BaselIII:AsolutiontoprudentRiskManagement

03/09/2012

BASELIII:ASolutiontoPrudentRiskManagementby:KamalSafdar Khan Abstract

Recentfinancialcrises(2007/2008)havedemonstratedmanyweaknessesin theglobalregulatoryframeworkofBaselI&IIandriskmanagementpractices(Auer andVonPfoestl,2011).Theunderliningproblemrelatestoshortcominginthe regulationofsystematicriskandexposedmoralhazardthatisassociatedwith systematicallyimportantinstitutes(Banks).As,aresultgovernmentswerestrained tobailouttheselargeandcomplexfinancialintermediariesastheyfearedthe unforeseeableconsequenceoftheirdefault(CoPierre,2011). Toovercometheseshortfalls,theG20hasendorsedthenewregulatory framework,referredtoasBaselIIIattheirNovember2010SummitinSeoul(Leach, Hall,Sayer,Williams,Lindenbergh,Ott,2010). ThispaperexploresthenecessityofBaselIII.Inaddition,howitcan overcometheshortfallsofBaselI&IIwithanaimtoavoidfinancialcrisesinfuture. Furthermore,woulditbeabletobringaboutprudentriskmanagementamong banks? ThepaperconcludesthatBaselIIIcanovercometheshortfallsofBaselIand BaselIIasitsframeworkbringsmanyimprovementsandstringentmonitoring criteriaforbankingindustryglobally.Inaddition,itisasolutiontoprudentrisk management. However,BaselIIIstillfaceschallengesinitsimplementationproposedbythe BaselCommitteeonBankingSupervision.
Keyword:Financialcrises,RiskManagement,BaselI,BaselII,BaselIII

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Electronic copy available at: http://ssrn.com/abstract=2140644

BaselIII:AsolutiontoprudentRiskManagement

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1.0

Introduction
Itisclearthatthebanksbearsomeresponsibilityinrecent(2007/2008)

financialcrises.Governmentswereforcedtobailouttheselarge,complexandhighly connectedfinancialintermediaries,astheyfearedtheunforeseeableconsequences oftheirdefault.Asaresult,bankshavereceivedmuchoftheattentionbothnational aswellasatinternationallevel.Atinternationallevel,G20respondedtothecrisis withidiosyncraticchangesinfinancialinstitutionandmarketregulation(CoPierre, 2011). TheregulationsarecommonlyreferredasBaselIIIframework;itoversees areasofmarketintegrity,banksupervision,capitalrequirementsandleverageratios, bankstresstestsandexecutivecompensation(Preyma,2011). However,thequestionifBaselIIIcaneffectivelyregulatesystemicriskand resolvethemoralhazardthatisassociatedwithfinancialinstitutionsremainstobe answered. Theaimofthispaperistoanswerthisquestionbyexploringthenecessityof BaselIII.Inaddition,howitcanovercometheshortfallsofBaselI&II?Furthermore, woulditbeabletobringaboutprudentriskmanagementamongbanks? Thereminderofthispaperisorganisedasfollows:section2outlineshistory ofregulationleadinguptoBaselIIIanditsresponsetofinancialcrises,section3 analysestheBaselIIIPrudentRiskManagementBehavioranditsChallenges,and Section4concludes.
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Electronic copy available at: http://ssrn.com/abstract=2140644

BaselIII:AsolutiontoprudentRiskManagement

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2.0

HistoryofRegulationandresponsetoFinancialCrises
ThereactiontofinancialcrisesbeforeGreatDepressionof1929hadbeen

