taking its toll on both developing and developed world. Sooner than later, the effects of the current economic crisis could become devastating. In a sense, the world risks to lose its hard-won gains of the last decades. The current financial crisis can largely be attributed to the banks and other financial institutions. Most people believe that poor regulations and supervision of banks triggered the current financial crisis. A banking system that is strong and resilient acts as an engine of economic growth. A well regulated financial system plays an important role of supporting the people’s standard of living. This is because it facilitates financial intermediation between savers and investors.
Today’s momentous times have called for the evaluation of the worthiness of the Basel regulatory framework. The following essay discusses the importance and effectiveness of the Basel regulatory framework in curbing the current financial crisis. The Basel regulatory framework refers to an agreement among central banks on the liquid amount of capital that should be held by banks. The first Basel regulatory framework was created in 1998 and played an important role in enhancing banks’ strength and resilience across the globe. Basel 2 was developed in 2004 by the bank supervisory authorities in the US and other countries in order to adequately measure risk exposures. In July 2009, Basel 3 was created by the Basel Committee on Banking Supervision following the global financial crisis that began in 2007 in order to govern the banking industry with a view of enhancing its resilience. The Committee is comprised of senior members of central banks from 28 countries across the globe and it’s headquarter is based in Basel, Switzerland (Engelmann, & Rauhmeier, 2011, 5).
The role of the Basel regulatory framework in enhancing the accountability of regulatory bodies
The Basel Committee on Banking Supervision agreed that lack of accountability of regulatory body was one of the factors that led to the current financial crisis. The Basel regulatory framework requires that the regulatory bodies should be able to manage their resources effectively and efficiently. Also, the framework requires the regulatory bodies to formulate and implement sound regulations and policies. The regulatory bodies should carry out their objectives effectively. The committee requires the regulatory bodies to pursue their objectives independently i.e. they should not allow any political interference. The second and third pillars of the Basel regulatory framework aim at regulating the environment within which global banking institutions operate. The second pillar spells out the role of banking organizations of monitoring themselves. The pillar also requires the regulatory bodies to set minimum standards that banking organizations must follow. The Committee has proposed that the regulatory bodies should intervene early in order to prevent another financial crisis from occurring. With this regards, the regulatory bodies should impose penalties when the banking organizations fails to meet the prudential requirements. Regulatory bodies should have powers to dismiss individuals and revoke operating licenses. The third pillar of the Basel regulatory framework requires banking institutions to carry out their activities transparently (Hirschey et.al. 2003, 51).
The role of Basel regulatory framework in raising the global capital framework
The Basel regulatory framework aims at enhancing the long-term soundness and safety of the banking system by raising the global capital framework. The Basel regulatory framework requires the supervisors to ensure that the regulatory capital remains relevant. The Basel Committee of Banking Supervision proposed several reforms with regards to bank’s capital requirements. The main purpose why Basel regulatory framework was created is to set the minimum amount of regulatory capital that should be held by banks in order to avoid insolvency. With this regards, the Basel regulatory framework has redefined the regulatory capital in order to exclude certain items that don’t represent capital. For instance, the committee held the view that goodwill which forms part of capital available should not be used in absorbing losses. The committee tightened the bank’s capital requirement. The Basel Committee of Banking Supervision agreed that the minimum common equity should rise to 4.5 % from the current 2.5 %. The committee redefined capital with a view of further increasing the capital requirement and also to widen the number of exposures covered. The committee introduced a leverage ratio of 3% in order to harmonize the global risk-based capital requirements (Ozdemir & Miu, 2008, 186).
The Basel regulatory framework aims at ensuring that the regulatory capital appropriately addresses the current financial crisis. For the largest banks, efforts are directed towards developing a more risk sensitive regulatory framework that addresses the complex activities and operations of these financial institutions. Basel regulatory framework plays an important role in recognizing the flaws that exists in risk-based capital. It promotes significant advances with regards to risk management that in turn benefits the banks by enhancing their safety and soundness (Chiti & Mattarella.2011, 339).
Banks usually increases their risk exposure by engaging in regulatory capital arbitrage. Also, they back their risk exposures by using such aspects as collateral, credit derivatives and guarantees. The Basel regulatory framework redefines the regulatory capital by raising its quality and transparency. The framework requires that capital must be comprised of retained earnings and equity i.e. shareholders equity. Thus, banks can hold a small percentage of risk weighted assets with the minimum common equity being 4.5 % (Lore, & Borodovsk, 2000, 330).
According to the Basel Committee on Banking Supervision, the main factor that made the financial crisis to deteriorate was that major banks across the globe had undercapitalized their lending. Their level of capital base was also eroded. At the same time, the banking organizations did not have adequate liquidity buffers. Therefore, the banking organizations did not have the capacity to handle the resulting credit and systematic losses. Also, the banking system could not cope with the reinter-mediation of huge off balance-sheet exposures. To prevent this crisis from occurring in the future, the Basel Committee on Banking Supervision has introduced a leverage ratio that is aimed at achieving the following objectives; the first objective is to limit the build up of leverage in banking organizations. This will help to avoid the deleveraging as well as the destabilizing processes which affects the financial system and the larger economy. The second objective is to support the risk-based capital requirements. In dealing with the identified weaknesses, the Basel Committee on Banking Supervision has also developed a reform agenda aimed at ensuring that capital requirements puts into account all the material risks. The committee has emphasized on strengthening the regulatory, supervisory and risk management frameworks with a credible leverage ratio (Robbie & Ali, 2005, 464).
