Introduction to Capital Requirements & Basel Accord

In 2007-08, the globe witnessed an inevitable financial crisis which is widely known as ‘The Great Recession’ and in terms of impact; the International Monetary Fund (IMF) has termed it the worst after World War II.

One of the foremost reasons for collapse of financial sector during the economic crisis of 2007-08 was gradual erosion in the quality and level of capital base of financial institutions. Steps taken by governments to overcome such crisis were severe and unprecedented hence resulting in significant injection of tax payer’s money in the financial sector bail out. In this article, we try to understand how the financial institutions are expected to maintain and calculate their capital in accordance with the international standards and their respective regulatory requirements.

Capital requirements for financial institutions specifically banks are more complex and regulated unlike any other industry.

Capital requirements for financial institutions are part of regulatory environment that oversees the operations of financial institutions. Purpose of capital requirements is to ensure that financial institutions maintain sufficient capital resources to sustain loss and honour their commitments towards creditors and depositors and deal with undesired / unexpected events.

Capital requirements for financial institutions are based on numerous factors, with primary focus on risk associated with the each type of asset held by the institution. Such capital requirements calculated systematically and allocated across the globe on the basis of Basel regulations.

BASEL Accords

The financial market turmoil which collapsed Bretton Wood system of managed exchange rates in 1973 resulted in significant foreign exchange losses to the banks. In 1974, West Germany’s Federal Banking Supervisory Office identified that foreign exchange exposures of various banks amounted to approximately three times of their capital. As a result, licenses of such banks were withdrew by the German authorities which caused considerable foreign exchange losses to foreign banks in their unsettled trades with such banks, thereby extending the turmoil internationally.

Basel Committee on Bank Supervision (BCBS) was formed in 1974 by central bank governors of G10 countries as a forum to enhance financial stability by improving banking supervision and capital adequacy of banks. BCBS issued three set of regulations, elaborated below, which are commonly known as Basel Accords. These regulations provide recommendations to the financial institutions to maintain their capital keeping in view the credit, operational and market risk faced by them.

BASEL I

Basel I was the first Basel Accord issued by the BCBS in 1988 with primary focus on Credit Risk faced by the financial institutions and revised in 1996 to incorporate Market Risk in the accord. Basel I divided and grouped the assets of banks into five categories based on their credit risk and assigned percentage of risk carried by such group (Risk Weighted Assets). Banks with international presence were required to maintain capital up-to 8% of their Risk Weighted Assets.

BASEL II

The Second Basel Accord was published in 2004 with aim to ensure that capital requirements of the bank are more risk sensitive, enhance disclosure requirements of the bank to enable market participants to assess the capital adequacy of the bank and to provide formalized and/or standardized quantification methods to calculate credit risk, market risk and operational risk. This second Basel Accord is divided into three main pillars

First Pillar – Minimum Capital Requirement: The first pillar deals with capital requirements and comprises of credit risk, market risk and operational risk calculation methods. The aim is to ensure that all risks faced by the financial institutions as a result of their traditional operations or new financial innovative products are identified, considered and take into account while setting aside capital for the bank.

Second Pillar – Supervisory Review: The second pillar provides supervisors and regulatory authorities to monitor and evaluate the capital adequacy and internal assessment process of the bank. It provides supervisors and regulatory authorities to govern, monitor and verify that bank is sufficiently capitalized against the risk faced by it.

Third Pillar – Market Discipline: The third pillar is aimed to further improve the governance of capital and risk management by providing mandatory disclosure regulations regarding minimum capital requirements and capital transparency thereby providing the other market participants and relevant stakeholders to assess the bank’s capital adequacy.

BASEL III

BCBS issued proposed standards (third Basel accord) in 2010 to improve, enhance and strengthen the supervision of banks. The third Basel accords builds on the work of previous two accords and notably includes an additional layer of capital conservation buffer in the minimum capital requirements, a leverage ratio for all the on and off balance sheet exposures of the bank regardless of their risk weight, a liquidity ratio to be maintained for short term and long term needs and net stable funding ratio to address maturity mismatches in the balance sheet.

The foremost reason for adding the liquidity buffers and leverage ratios were the considerable weaknesses revealed by the financial crisis of 2007-08.  Banks were the core of this financial crisis and it was a result of multiple direct and indirect factors. U.S. Financial Crisis Inquiry Commission reported its findings in January 2011 and concluded that “The crisis was avoidable and was caused by: widespread failures in financial regulation, including the Federal Reserve’s failure to stem the tide of toxic mortgages; dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk”

This recession highlighted the need for more stringent regulations on financial institutions as their recklessness and demise impacted the entire world. Excessive leverage, inadequate liquidity buffers, mispricing of credit and inadequate capital management sparked a need for further improvements in banks capital adequacy and supervision to avoid such circumstances in future.

Regulators were also to blame for financial crisis due to their inability to monitor and curtail the excessive high risk taking behaviour of the financial institutions and allotment of high credit rating for investment products backed by toxic mortgages.

Conclusion

Although the technical implementation deadline for Basel III is 2019, keeping in view the recent developments in the banking sector, BCBS has released a consultative paper for ‘Basel IV’ with aim to seek out views on capital requirements and other relevant factors. Consultative paper on Basel IV proposes to further increase the capital requirements, encourages enhanced disclosures, increases the liquidity and leverage ratios and aims to reduce on and off balance sheet exposures of the banks.

As Basel evolves, the strategic and business implications for the banks have become more distinct and shall continue to do so.  As a result of these accords, banks are required to hold more capital and/or reduce /limit their on and off balance sheet exposures, which in turn has reduced the availability of finance for lending.

Basel accords serve their basic purpose to enhance financial stability by improving banking supervision and capital adequacy of banks. Full implementation of Basel III and Basel IV will further strengthen the banking sector by improving their liquidity, maturity mismatches and capital adequacy. Transparency measures suggested by the Basel Accords shall help in boosting the confidence of wider public in the banking sector.

However, the Basel accords cater all those factors which have resulted in financial distress in the past; their ability to limit any future financial distress is questionable.

by Muhammad Hassaan Bhagat, Senior Consultant in Forensics & Compliance Department of Grant Thornton UAE

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