Basel III framework Bank Regulation

The Basel Commission on Bank Regulation has the job of overseeing the effects and dynamics required for reforms in order to assess the impact of the newly designed Basel III framework. Basel III suggests stricter capital and liquidity regulations for the purposes of this paper in order to avert another financial calamity. Risk management and governance are two of the framework’s sections. As a result, the study describes four significant risks that financial institutions failed to manage before to the 2007-2008 global financial crisis (Claessens & Kose, 2013). The second section examines risk measurement and management strategies. Lastly, the paper will analyze the changes employed by four Australian Banks as a consequence the GFC, by taking into consideration the Basel III framework.

Major risks and Management Methods

Systemic Risk and Interconnectedness

Systemic risk is the risk associated with the breakdown of an entire system rather than an autonomous of single banks or financial institutions. According to Orbis (2017), interconnectedness with the financial system also contributed to the crisis. On a crisis perspective, it captures the cascading failure of U.S financial sector which was caused by the interlink-ages with the financial system, leading to a worldwide economic meltdown. Systemic risk focus danger on the entire financial structure. Therefore, the consequence of a systemic financial crisis are more devastating as seen in the 2007-2008 global financial crisis (Claessens & Kose, 2013). According to Basel III, there are four key elements that explain systemic risk and they include:

Endogenous risk – This is the risk created within the financial system rather than workings of the outside forces.

Amplification mechanisms- This is the occurrence of systematic crisis, frequently caused by a small event, whose influence is intensified by the weakness of the existing financial framework.

Policy responses: Failure of regulators to focus on factor s and policy initiatives that reduce systemic risk can result in great economic downturn as seen in the 2007-2008 crisis.

How Basel III Addresses this risk

To solve systematic risk problems, Basel III and FSB have developed a well-integrated approach that includes a combination of contingent capital and bail in debt. It recommends the use of a combination of qualitative or/and quantitative indicators that measure the systemic standing of managing risk faced banks globally (Koulafetis, 2017). Also, the committee came up with a strategy known as the magnitude of additional loss absorbency, a system of global recognized financial institutions that regulate the various financial instruments. Other proposed techniques to mitigate risk includes liquidity surcharges, larger exposure restrictions and enhanced supervision. Among other techniques formulated by the Basel committee includes provision of capital incentives for banks that use counterparties especially with respect to over the counter derivatives (Koulafetis, 2017). Also, the committee addressed the issue of higher capital stipulations for derivatives activities and inter financial sector disclosures. The committee introduced minimum requirements that ensure penalizing of unwarranted dependence on short-term and inter-banking backing that supports longer dated assets.

High market and Liquidity Risk

There are two kinds of liquidity risks namely market liquidity and funding liquidity.

Banks finance their balance sheets by use of equity capital and deposits. However, these source became scarce during the crisis. The crisis was triggered by the bursting house bubble and therefore, this led to significant bank losses associated with lack of liquidity to fund these assets. Therefore, as the bank’s balance sheet had to de-lever, they had to start selling assets and hoarding cash (Skoglund & Chen, 2015). Strains in interbank money markets and other similar market’s liquidity risks were considered as the instigators of the financial disaster. This was caused by a rise in volatility across major asset classes, mostly cost of homes. The uncertainty due to credit losses as well valuation of certain products caused vulnerability in financial institutions. Investors had to sell assets to meet funding requirements make it.

Bank’s liquidity problems quickly spread especially those financial institutions that relied on hedge funds as banks become less willing to lend. Banks such as Lehman were considered too big to collapse. Unfortunately, Lehman brothers collapse 6 months later. This was not the case. The funding liquidity crisis led to market illiquidity and investors were scared to invest, leading to drop in prices. Eventually, the crisis spread to other asset class and to Main Street (Horcher, 2013).

Graphical Representation of Liquidity risk

Basel III’’s Strategy to mitigate Liquidity risk

According to Obis, funding swiftly dried-up and money was short in supply. To solve this, the Basel framework came up with a a minimum liquidity standard that made banks more strong and immune to such crises, especially in accessing funding and long-term operational liquidity (Robertson, 2016). More so, the Basel III framework came up with the net stable funding ratio (NSFR) which delivers long-term structural alterations and provides incentives to banks and thereby providing an assurance of reliable funding (Skoglund & Chen, 2015). The charter also came up with a set of monitoring metrics that identifying and monitor liquidity risk in both the financial structure as well as the specific banks.