The role of Basel regulatory framework in introducing a global liquidity standard
A banking system that is strong and resilient should have strong capital requirements. The Basel Committee on Banking Supervision has also proposed for the introduction of minimum global liquidity standards. This will ensure that the banking organizations are well regulated and supervised and obliged to internalize financial risks that they create. The introduction of a global liquidity standard will play an important role of promoting a global level playing field. The committee observed that many banks across the world experienced major financial challenges due to failure to control their liquidity. Managing the liquidity prudently is important as far as proper functioning of banks is concerned. The Basel Committee on Banking Supervision issued out sound liquidity risk management principles that provided banking institutions with guidance on how to manage their risks prudently (Duttweiler, 2009, 252).
The Basel Committee on Banking Supervision intends to conduct a thorough follow up in order to make sure that the banking organizations stick to these basic principles. To harmonize these principles, the Basel Committee on Banking Supervision has developed two minimum standards for improving global supervisory consistency. The Committee proposed both short-term and mid- to long term liquidity standards. The two standards include the Liquidity Coverage Ratio and the Net Stable Funding Ratio. The main purpose of Liquidity Coverage Ratio is to enhance the banks’ strength and resilience. This standard is crucial as it ensures that banking institutions throughout the world have adequate liquid assets that could be used to offset the financial loss over short term. The committee designed the net stable funding ratio in order to enhance the bank’s funding activities with capital which is less risky. This move is crucial as it creates a good foundation for bank’s long-term solvency. In order to ensure that another global financial crisis does happen in future, the Committee held the view that, liquid assets should be qualified and unencumbered (Bradford & Lim, 2011, 72).
The role of the Basel regulatory framework in promoting countercyclical buffers
The committee also emphasized on the need to increase counter-cyclical and provisioning adjustments in order to enhance the bank’s ability to absorb shocks. The Basel Committee on Banking Supervision have stressed on the need to build cyclical buffers of resources in good times. With this regards, the Basel Committee on Baking Supervision has established a capital conservation buffer that enables the banking organizations to build up capital buffers when they are faced with financial difficulties. Banks are therefore able to expand their lending activities when economic activity is expanding and also contract their lending activity when they are faced with financial stress. During economic contractions, lending tends to be more risky and thus the Basel regulatory framework recommends higher levels of capital and preventing or slowing banks from lending. The Basel regulatory framework requires the banks to rebuild the buffer after drawing it down. In building buffer, the following actions are necessary i.e. salary bonus payments, dividend payments and reducing the discretionary distribution of earnings. According to the Basel regulatory framework, regulators should not allow banks to distribute capital as an indication of their financial strength when they have depleted their capital buffers (Underhill, Blom & Mugge, 2010, 284).
Procyclicality refers to banks’ ability to increase their lending activities during boom periods and disproportionately decrease their lending activities during recession. During recovery periods, lending is usually less risky and therefore, the Basel regulatory framework does not allow banks to have higher levels of capital. During recession, lending is usually more risky and thus, the Basel regulatory framework recommends higher needs of capital. The framework prevents the banking institutions from lending during economic contractions. The Basel Committee on Banking Supervision has introduced various measures of addressing procyclicality. The measures include the following; dampening excess cyclicality with regards to minimum capital requirement by adjusting the capital requirements over a trade cycle. The adjustment of capital requirement is aimed at ensuring that less capital is required during financial stress times than during boom (Northrup, 2003, 442).
The second measure that the committee introduced is the creation of more forward looking provisions. The Basel Committee on Banking Supervision supports the International Accounting Standards Board intentions of setting high level accounting principles that would enhance an expected loss approach (Labrosse, 2011, 353).
The role of the Basel regulatory framework in Addressing systemic risk and interconnectedness
The Basel Committee on Banking Supervision has proposed reforms to address the systematic risk and interconnectedness. An international agreement has been reached to enhance the interconnectedness and risk management of banks. The committee recognized that large financial institutions led to the global financial crisis by threatening the stability of the entire financial system. With this regards, the committee has set up measures aimed at ensuring that large financial institutions are well regulated (OECD – Organization for Economic Co-operation and Development &Publishing Oecd Publishing, 2010, 54).
The Basel regulatory framework addresses all the major risks faced by banks i.e. operational, liquidity, and interest rate, strategic and reputational risks. On reducing the systematic risks, the committee has emphasized on the reduction of reliance on credit rating agencies. The committee has designed a regulatory regime for all the financial derivatives. Also, Basel regulatory framework uses both micro prudential and macro prudential reforms in an attempt to reduce systematic risks. The Basel regulatory framework recognizes the importance of collateral, guarantees and other credit risk mitigation techniques in managing systematic risks. The Basel regulatory framework uses the supervisory review in addressing these risks. The rapid rate of innovation in the banking organizations have led to emergence of new financial transactions. The Basel regulatory framework reflects the financial innovations and risk management practices by large banks across the globe (Heffernan, 2005, 11).
