On 1st June 2011, the Basel III standard was finalized, which is the basis for a regulatory framework aimed at ensuring that in future global banks have adequate capital as this is a critical step in averting a recurrence of the global financial crisis witnessed in 2007 and 2008. It succeeds the Basel II framework, which became inadequate in the face of this crisis (Pietersz, 2011, pp.10). According to Bank for International Settlements (2011, pp. 1), Basel III promises bilateral trade characterized by banks and banking systems that are more resilient. The capital rules captured in Basel 3 are designed to tackle the credit valuation risk, which is a risk associated with bilateral trade environments and which is such that the credit offered results in losses owing to a change in its quality. Failure of the Basel Committee on Banking Supervision to critically and adequately address this risk in the Basel 2 standard is what started and facilitated the 2008/9 financial crisis.
The 2008/9 global financial crisis also known as the global recession or the credit crunch is the worst financial crisis to hit the world in recent history. The crisis created a situation where banks and other lending institutions reduced credit-lending activities, as the credibility of borrowers to repay the credit had become increasingly questionable (BBC, 2011, pp.43). By its end, the crisis had wrecked known financial institutions, depressed stock markets (Shah, 2011, pp.1) around the world, and as an action plan to deal with it bailouts were arranged for borrowers who were the worst hit by the crisis e.g. U.S’s car industry. Bailouts are financial arrangements such that borrowers facing bankruptcy s are financially rescued from it (BBC, 2011, pp.10). Bailouts are implemented in several ways. One way of implementing a bailout is through loaning a borrower whose credibility to repay is highly questionable among lending institutions in the market. This was the apt option for tor the U.S government to save major companies in the country’s car industry who were hit very hard by the crisis (BBC, 2011, pp.11). Not only did the crisis result in financial harm to economies it equally caused emote tonal harm to people in that homeowners through mortgages (or certain other credit arrangements) lost their homes.
The starting point of the crisis was the U.S where a number of issues combined led to problems invalidity and liquidation, which is what triggered the crisis (Wikipedia, 2011, pp. 2). One of these issues was the high credit valuation risk associated with credit products such as loans, mortgages, etc that were being offered before the crisis hit. Another issue was the complexity in the financial credit products being offered by lending institutions to individuals. The complexity hid the high level of risk associated with the credit services being offered at the time. Another issue that contributed was existing conflicts of interests inside financial institutions and stock markets. Another issue was a failure by financial regulators who having sufficient information failed to formulate mechanisms in time to avert the crisis. These show a lack of critical thinking, ethics, and insight from these experts.
Credit rating agencies also contributed to the actuation of the crisis as they failed to help in setting the limit on the credit products to be offered. For instance, the mortgages being offered by lending institutions carried with them a very high level of risk, however, credit rating agencies did nothing to prohibit and discourage the issuance of such products and failed to enlighten the government on why it should confirm its regulatory practices to match those of the mortgage market of the 21st century. Again, this shows a lack of critical thinking, ethics, and insight from the credit rating agencies.
Assessing the approach
Capital rules of the Basel 3 standard
In Basel 3 standard, the Basel Committee on Banking Supervision (BCBS) agreed on a 2% increment in the level required for tier one capital (Pietersz, 2011, pp.10). Previously the required level for tier one capital was 4%, however, with Basel 3 this rose to 6%. Additionally, in Basel 3, the Basel Committee on Banking Supervision also agreed on a 2.5% increment of a bank’s common equity (Pietersz, 2011, pp.10). Previously the required common equity was 2%, however, with Basel 3 this figure rose to 4.5%.
Another capital rule in Basel 3 is that banks additionally acquire a further 2.5% common equity on top of the 4.5%, which will be specifically for use as a conservation buffer (Pietersz, 2011, pp.10). Another increment agreed on by the Basel Committee on Banking Supervision in Basel 3 standard is the counter-cyclical buffer for banks to be raised by a value ranging between 0% and 2.5% (Pietersz, 2011, pp.10). Taking into account the increments in conservation and counter-cyclical buffers proposed in Basel 3 the total bank capital is increased by 1.5% in an effort aimed at discouraging banks from issuing credits on capital bases founded on Basel 2 or Basel 1 (Pietersz, 2011, pp.10).