Management Methods

Risk Management and supervision - Basel III recommends that investment and liquidity bottom lines should be associated with efficient risk-management techniques and regular monitoring. This is imperative in a set up whereby there is continuous financial innovation. For instance, the committee conducted a pillar two review procedure that addresses weaknesses exposed in banks ‘risk management set ups. Some of the issues addressed includes firm wide governance, risk of off-balance sheet exposures and sound compensation practices (Horcher, 2013).

Corporate Governance - Following a public consultation, BASEL III issued a set of doctrines that develops efficient corporate governance practices in banks and other financial institutions. These principles address fundamental deficiencies that became apparent during the financial crisis. These principles however should be in line with the national laws, regulations and codes.

Credit Risk

Credit risk is the essential and core risk for commercial banks and other lending financial institutions. It is widely accepted that the crisis was caused by poor risk management practices relating to issuance of debt. Credit risks were not properly managed by banks which ultimately led to increase in structural bankruptcies, disintermediation, increased competitive margins leading to over-lending and decline in values of collateral (Chudik & Fratzscher, 2012).

Management Methods as Recommended by Basel III

Basel III came up with Mandatory disclosure requirements which allowed market participants to assess capital adequacy as well attain the set minimum requirements. Secondly, it came up with a regulations that ensure capital allocation is more risk sensitive. Another technic was to align economic and regulatory capital to reduce the chances of capital inadequacy of a commercial bank (Golin, 2010). Thirdly, there was introduction of maintenance of regulatory capital which calculated the major components of risk and measures them using the standardized approach and internal rating base approach. In the standardized approach, the bank is required to allocate a risk-weight to each asset and then produce a sum-of-risk of weighted assets. Individual risk weight depends on a broad category of borrowers such as sovereign, other commercial banks and corporations. On the other hand, the IRDB approach allows the bank to use its own internal estimates such as checking the borrower’s credit worthiness. However, distinct analytical frameworks are provided so that the company can adhere to the set methodological and disclosure standards.

More so, the Basel Committee came up with techniques to quantify credit risk, operational risk and market risk. Basel III introduced new capital and counter-cycle buffers. For instance, the new framework ensures that that capital charge and conservation buffer was set at a minimum of 2.5 percent. Also, the new leverage cap is set at 3 percent. A new capital definition was formulated whereby it was divided into tier 1 capital, tier 2 capital and tier 3 (Apostolik & Donohue, 2015). Tier 1 providing the stipulations on the going concern capital that ensures solvency of institutions. Tier 2 entails concerns repayment of deposits and debt while tier 3 was recently eliminated. The essence of classification of capital on this basis is to upsurge the quality of the capital; thereby eliminating credit risk.

Operational Risk

The Basel III definition of operation risk, is the loss resulting from failed internal process. This type of risk stems from varied causes such as transaction and execution errors and improper business practices, technology failures, personnel issues, among others. Operational risk could be in the form of internal fraud, external fraud, rogue trading, external robbery, legal issues, IT disruptions and principal-agent risks (Apostolik & Donohue, 2015). In the 2007-2008 crisis, operational failures contributed to the most catastrophic loss especially at the highest level of corporate governance. For instance, the American Insurance Group represented the largest corporate loss yet recorded and its loss emanated from a principal-agent risk. The role of operational risk in the crisis is explained in the following paragraph.

To begin with, loans were granted to individuals with limited liability to repay the loans. This was instigated by improper documentation and uncertainty on wealth and employment status. In fact, first time applicants for loans doubled the bankruptcy filings. Eventually, risks were passed to investment banks through the sale and transfer of mortgage backed securities. Secondly, investment banks generated CDOs and substantially invested in them. For instance, Citibank warehoused it mortgages for future securitization, an element that piled up losses in the housing and CDO market. Therefore, the risk models for such companies did not include the scenario that real estate values would significantly drop. Investment banks also failed to set up proper risk management measures which substantially increased the default rates (Golin, 2010). Thirdly, operational risk emanated from the good ratings that constructed securities received. Credit rating firms assigned a similar rating to derivatives. These rating became a problem because sub-prim loans were usually under-documented which made it nearly impossible to make informed evaluation of the future default rates.

