This action might not be possible to undo. Are you sure you want to continue?
Basel II: A Review of Literature
By Saurabh Malik
Student No. 0954187
University of East London May 4th, 2010
Conclusion -----------------------------------------------9 4. Contents 1. Literature Review ---------------------------------------4 3. Abstract----------------------------------------------------3 2. References------------------------------------------------10 .
thus.K. The study will take into consideration some of the important aspects like Retail and Small & Medium Enterprises. the flow of money in Emerging Economies (EMEs). In this paper. I will analyse the implications of Basel II in different sectors of the international banking organization. INTRODUCTION Basel II is the International Convergence of Capital Measurement and Capital Standards: a Revised Framework which offers a new set of international standards for establishing minimum capital requirements for banking organisations. is to provide improved risk management practices in International banks. the cyclicality effects in U. Commercial Banks. banks and finally the effectiveness of Basel II in the recent financial crisis all of which will evaluate the effectiveness and the complexities of Basel II in the current scenario. operation risk and market risk) Pillar 2: Risk based supervision (supervisory review process) . The explicit objective of Basel II. BASEL II ABSTRACT The implementation of the second of the Basel accord (Basel II) has been a crucial debate around the world. This objective can be achieved through 3-pillars:Pillar 1: Risk based minimum capital requirement (credit risk. Last section will show the conclusion based on the findings.” 1. International Competition Effects in European and U. Credit Card Industry.S. The methodology used in this paper is the critical review of different literature and journals published during the last few years. Basel II is developed to form relationship between capital and risk. The main purpose of New Basel Capital Accord (or Basel II) which was approved by Basel Committee on Banking Supervision (BCBS) in June 2004 is “to build a structure with greater flexibility and sensitivity to risks and to evolve the practices of supervision and risk management.S. the U. the Home Host implementation issues.
Another objective of Basel II is to create more future oriented policies which can easily grow. In the past few years. It is sometimes also argue that Basel II is better than Basel I because of its more risk focused nature in different approaches like standardised approach. only some big firm are using the ratings by some official international agencies. In this paper. LITERATURE REVIEW An important study of Basel II and its international competition issues was made by Gottfried Haber (2007) in which the author highlights some issues which are important to consider on effects of competition of the new capital accord. However these advanced approaches may not be suitable for many international banking systems due to their differential goals. the new Basel accord is a set of three pillars therefore it will not be considered as implemented fully if any of the three pillars is missing. The comparison between European and US bank lending are based on the type of rating system followed in each country. Pillar 3: Improved disclosures (market discipline) 1 See Elizabeth de Almeida Neves Di Beneditto. For example. The author strongly recommends . Thus. the external ratings are common is US whereas in Europe. But this Internal Rating Based (IRB) approach may not necessarily follow the standardized regulatory framework which is developed by Basel II for their risk assessment system. I will review some of the important literature about the implication of Basel II. the risk management practices and the role of supervisory agency. This can be accomplished through risk management rules followed in banks. The global competition effects are important as European countries are following Basel II quicker where as US is still having doubt about its implication. foundation approach and advanced approach. For example. Basel II has been highly objected for its complexities. the governance of bank. Due to the lack of external rating structure the banks in Europe have initiated a rating system internally since last 20 years because of the “risk transformation” which is a main revenue source for banks. Accord (Basel II) – A multiple case study. in many countries the objective of the banks are to improve their legal and accounting standards. Dec 2008 The credit risk and minimum capital requirement are the crucial element of Basel II along with market risk and operational risk. Banks are managing themselves more widely on business lines without giving proper care to legal entities.