Addressing the capital adequacy for banks in the Basel III in such a way that they hold more capital and own assets they can easily liquidate is a step that the BCBS believes will be effective in countering the effects of the credit valuation risk, which was at the epicenter of the 2008/9 financial crisis. According to Elliott (2010, pp.1) the Basel 3 standard will bring about a situation whereby banks are more liquid and hold more capital than was the case, and as such operating costs will be higher which in turn will make loans and other credit services expensive. The resultant effect of these is that banks will reduce lending activity and thus, loans and other bank credit products will not be the preferable choice for borrowers.
Capital is the fraction of the assets of a bank which it fully owns and which it has set aside to mitigate the effects resulting from a decline in the value of its other assets and/or an incline in its liabilities (Elliott, 2010, pp.1). As discussed above the restrictions imposed by the Basel 3 standard require that the minima for common equity Tier 1 and Tier 1 capital be raised to 4.5% and 6% respectively. The restrictions also require that the minima of the total capital, which is the sum of Tier 1 and Tier 2 capital be raised to 8.0%. Liquidity with respect to a bank refers to the ease in which the bank can convert its assets to cash (Elliott, 2010, pp.3). If faced with a situation similar to that of the 2008/9 financial crisis banks have a strong capital base and/or assets which they can liquidate pronto and bail themselves out of the crisis.
Sufficiency of the Basel 3 standard
The Basel 3 standard will avert a recurrence of the 2008/9 financial crisis in two ways. The first being that by raising banks operating costs it will discourage them from issuing credit services and the second being that banks will be properly cushioned from the credit valuation risk. The Basel 3 standard discourages banks from issuing credits on Basel 2 and Basel 1capital bases as such financial activities lead to lower ratios, which is an outcome that frustrates economies trying to pull out from the 2008/9 financial crisis. It achieves this mainly by raising the capital adequacy requirements for lending in banks.
A factor taken into account in the Basel 3 standard is addressing capital material risks such as counterparty credit risk. In Basel 1 and Basel 2, capital material risks were not factored in and therefore the standards were powerless in the wake of the 2008/9 financial crisis. To deal with capital material risks the Basel 3 standard proposed a number of recommendations. One of the recommendations is that the capital requirement for banks that is specifically for containing the effects of material risks should be calculated using strained inputs. By determining its capital requirement in this manner pro-cyclicality is avoided as witnessed in the 2008/9 financial crisis. Another proposed recommendation is that banks impose what is known as a capital charge, which is a fee that helps bank cop with a decline in the quality of its credits.
Another proposed recommendation is that banks impose what is known as a Pillar 1 capital charge, which is a fee that helps bank cop with wrong-way risk. The wrong-way risk actuates when a bank’s credit activities with its counterparties do not bear the desired yields. Another proposed recommendation is that banks use a multiplier value of 1.25 in determining the asset value correlation (AVC) when dealing with the exposures of financial firms with assets with a value of at least $25 billion. Using this multiplier will relatively relieve banks of the weight of dealing with risks associated with such exposures. Another proposed recommendation is that, when banks are determining their regulatory capital with a counterparty who has derivative exposures that are large and illiquid their are to use longer marginal periods. Another proposed change is that, for certain centralized exchanges banks will be able to enjoy zero risk weight. In this way, banks will be encouraged to use centralized exchange rates in its credit dealings with its counterparties.
The Basel Committee on Banking Supervision identified excess leverage as facilitating further credit crisis and thus in the Basel 3 standard proposed that banks use a leverage ratio (Blundell-Wignall and Atkinson, 2010, pp. 9). The leverage ratio is a means of monitoring the amount of leverage pumped by a bank as means to realize steadiness in the face of a credit crisis. The leverage ratio in effect therefore enlightens a bank on when to stop or how to limit its leverages against credit crises. The leverage ratio is computed taking into account a bank’s Tier 1 capital, which as discussed comprises of two categories, namely, common equity Tier 1 and additional Tier 1.
In addition to this the leverage ratio takes into account a full treatment of exposure net provisions, which include cash and instruments that generate cash (Blundell-Wignall and Atkinson, 2010, pp. 9). A special case in the calculation of the leverage ratio is the inclusion of specific off-balance sheet exposures. The inclusion is such that the credit conversion factor applied in the conversion of this exposures is of 100% (Blundell-Wignall and Atkinson, 2010, pp. 9). The Basel Committee on Banking Supervision proposes that to realize and maintain a healthy leverage ratio the collateral held by a bank should not be netted. In addition to these, derivative exposures in the off-balance sheet should also not be netted.
