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Running Head: Basel III and Risk Management

Basel III and Risk Management in Banking

Baitshepi Tebogo Institute of Development Management, Botswana btebogo@idmbls.com

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

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

Basel III and Risk Management

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

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

Basel III and Risk Management 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 (CoPierre, 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

Basel III and Risk Management

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

Basel III and Risk Management

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

Basel III and Risk Management

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.

Basel III and Risk Management 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 banks 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.

Basel III and Risk Management

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

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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

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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

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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.

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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).

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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.

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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.

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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 (BlundellWignall, & 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.

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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