there also exist location differences in the banks and supervisors within or outside G-10. The “fifth quantitative impact study” (QIS 5). there exist a huge difference between the complexities of big international banks and the smaller banks. so it is difficult to say which banks will be more sufferer i. Under Basel II. the capital requirements may vary with the change in economic conditions i. The host country has legal responsibilities which should be recognised. As a result of Basel II. The other cost which author consider is the one time cost of implementation for commercial banks but this may not affect much to both the European and the US banks. European or US. This is because of the lower minimum capital requirement in Standardised Approach which is similar to the minimum capital requirement of Basel I accord. The third reality considers growing diversity between the banks and their legal structures that are supervised under law. The host countries are required to depend upon home country because of the centralized analytics andrisk management task. With this the Bank of England emphasizes the cyclical variability of capital requirement for entire UK banking sector but the Financial Services Authority (FSA) focus on the individual bank’s . The Accord Implementation Group (AIG) is the first for the Basel committee and it has extended the arrangement of home-host cooperation. Secondly. The Basel committee never considered a “one size fits all” approach of Basel I will keep developing on. home countries are to rely on the host countries in order to measure the validation of locally applied Basel II analytics and data. This may result in increase in the sensitivity of supply of credit. James Benford and Erlend Nier (2007) in their literature has analysed some evidences on the cyclicality of Basel II capital requirements in UK banks. The impact of the new Basel II will thus be very limited.e. Similarly. IMF and World Bank are accessing the countries who want to implement Basel II.e. Basel II may also reduce interest rate distortions thereby improving market efficiency but it is only possible if Basel II is globally accepted and implemented. Basel II as an incentive for banks. However the benefits of the high quality of the risk management may equally affect both the banks. The author explains this divergence through home-host implementation problems. There are also structural differences in terms of borrowers in both the countries. First. low in boom period and high in recession. the relation between the host and the home countries is changing. shows that the minimum capital requirement remained same for most of the banks. For this reason. so the new framework is likely to be followed by many countries through different approaches. Nicholas Le Pan (2008) talks about three main realities which BSBS was facing in implementing Basel II.
Simon Hayes & Victoria Saporta (2002) have studied the impact of Basel II on the supply of capital in Emerging Market Economies (EMEs). during economic . However. Unlike Basle I where capital charges are based on the borrower’s domicile in OECD or non-OECD region. credit card industry reveals that the bank issuers that follow Basel II capital regulations (Basel II banks) will have no competitive effects during normal economics conditions. Secondly. However. Basel II explicitly measure capital charge to credit risk through external (Standardized Approach) or internal (Internal Rating Based) approach. The regulatory charge of lending to EME will fall. They call it as ‘economic capital’ which is associated with the credit quality of the bank’s assets. Under Basel II.6% charge for shorter term loans). Basel II could also reduce the distortions lending patterns (like 8% charge for longer term and 1. the foreign bank participation in EMEs by establishing branches or purchasing subsidiaries will raise a question which approach will be used. the unintended effects of Basel II can be avoided by the industry and the market participants if banks do careful consideration in capital planning by holding a voluntary buffer capital over the minimum requirement and if the market participants make a careful scrutiny of bank’s rating system. the authors argue that banks themselves want to keep a sensible amount of capital stock in order to prevent them from unexpected losses. A joint study made by William Lang. domestically owned banks will follow standardised approach for which capital charge for lending to EME will not be affected. The lending through international banks will clear the OECD effect and maintain a clear relationship between credit quality and regulatory capital. Loretta Mester and Todd Vermilyea (2006) about the competitive effects of the regulation of Basel II capital on U. They criticized the argument that the new Basel accord will increase the lending cost to low credit quality borrowers in EMEs thereby curtailing the supply of credit. The loan prices largely depend upon the cost of economic capital and thus will be unaffected by the regulatory capital change. The use of internal ratings for minimum capital requirements in Basel II improves risk sensitivity and provides improved risk management. As far as domestic lending is concerned. However. However. also generates the risk by making the capital requirement more cyclical with economic conditions. capital adequacy.S. Since international banks have adopted IRB approach. the credit quality of a loan portfolio depends upon the international banks regulatory capital which implies that the capital charges to lend to the borrowers will be expensive. The literature suggests that the output of retail and corporate rating of UK lenders is expected to vary with the change in market conditions. the new accord will affect the lending to EMEs internationally and domestically.