The Basel Committee on Banking Supervision identified pro-cyclical factors as playing a key role in the worsening of the 2008/9 credit crisis (Blundell-Wignall and Atkinson, 2010, pp. 9). The pro-cyclical factors identified result from a number causes (Blundell-Wignall and Atkinson, 2010, pp. 9). One of the causes was market-to-market accounting and loans that were held up to their maturity. Another cause was margining practises that were currently being practised. The other cause was build-up to excess levels of leverage and the negative impact this had on all participants in the affected financial markets. To deal with pro-cyclicality the Basel Committee on Banking Supervision made a number of recommendations (Blundell-Wignall and Atkinson, 2010, pp. 9).
One of the recommendation is that in creating a model for risk, the probability to realize a default outcome is calibrated on a long-term basis. In special cases the Basel Committee on Banking Supervision recommends a supervisory override using Pillar 2. Another recommendation made by the committee is that banks should not confine themselves to the regulatory minimal limit for holding buffers previously recommended but should do so surpassing this limit. The idea behind this recommendation is that when faced with another credit crisis banks still have sufficiently large buffers that offer a cushioning effect against the depression caused by the crisis. In addition to this, large buffers also ensure that banks do not spend on buying back buffers allowing for the money that would have been used to be channelled to other credit-crisis mitigation activities. Another recommendation by the Basel Committee on Banking Supervision is that the buffer system be implemented in a framework that is macro-prudential. Implementing it in this way ensures that credit growth is normal and financially healthy for banks and for all parties involved in a credit dealing.
Other Strengths exhibited by the Basel 3 standard
A strength exhibited by the Basel 3 standard is that it exhibits a lot of insight into the causes of the 2008/9 financial crisis. Its insight is captured on its use and implementation of the concept of integration of knowledge (Clemens, 2004, p.4). Knowledge integration is evidenced by the fact that it’s an advancement of the Basel 2 standard. By achieving knowledge integration, the Basel 3 standard helps individuals and/or lending institutions to; first, make use of available knowledge to formulate solutions to address future credit crisis or challenges that they may face during growth (Clemens, 2004, p.3). As mentioned above, there was a failure by financial regulators to use the information available to them to avert the financial crisis, however, this is made up for in the Basel 3 standard. Secondly, knowledge integration helps to expose underlying assumptions and inconsistencies through reconciling conflicting ideas (Clemens, 2004, p.5). As mentioned above, one cause of the 2008/9 financial crisis was the complexity in the financial credit products being offered by lending institutions their borrowers. Through knowledge integration this is exposed and dealt with in the Basel 3 standard.
Thirdly, knowledge integration helps an individual or organization to identify effectively areas with incoherence, uncertain and in disagreement, which it does his through synthesizing different perspectives (Clemens, 2004, p.6). Finally, by weaving different ideas together knowledge integration achieves a whole that is better than the total of its part (Clemens, 2004, p.7). Knowledge integration is the way of ensuring improvements in the quality of credit products issued by banks to its borrowers and counterparties thus the Basel 3 standard is effective in lessening the risk of a recurrence of the 2008/9 financial crisis.
Another strength exhibited in the Basel 3 standard are the elements of critical thinking. Critical thinking is exhibited in the Basel 3 standard as it identifies the causes of the 2008/9 financial crisis for which it formulates very formidable solutions. Critical thinking skills exhibited in the Basel 3 standard are aimed at helping an individual and/or banks ( and other certain lending institutions) act purely objectively and rationally (Kurland, 2000, p.1). According to Kurland (2000), the characteristics of critical thinking are rationality, self-awareness, honesty, open-mindedness, discipline and judgment. Clearly, a sense of objectivity and rationality is important in the complete implementation and realization of Basel 3 standard. This is so putting in mind that by the time the 2008/9 financial crisis hit, banks and other lending institutions had not fully implemented the requirements of the Basel 2 standard. In addition, from the causes of the crisis it has been seen that financial experts and credit rating agencies were lacking in critical thinking and thus were unable to pre-empt or formulate action plans for the crisis that was building up.