mildandscattered.Therefore,oneshouldacknowledgethatthecrises,which startedin1929,reallyrepresentaseminalmomentinthematterofregulatory responses. Inthemidthirties,thelargersetoffinancialinstituteshadtosubmit comprehensiveandsoundproof"Regulation"almostglobally(Gigliobianco,2009). Financialinstitute'sregulationis"typicallyfunctionalinnature(tellingthe financialinstituteswhattodoandwhatnottodo)ratherthanmerelytransparency enhancing"(CalomirisandMason,1997). Inaddition,regulationplaysanimportantroleinenhancingcooperate (financialinstitutes)governance.Cooperategovernance,refersto"twoseparate,but connectedconditions:accountabilitytothepublicfortheimpactofinstitutions functioningonsocietyandaccountabilitytotheownersfortheeffective managementofassets"(MonksandMinow,2001).Therefore,byenhancing cooperategovernanceregulationsjustifiestheneedofcoreelement. Thecoreelementsoftheseregulationsarebasedonthreefactors,first,the severityandworldwidedimensionoffinancialcrises,second,thefinancialinstitute activities,andthird,publictrustinfinancialinstitutes. Afteroutlining,thetheoreticalnodeofregulationsimportance,theemphasis isonwhatoccurstotheregulationsaftercrises?Occurrenceof1929Great depression,198695theU.S.savingandloan,199899Asianbanking(Indonesia Malaysia,Korea,PhilippinesandThailand)and2007globaleconomydownfallare someoftheexamplesoffinancialcrises(Collyns,2008).
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Aftermajor,severecrises,thefaithinthemarkettapersoffandthepartisans ofstrongregulationtendtohavetheupperhand.IntroductionofGlassSteagallAct of1933,GermanBankingActof1934,ItalianBankingActof1936,Depository InstitutionsDeregulationActandMonetaryControlAct1980andtheGarnSt GermainDepositoryInstitutionsAct1982aresomeaftereffectsofcrises(Merrick& Saunders,1985). Although,onemustnote,thatitisstilldebatablethattheseactsfully compliedwithallcoreelementsmentionedearlier.Researchershavebeendebating onthisissueforlongandsomehasreferredthemevenasdiagnosticerrors(Anerror resultinginthefailureofanalystsandpoliticians:tocorrectlyidentifythecausesofa crisis;normally,thetherapy,whichfollowsadiagnosticerror,withwrongoutput). Thesediagnosticerrorscausea"triggereffect"(Gigliobianco,2009).One suchtriggereffecthasalsoresultedinBaselAccordrefertobankingsupervision accordswithanaimofbankingsupervisionbyBaselcommitteeinbanking supervision.Baselaccordhasseenthreeupdatessofar,thefirstwasintroducedin 1988asBaselI. BaselIfocusedonmeasuringcapitaladequacy,riskweights,targetstandard ratioandtheminimumstandardtobeachievedatnationallevelundersupervisory authoritiesforthosecountries(G10),whorepresentedontheCommittee. However,BaselIwascriticisedforitsshortfallssuchas,itonlycoversthe creditandonlytargetstheG10countries(BelgiumCanada,France,Germany,Italy, Japan,Netherland,Sweden,Switzerland,UnitedKingdomandUnitedStates);itwas seenastoonarrowinitsscopetoensureadequatefinancialstabilityinthe internationalfinancialsystem.

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Inaddition,BaselIsomissionofmarketdisciplineisseentolimittheaccords abilitytoinfluencecountriesandbankstofollowitsguidelines. Thesecondcriticismrelatestothefactthatitwasimplementedincountries wheretheyhadahistoryofknownregulationfoundationandoversellingofBaselI willaddpressuretoemergingmarketeconomiestofollowBaselIwhereno regulationshaseverbeeninplaced. Third,criticismofBaselIfocusonmisalignedincentivesitgivestobanksin theirriskweightingapproach.TheAccordputmoreriskonbanksloanbooksthan whatwasintendedpriortoBaselI(Balin,2008) BaselIIwasintroducedin2004inresponsefinancialcrises,whichoccurredin

1990andtoovercometheshortfallsofBaselI. BaselIIwasexpandedversionofBaselI,maintainingtherequirementsof BaselI.Inaddition,tocovernewadvancementtocreditrisk,adapttothe securitizationofbankassets,covermarket,operational,andinterestraterisk,and incorporatemarketbasedsurveillanceandregulation(Lind,2005). BaselIIwasalsocriticised,asitsscopedidnotcovertheemergingmarket

economiesaswell.Inaddition,antherpossibleshortfallrelatedtoemergingmarket waslendingtoemergingmarketmightfaceextrascrutinyastheymightnotbeable tohavetheirdebtratedbyratingagencies.Therewasalsoapossibilityifthebanks inemergingmarketeconomieswererated;theymightnotgethighratingdueto uncertaintysurroundingdifferencesinaccountingpracticesandbankingregulations (Barth,Caprio,andLevine,2006).