They argue that R&SME has got important place under Basel II because of the smaller exposure to systematic risk. The authors use the regression models to evaluate that higher capital requirements under Basel II are possibly to be binding due to a possible increase in bank’s estimated risk parameters like possibility of default (PD). if the regulatory constraint has a significant impact on credit card portfolio. first. create the retail distribution of credit loss. They use the data from the loan portfolio of two Swedish Banks (bank A and bank B) to evaluate the Basel II implications. They use the non-parametric Monte Carlo re-sampling method which follows the approach of Carey (1998) on two banks’ entire portfolio to prove their theory. the Basel II capital constraint can be avoided by transfer of asset to the nonbank parent. They found no such empirical evidence through their sampling model. and credit portfolios of corporate and then evaluate the economic capital required which is maintained by these distributions. . downfall in credit card portfolios there are more chances of Basel II banks to face a competitive disadvantage as compare to the banks that operate under Basel I capital requirements (Basel I banks) and to nonbank rivals. Their main purpose was to study if the difference in the treatment of “other retail” credit and SME loans in Basel II is supported by the real loss distribution in their data. The same results were seen for retail credit. Basel II could create competitive advantage only if the minimum capital regulatory is “binding” i. They. that normally issue credit card loans through Credit Card Speciality Banks (CCSB). Their study criticizes the assumption of Basel II regulation that SME and retail loans portfolio depicts smaller losses than corporate loan portfolio which owes a smaller dependence on systematic risk factors. On the other hand. Basel II regulatory capital cost may not have a direct or indirect impact on the regional banks (with assets of more than $1 billion) and community banks (with assets of less than $1 billion) because of less competition of these banks in credit card market. Thus they could benefit if the bank competitors face a rise in the amount of capital requirements. As far as non bank credit card issuers are concerned. loss given default (LGD) and exposure at default (EAD) during the downfall periods. Basel I banks may not face this binding constraint but they do need to face high level of market and supervisory requirements in case of poor performance of their portfolio. SME. risk weight function of Basel II emerges to be only moderately successful corresponding to the actual rates of loss computed in their data. Jesper Linde & Kasper Roszbach (2005) explains the Basel II with its implication on Retail and Small & Medium Enterprises(R&SME) credit. This will result in more use of relatively cheaper Tier-2 capital.e. Moreover. In this literature Tor Jacobson.
It resulted in an underestimation of the potential for loss and eventually this led to a major U. The problem arises if the supervisor in the parent country approves the adoption of IRB approach but the host country’s supervisory capacity may allow it to adopt standardised approach thus leading to home-host implementation problem. This may create adverse impact on domestic market operation.e. It fails to examine the capital adequacy outside the banking system during unlikely or unidentified events for which there in no historical data. One such study was made by Jeffery Atik (2009). This literature emphasizes a reconstruction of international banking framework i. However. However. defaults were less due to positive economic conditions and the rise in housing prices helped the borrowers to come out of any difficulty by selling the assets. I will conclude that Basel II is costly for banks to raise additional capital in case of unfavourable market conditions and when it requires quick action.S. I will discuss the ability of Basel II to react to the recent global financial crisis. In case of U. the remaining one percent may result in more serious losses as in the case of recent global financial crisis. the study also reveals that some banks were successfully managed to get additional capital from the national or international organisations in their role lender of last resort. These incidents explain the need of far more capital required by banks than the minimum standards under Basel II. The assumption of Basel II that . Basel II optimizes a set level of capital adequacy requirement which is only a ninety nine percent survival system. The BCBS does not have a proper answer about the actual amount of additional capital require to fight against for such low probability high impact events. This is because during the housing boom. The main concern is that the extent of losses which arise due to the unexpected events should also be considered along with the frequency of events. mortgage loans. the prediction of defaults on mortgages was based on the prosperous times which underestimated the risk. He argues that the new capital accord focus only on the risk faced by individual banking institution which are based on the risk estimation of historical data. The same was true with the loss given defaults which remained underestimated. The assumption of correlation of asset performance is not true in Basel II framework under extreme financial crisis.S. Now. The regulation of Basel II is difficult to implement on a bank with cross-border operation. Basel III which should also include those possibilities that are not suggested by the historical experiences or may be found outside the chosen period. subprime crisis. CONCLUSION Thus after careful review of the different literatures.