Another strength exhibited by the Basel 3 standard is its appeal to banks and other lending institutions to exhibit ethics and to adopt an ethical decision making model in their credit activities. The inspiration behind the Basel 3 standard is that it leads to the creation of a framework that averts a recurrence of the financial crisis, which can cause both financial, economic and emotional harm. Therefore, it is a standard that inherently appeals for a high code of ethics and adoption of ethical decision-making models in banks and other certain lending institutions. Ethics are the principles by which you decide what is right and wrong.
Ethics form the basis on which a person or an organization determines which action is fit to take as a response to the various situations, which they encounter (Markkula Center for Applied Ethics, 2010, p.2). Ethics constitute the standards of behaviour that promote proper coexistence in a community or a society (Markkula Center for Applied Ethics, 2010, 2). It is the case that a decision making process founded on ethics promises good decision making which is important in building a strong partnership. It is therefore imperative for an ethical person or organization to match its standards with a proper ethical decision making model. Examples of ethical decision making models as given by Wellington (2009) include the Resolved Method by Jonathan Kranky, Laura Nash’s Twelve Questions, Michael McDonald’s A Framework of Ethical Decision Making and Thomas Bivins’ The Ethical Worksheet among others (pp.1).
Shortcomings of the Basel 3 standard
In as much as the Basel 3 has made improvements it has failed in addressing successfully some fundamental problems. One of the problems that Basel 3 has failed to address successfully is in its model framework (Blundell-Wignall and Atkinson, 2010, pp. 11). The model framework for Basel 3 is based on the assumption of invariance in bank portfolio, which leads to more linearity in the model a case that is undesirable. Another of the problems that the Basel 3 has failed to address successfully is regulatory and tax arbitrage (Blundell-Wignall and Atkinson, 2010, pp. 12). The Basel 3 standard does not relieve borrowers of taxes but rather permits the ongoing practise where banks and other lending institutions maximize returns on the expense of borrowers to continue. The third problem that the Basel 3 has failed to address is the need for more capital. Basel 3 is requires that banks raise their capital adequacy as means towards averting future credit crisis. This is a burden for banks especially those that are trying to pull themselves out of the credit crisis.
From the discussion above, it has been seen that the Basel 3 standard has strengths as well as weaknesses. However, when you consider its recommendations it is clear that it leads to the creation of a formidable framework that can deal with future credit crises. However, considering its weaknesses this essay recommends that in order for it function optimally its imposition allows for continuous quality improvement since in this way its quality as a credit crisis prevention standard will be improved. In other words through continuous quality improvement it will not become obsolete in the face of future financial credit crises like its predecessor the Basel 2 standard.
Continuous quality Improvement refers to the formal approach applied in analyzing performance as well as improving it (Duke University Medical Center, 2005, p.1). Considering that financial institutions have their interests and those of its partners at heart, it is important for it to develop financial products that meet the set standards. As this is important in avoiding any possibility of failures occurring that are likely to take the institution down together with its partners and clients. Thus, it is very important to undertake continuous quality improvements in their financial products. The Failure Mode and Effect Analysis (FMEA) is one underlying concept of continuous quality improvement (Black, 2002, p.25).
FMEA is an abbreviation for Failure Modes and Effect Analysis. FMEA is an analytic activity carried out on a product, service or process in order to know its strengths and weaknesses, deal with a potential problem before it occurs and ensure that it meets the set requirements (Black, 2002, p.25). FMEA has its origin at the National Aeronautics and Space Administration (NASA) in the USA where it was used as a risk analysis and mitigation technique, however more recently; it has become widespread in industries being used to attain process improvement. FMEA is a vital tool for project teams and companies as a whole and who are faced with questions like how a failure can occur, the effect of such a failure on a system and what actions can be taken to counter such potential failures if they happen (Dovach, n.d., pp.1). It provides a suitable approach to developing remedies to these questions. In as much it is used in engineering fields it is a concept that can be borrowed in the financial arenas.
The functions of FMEA include, first, it predicts design or process related failure modes and by doing so, it works to ensure that set requirements for a process or product are met. Secondly, FMEA tests and finds out the effect and severity of a given failure mode. Thirdly, FMEAs pin point the cause and works out the probability of occurrence of a failure mode. Fourthly, it identifies a control and weighs its effectiveness; it quantifies each associated risk and ultimately arranges the risks in order of priorities. Finally, it develops and documents action plans that appear to reduce the risks involved (FMEA-FMECA.com, 2010).
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