In 2009, the Basel Committee on Banking Supervision published a consultative document aimed at enhancing the risk coverage as well as reducing the financial shocks in the banking institutions. The committee stressed on the adoption of stressed inputs in order to determine the bank’s capital requirement for counterparty credit risk. The committee advocated for the establishment of a well-functioning credit risk management system (OECD – Organization for Economic Co-operation and Development &Publishing Oecd Publishing,2010,54).
The current financial crisis has called for banking organizations to enhance their risk coverage. The banking organizations ignored off-balance sheet positions and commitments and this was a major factor that led to the current financial crisis. With this regards, the Basel regulatory framework has devised several reforms that are aimed at raising the capital levels for trading book exposures. Since the financial crisis began, the Basel Committee on Banking Supervision has worked together with other regulators such as the U.S federal financial regulators with an aim of increasing the risk coverage of regulatory capital framework. The Basel regulatory framework seeks to ensure that banking institutions hold sufficient levels of capital against trading book exposures. With this regards, the Basel Committee on Banking Supervision have revised its market risk framework (OECD – Organization for Economic Co-operation and Development &Publishing Oecd Publishing,2010,54).
Criticisms of Basel regulatory framework
The Basel regulatory framework has received harsh criticism form analysts with response to the current financial crisis.
According to a research which was done by Ayadi, & Resti (2004), Basel regulatory framework’s procyclicality effect works against the monetary policy. Monetary policy aims at easing credit and expanding lending with a view of reversing a contraction and tightening credit. Procyclicality on the other hand has a destabilizing effect on the economy.
The move to redefine capital does not address the issues related to estimation of capital ratio. The risk weights are usually arbitrary and the move increases the pro-cyclicality of banks does not solve regulatory arbitrage issues. Also, the introduction of a gearing ratio by the committee has a redundant effect on the capital ratio.
The Basel accords have raised several questions by policymakers. Some of the issues include the following; Basel regulatory requirement has been criticized for discriminating against developing countries. Also, it has been criticized for reducing the flow of capital to emerging markets (Singh, 2011, 12).
The Basel accords i.e. Basel 1, 2 and 3 are important as far as banking organizations across the globe are concerned. The accords are implemented by more than 150 countries throughout the world. The Basel regulatory framework is equipped with tools to adequately address the current financial crisis. Adopting the Basel regulatory framework is a major step of ensuring that the banking organizations provide a stronger capital cushion against insolvency. The Basel regulatory framework incorporates some key pillars i.e. minimum capital requirements, transparency by banking institutions, regulatory capital arbitrage among others. However, the regulatory framework has generated intense debate among analysts since its publication.
Ayadi, R & Resti, A., 2004.The New Basel Capital Accord and the Future of the European Financial System. London: CEPS.
Bradford, C. I & Lim, W., 2011. Leadership in Transition: Making the G20 More Effective and Responsive. Massachusetts: Brookings Institution Press.
Chiti, E & Mattarella, G., 2011. Global Administrative Law and EU Administrative Law: Relationships, Legal Issues and Comparison. Berlin: Springer.
Duttweiler, R., 2009. Managing Liquidity in Banks: A Top Down Approach. Hoboken: John Wiley and Sons.
Engelmann, B & Rauhmeier, R., 2011. The Basel II Risk Parameters: Estimation, Validation, Stress Testing – With Applications to Loan Risk Management. Berlin; Springer.
Heffernan, S., 2005. Modern Banking.Hoboken: John Wiley and Sons.
Hirschey, M et al., 2003. Corporate governance and finance. London: Emerald Group Publishing.
Labrosse, J. R., 2011. Managing Risk in the Financial System. Cheltenham: Edward Elgar Publishing.
Lore, M & Borodovsk, L., 2000. The professional’s handbook of financial risk management. London: Butterworth-Heinemann.
Northrup, C. C., 2003. The American economy: a historical encyclopedia.California: ABC-CLIO.
OECD – Organization for Economic Co-operation and Development &Publishing Oecd Publishing., 2010. OECD Economic Outlook, Volume 2009, Issue 2. London: OECD Publishing.
Ozdemir, B & Miu, P., 2008. Basel II Implementation: A Guide to Developing and Validating a Compliant, Internal Risk Rating System. New York: McGraw-Hill Professional.
Robbie, J. J. & Ali, P. A., 2005. Securitization of derivatives and alternative asset classes: yearbook 2005.Volume 8 of Global trade and finance series. Alphen aa den Rijn: Kluwer Law International.
Singh, R., 2011. Indian Economy for Civil Services Examinations. New York: McGraw-Hill Education.
Underhill, G. R., Blom, J & Mugge, D., 2010. Global Financial Integration Thirty Years On: From Reform to Crisis. Cambridge: Cambridge University Press.