credit card industry which depends upon the nature of regional and community banks. the distinction of OECD and non-OECD region is welcomed in Basel II by following the new IRB approach. In U. The compliance of new Basel accord is expensive and complex with inefficient supervision in some countries.S. it will improve the risk sensitivity and better risk management. The affect of Basel II on the supply of capital in EME will also be negligible. It takes into consideration the minimum capital require for expected events but leave the scope of capital low probability high impact events. Moreover. The new accord only highlights the risk estimations of the individual banks based on the historical data and it does not take into account the possibility of unexpected event. However. banks market also we can conclude that with the IRB approach. Similarly the new capital accord will have very nominal impact on the U.S. Still the question arises is there a need for a revised Basel III? How well the banks can perform by adopting Basel II? These questions remained unanswered until Basel II is implemented globally. R&SME loans portfolios are less risky than corporate loans is also not valid as the no results have been received by empirical evidence. thus underestimates the potential loss. The new Basel accord will rather closely linked economical capital to the capital charges. and European banks will lead to reduced interest rate distortions.K. on the positive side the improved risk management along with improved market efficiency in U. .
No.bankofengland. MESTER & TODD A. Financial Markets.rbi. “Competitive Effects of Basel II on U. February Published by: Blackwell Publishing.S.pdf SIMON HAYES & VICTORIA SAPORTA.pdf?page=1 JEFFERY ATIK. Bank of England Financial Stability Paper No. Inc.uk/publications/fsr/2002/fsr13art4. and DAVID LODGE.co. LORETTA J. Financial Industry and Regulation Division. Journal compilation New York University Salomon Centre.gov/bank/analytical/cfr/2006/sept/VermilyeaT TOR JACOBSON.3 December 2007.co.uk/publications/fsr/fs_paper03.asil. May 2006. Bank Credit Card Lending” Available at: www.com/content/p046448834m301h4/fulltext.pdf . Available at: http://www.pdf WILLIAM W. & COMTEMP. Basel-II: International Competition Issues.in ELIZABETH DE ALMEIDA & NEYAES DI BENDITTO Accord (Basel II) – A multiple case study. References: http://www. Published online: 30 November 2007# International Atlantic Economic Society 2007.bankofengland. V. Available at: http://www. __ (2009 forthcoming). JESPER LINDE & KASPER ROSZBACH.org. LANG. 2005 Available at: http://www. 1. “Basel II: A Post-Crisis Post-Mortem” 17 TRANS.org/files/atik. 17. Credit Risk versus Capital Requirements under Basel II: Are SME Loans and Retail Credit Really Different? Journal of Financial Services Research. “Remarks on Basel II” The Authors.springerlink.pdf?page=1 NICHOLAS LE PAN. L.springerlink.2008 JAMES BENFORD & ERLEND NIER. VERMILYEA. “Monitoring cyclicality of Basel II capital requirements” Available at: http://www. Bank of England. Financial Stability Review: December 2002 – “The impact of the new Basel Accord on the supply of capital to emerging market economies” Available at: http://www. PROB. International Finance Division. Institutions & Instruments.com/content/f7741v12348t1qx1/fulltext.fdic. Dec 2008 GOTTFRIED HABER.
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue listening from where you left off, or restart the preview.