Basel III Proposal to Mitigate Operational Risk

To begin with, the framework proposed a combination of simple standardized measure of operational risk in relation to the specific bank loss. This element provides a sensitive measure of operational risk. The committee argued that this combination would reduce model complexity as well as promote comparability of risk-based capital (Banks & Palgrave, 2014). Secondly, the committee has developed a standardized measurement approach that estimated operational risk capital. The SMA provides a single non-model based approach that is founded on simplicity and comparability offered under a standardized approach. In addition, the framework introduced a loss component that enhance SMA’s sensitivity and also provide incentive to improve on operational risk management.

Change in Asset and Liability Composition

Australia was lucky that the global financial crisis did not leave a huge impact to its banking system as compared to other countries. This is attributed to the country’s strongly regulated banking industry. Nevertheless, this does not mean that the sector was not impacted by banks and other lenders.

The banks under consideration will be the big four firms in Australia and they include Australia and New Zealand Banking group (ANZ), Commonwealth Bank (CBA), National Australia Bank (NAB) and Westpac (WBCT. Asset performance is key indicator of a bank’s stability. The four major Australian banks has steadily improved since the global financial crisis. The overall ratio of loans to non-performing assets was 0.9 (KPMG, 2016). After the crisis, reserve bank improved the conditions on issuance of housing non-performance loans. Therefore, its liabilities have significantly dropped. It is evident from the charts and graphical representations that the bank’s performance has gradually increased up to date.

Performance of the banks

The graphs below represents the performance of the four banks against each other/ other economies (KPMG, 2016).

Their financial results are shown below:

The graph below the performance of the four banks during the 205/2016 financial year.

Analysis by KPMG shows that the banks have been posting a rise in income and profitability as well as increase in assets and decrease in liabilities. The increased performance of the bank is attributed to a number of factors. To begin with, the Reserve Bank unfroze and restored liquidity to the financial markets. Before the financial crisis, the Reserve Bank had extended the amount of collateral that would be accepted as security. Repurchase agreements were extended through to one year. However, after the crisis, the government applied the use of Basel III by withdrawing from the financial market two largest financiers namely GE Money and GMAC.

The increase in financial position (increase in assets and reduction in liabilities) is also attributed to the introduction of new regulations that prevent instability of the financial market. This includes burning of short-selling in the SAX and tougher regulation of loan issuance margins; all these stemming from the newly formulated Basel III framework (KPMG, 2016).

Conclusion

To conclude, the paper explores the 2007 financial crisis and how Basel III was influential in ensuring that economies get back to their feet. By employing Basel III’s framework, companies and institutions have been able to mitigate risk as well as enhance profitability. The paper discusses the different kinds of risks that caused the crisis and how Basel III framework is used to solve the issue. The last section describes the performance of the four biggest Australian banks, before and after the crisis.

References

Apostolik, R., & Donohue, C. (2015). Foundations of financial risk: An overview of financial risk and risk-based regulation.

Banks, E., & Palgrave Connect (Online service). (2014). Liquidity risk: Managing funding and asset risk.

Chudik, A., & Fratzscher, M. (2012). Liquidity, risk and the global transmission of the 2007-08 financial crisis and the 2010-2011 sovereign debt crisis. Frankfurt am Main: European Central Bank.

Claessens, S., & Kose, M. A. (2013). Financial Crises Explanations, Types, and Implications. Washington: International Monetary Fund.

Golin, J. L. (2010). The bank credit analysis handbook: A guide for analysts, bankers and investors. Singapore: Wiley.

Horcher, K. A. (2013). Essentials of financial risk management. Hoboken, N.J: Wiley.

Koulafetis, P. (2017). Modern Credit Risk Management: Theory and Practice

Robertson, D. D. (2016). Managing operational risk: Practical strategies to identify and mitigate operational risk within financial institutions.

KPMG. (2016). Australian Banks: Full Year 2007-2015 Results Analysis.

Skoglund, J., & Chen, W. (2015). Financial risk management: Applications in market, credit, asset and liability management and firmwide risk.