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ThesecondcriticismBaselIIfacedwasretentionofthesovereignceilingin itsestimationofbankassetrisk.Itfocusesonregulatorsabilitytoarbitrarilyrate bankdebtaslesscreditworthy(Lowsolvent)thanthedebtofthebankssovereign authority(Highlysolvent).Thus,largeinternationalbankswilllikelylimitloansto highlysolvent,lowriskbanks(Balin,2008). Thirdcriticism,BaselIImightcausebankstofunctioninproconventionalway foritsriskweightcalculation.Asriskweightsarebasedonexpectationsoffuture economicperformance,bankswilltendtowithdrawcreditintimesbeforeand duringarecessionandextendadditionalcreditoncearecoveryisunderway. Therefore,thisapproachwillpossiblyamplifyrecessionsandperhapsspurinflation duringperiodsofhigheconomicgrowth(Balin,2008).

BaselIandBaselIIregulationscouldnotpreventrecentfinancialcrises

(2007/2008)andBaselIIIwasintroducedinSeptember2010byBaselCommitteeas asolutiontothefinancialcrisis,intendstoreinforcethecapitalframeworkofBaselII andenhancethefinancialinstitute'sabilitytoendurefinancialandeconomicshocks (Eubank,2008). AnotheraspectofBaselIIIwastoprovideamacroprudentialstrategyfor systemicrisksandprocyclicality(ThorntonandGiustiniani,2011). ThorntonandGiustiniani(2011)alsostatedthatthenewBaselIIIagreement wasaimedatintroducinginternationallyharmonizedstandardsofregulationto governthelevelsofliquidityinbanks.

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IncomparisontoBaselII,severalchangeswerebroughtinforBaselIIIby BaselCommitteeonBankingSupervision(2010)1.Fulldetailsofchangesare mentionedinthefootnote. Theproposedchangeswererelatedtocapitalrequirements,capital conversionbuffer,countercyclicbuffer,liquidityratio,riskcoverage,andmeasures ontheleverageratios. Inaddition,toproposedchangesmentionedabove,theBaselIIIframework alsoemphasizeonOffBalanceSheetActivities. OffBalanceSheetActivitiesofbanksrelatestoactivitiesthatcanearnfeesas anexampleacommercialbankcontingencycontract.Thecontractisusuallyusedto guaranteethefinancialsoundnessofapartytoabusinesstransactionthatinvolves thesaidpartybeingabletoprovidefunds.However,ifthereisnoneedforthe backupfunds,thebankdoesnothavetoreleasethemoneyandyetearnsafeefor thetransaction(Johnson&Murphy,1987). BaselIIIwillrestrictoffbalancesheetactivitiesbyemployingvolumebased ratiosthatdividetotaltier1capitalbytotalexposures;bothoffandonbalance sheet.Another,offbalancesheetactivityisOTCDerivativeMarket.InOTCderivative market,asmallamountcontrolsalargenotionalvalue.Asanexample USD$1,000,000couldcontrolUSD$200,000,000(VonKleist&Ptre, 2011).Therefore,becomesanunexpectedliability(Johnson&Murphy,1987).
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BaselCommitteeonBankingSupervision(2010)proposedchanges:

1)Bankstomaintaina4.5%commonequityofriskweightedassets, 2)Inaddition,introductionofdiscretionarycountercyclicalbufferof2.5%thatcontrolscapitalinhigh creditdurationsandamandatorybufferof2.5%forconservingcapital, 3)Minimumleverageratioof3%wasintroducedontopofothertwoliquidityratioscoveringthetotal netvolumeofcashoutflowsandtheratioofnetstablefunding 4)Countercyclicalbufferbasedontheeconomicsizeofcountryhugebankstier1capitalandtotal capitalof19%

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AfterdiscussingtheproposedchangesinBaselIII,inthenextsection,the abilityofBaselIIIinbringingprudentriskmanagementbehaviorsinthebanking sectorisassessed;also,thechallengesfacedbybanksintheimplementationof BaselIIIarediscussed.

3.0 BaselIIIPrudentRiskManagementBehaviorandChallenges
BaselIIIproposalbringsseveralapproachestoimproveandenhancerisk managementpracticesatbanks.Theimprovementrelatestoincreaseduseofstress tests,variousaccountabilitymodelsforriskassessmentandhigheremphasisonthe cyclicalnatureofbanking. TheseproposedchangesinfluencetheInternalCapitalAdequacyAssessment Process(ICAAP).Itwillstrengtheninternalriskgovernance,andcementtheroleof riskmanagementinseniormanagementwiththeincreasedindependenceofthe ChiefRiskOfficer(CRO).TheindependenceoftheCROalsosuggeststhattheCRO shouldreportdirectlytothechiefexecutiveandthebank'sboardofdirectors. Inaddition,supervisoryfocuswillincreaseonvariousspecificrisk managementareas,includingtheemergenceofembeddedriskconcentrations throughouttheassetandliabilitybaseofbanks(Went,2010). Moreover,BaselIIIriskmanagementalsoemphasizestheincreaseduseof

stresstesting.Anapproach,whichismostlyusedinmanagingmarketriskanddeals primarilywithtradedmarketportfolios.Theseportfoliosincludeinterestrate, equity,foreignexchange,andcommodityinstrumentsandareamenabletostress testingbecausetheirmarketpricesareupdatedonaregularbasis.Inaddition,stress testinghasbeenfoundtobeaneffectivecommunicationtoolbetweenafirms seniormanagementanditsbusinesslines(Lopez,2005).

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Additionally,BaselIIIriskmanagementapproachestomanagetheliquidity riskwerealsoproposed.Riskmanagementwillidentify,measure,andcontrol liquidityrisksandfurtherintegrateliquidityriskmanagementwhenmanagingcredit, market,andoperationalrisks.Inaddition,"assessingtherisksofintradayliquidity positions,managingcounterpartycreditandbilateralexposuresparticularlywhen consideringcomplexsecuritizedandotherproductswillrequirebankstodesignand implementearlywarningindicators"(Went,2010). Theaboveoutlinedriskmanagementactivitiesrangingfromcreditrisk, throughfundingrisk,tocounterpartycreditrisk,theincreasingconvergenceofrisk managementprocessprovethattheBaselIII,providesprudentriskmanagement behaviorinbankingindustry. However,BaselIIIstillfaceschallengesinitsimplementationasproposedby theBaselCommitteeonBankingSupervision.Someofthesechallengesarelisted below: Analysingthecapitalrequirementsoutlinesnumberofnegativeeffectsthat canstressbankscapitalbasesignificantly.Strictercapitaldefinitionlowersbanks availablecapital.Atthesametimetheriskweightedassets(RWA)for securitizations,tradingbookpositionsandcertaincounterpartycreditriskexposures aresignificantlyincreased.Botheffectsdecreasebanksrealisedcapitalratios enormously.Inaddition,therequiredcapitalratioismeanttoincreaseoverthenext fewyearstill2019(Auer,vonPfoestl,andKochanowicz,2011). OtherchallengescanbeextractedfromthelatestQuantitativeImpactStudy (QIS)publishedbytheBaselCommitteeonBankingSupervisioninDecember2010.

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Oneimportantoutcomeofthestudyrelatestothefactthat,afull implementationoftheBaselIIIpackagewouldleadtoareductionofCommon EquityTier1Capitalbymorethan40%,creatingashortfallof577billionEurosfor the91Group1banks(Auer,vonPfoestl,andKochanowicz,2011). Theseabovementionedchallengeswouldposeamajorproblemforsome bankstomeettheproposedchanges.

4.0

Conclusion
BaselIIIisglobalframework;itcanovercometheshortfallsofBaselI,and

BaselII.Inaddition,itcanbringmanyimprovementsandstringentmonitoring criteriaforbankingindustryglobally.Moreover,banksaffectedduringthefinancial crisesof2007/2008cantakeactionmandatedbyBaselIIItocreatestrongercapital andriskstructures.ByfollowingtheBaselIIIrequirementsthey(affectedbanks)may notreturntolevelsofprofitabilityexperiencedbeforetheglobalfinancialcrisisof 2008and2009,buttheywillbeinpositiontobewellpreparedforthenextcrisisand achievehighperformancewithintheirindustry(Auer,vonPfoestl,andKochanowicz, 2011). Furthermore,BaselIIIisasolutiontoprudentriskmanagement.However, BaselIIIstillfaceschallengesinitsimplementationasproposedbytheBasel CommitteeonBankingSupervisionTherefore,moreworkisneededtobedoneto overcomethesechallengesbythebankingindustry.
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Preyma,Lida.,(2011).TheG20andGlobalCapitalMarkets:CriticalIssuesand Analysis.GlobalFinance,TrinityCollege VonKleist,K&Ptre,D.,(2011,November).OTCderivativesmarketactivityinthe firsthalfof2011.BankforInternationalSettlements. Went,Peter.,(2010).BaselIIIAccord:Wheredowegofromhere?

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