Procyclicality in minimum regulatory capital charges for credit risk
There is a vast amount of literature available on the additional procyclicality of regulatory capital charges in Pillar 1 of Basel II. In this section, we shall briefly visit this literature and see if any conclusions can be drawn from this, before proceeding to the conclusion and mitigation of these procyclical effects. The majority of the literature, as expected, focuses primarily on the IRB approach, as this aspect of Basel II has drawn the most criticism from financial practitioners and academics alike. The greater part of this literature has found that there is an overwhelmingly substantial rise in procyclicality of minimum regulatory capital charges originating
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This is the biggest problem, and has to be addressed correctly once economic conditions are conducive to do so. Within the specified Tier 1 requirement, common shares and retained earnings should be a priority and form the predominant form of capital. To ensure the quality of this capital, the Basel Committee should harmonize capital deductions and prudential filters (FSF & BCBS, 2009). The committee should also enhance the disclosure of the components of regulatory capital in order to increase transparency within the system and avoid confusion in terms of the quality of capital required.
(2) The Basel Committee should make adjustments to their framework to inhibit excessive cyclicality of the minimum capital requirements
The Basel Committee has made a reasonable effort to mitigate this cyclicality already, by monitoring the impact of cyclicality through data collection (via their Capital Monitoring Group). This data is available every 6 months, and helps the committee monitor the extent to which the capital regime reveals excessively high levels of capital cyclicality. In correspondence with this data monitoring, the Basel Committee must review the ways in which cyclicality, arising from the Pillar 1 capital requirement calculation, can be abated. They must try and maintain the risk sensitivity of the inputs, but also create an emphasis on dampening the effects of cyclicality on the outputs. This way the
Regulations of financial institutions have always followed financial crisis and failures. Market failures and crisis are the primary triggers of that lead to the development of regulations of financial markets and institutions (Howells and Bain, 2004).
A good regulation should be able to be flexible. For instance, when the economy is safe and flourishing, the regulation should be more relaxed and have decreased barriers for banks in terms of the minimum requirement for capital reserves. And when the economy is floundering, a stricter approach should be used. For example, the minimum requirements for requirement for capital reserves should be increased.
Accordingly, banking regulators assessed minimum values for each of these key measures. At 2007, “adequately capitalized” (i.e., minimum) levels were 4% for the Tier 1 capital ratio, 8% for the total capital ratio, and 3% for the leverage ratio; “well capitalized” levels were 6% for Tier 1 capital, 10% for total capital, and 5% for leverage. Well capitalized banks qualified for, among other things, lower premiums assessed by the Federal Deposit Insurance Corporation (FDIC). Undercapitalized banks (e.g., below the 8% minimum required total capital) received a warning from the FDIC; continued violation of capital requirements triggered further regulatory costs, including intervention or (in the extreme) takeover by government regulators.
Basel III is a global comprehensive collection of restructured regulatory standards on bank capital adequacy and liquidity. It was developed by the Basel Committee on Banking Supervision to strengthen the regulation, supervision and risk management of the banking sector (bis.org, 2010). It introduces new regulatory requirements on bank liquidity and bank leverage in response to the financial downturn caused by the Global Financial Crisis. Stefan Walter, Secretary General of the Basel Committee on banking supervision said in November 2010:
According to Barth, Prabha, and Wihlborg (2014), the capital adequacy regulation can result in rapid increase of compliance costs. What’s more, Volcker Rule prohibits proprietary trading, which can damage bank’s hedging capability and threaten bank’s profitability. Those extra regulatory burdens caused by the Act makes it less desirable to be too large.
Investment Banking is now at a crucial junction, where Investment and Commercial Banking are splitting up due to the ring fence which is being built around these two banking areas. As well, the new upcoming regulation, Basel III, will have a huge impact in the investment banks, with higher liquidity and capital requirements, in order to increase solvency and stability in financial industries.
The 2008 financial crisis should not be the last one readers will experience, but this paper would like to present a picture of how it unfolded and where went wrong, so that hopefully we can learn from it. This paper will address some post-crisis regulations and why regulators responded this way. It concludes that the key is to carry out reforms addressing the moral hazard issue deeply in our current financial system.
Basel III is another law implemented that will place additional strain on Banks. Basel III is a set of reform measures, developed by the Basel Committee on Banking Supervision. It is a framework used to strengthen risk management and a banks ability to absorb shocks from financial and economic stress. Basel III implemented new tier 1 capital requirements, new minimum leverage ratio requirements and new liquidity coverage ratios requirements. Community banks enjoyed a small victory by delaying the final implementation requirements for Basel III to March 31, 2019.
Changes however have brought upon limitations in analytical approaches, risk assessment by the Federal Reserve, and transparency. Most of these changes by the Federal Reserve have not always followed its own guidance or principles. For example, when quantitative assessments are performed the Federal Reserve bases its determinations on the results of both the supervisory and company-run stress tests. This would in turn create tension between institutions’ desire to avoid failing the CCAR quantitative assessment and the power of their stress test decisions. When the Federal Reserve includes company-run stress tests in the CCAR quantitative assessment, they limit the risk-management and capital planning benefits for participating companies without increasing the effectiveness of the quantitative assessment. Another example of the Federal Reserve steering from its own principles is within qualitative assessment disclosure and communication. In this area, transparency is the main problem because the Federal Reserve does not publicly disclose information that allows for a better understanding of its assessment methodology. Also, the companies that must meet these expectations annually may face challenges from the irregular timing of communications. This in turn could limit the achievement of the Federal Reserve’s CCAR
In the aftermath, it became essential for regulators to review policy approaches to prevent recurrent the earlier crises going into the future. The lesson that informed regulators in reviewing the policies is that markets cannot be self-correcting, and regulators must intervene from time to time to prevent financial bubbles from forming or to prevent the effects of the financial crises when they occur (Tropeano, 2011).
The post-crisis regulatory framework has shifted from a framework which was centred on a single regulatory constraint – the risk-weighted capital ratio – to one with multiple constraints. In addition to the risk-weighted ratio, the post-crisis framework also includes a leverage ratio, large exposure limits and two liquidity standards (ie the Liquidity Coverage Ratio and the Net Stable Funding Ratio). And supervisory stress testing is playing an increasingly important role across a number of jurisdictions. Each regulatory measure has strengths and weakness. The multiple metrics framework is more robust to arbitrage and erosion
In this Essay I will explore the Proposals put forward by the UK government in the 2011 “Vickers Report” as well as exploring the proposals I will then give an in depth analysis in how effective the methods put forward are; in terms of how successful they are in ensuring financial stability within the current economic climate. Furthermore I will examine how these proposals are being enforced by UK law to achieve practical outcomes, as theoretical tools do not always work as imagined in real life scenarios.
The article concludes that the debate about FVA is full of arguments that do not hold up to further scrutiny and need more economic analysis. The authors concludes that in their view, it is better to design prudential regulation that accepts FVA as a starting point but sets explicit counter cyclical capital requirements.
prospective migration to Basel III while upgrading the existing risk management practices under Basel II;
The Basel committee on banking supervision (BCBS) in 1998 published a set of minimum capital requirement for banks. It focused entirely on credit risk or default risk, these were known as Basel 1. Basel 1 defined capital requirement and structure of risk weights for banks. Under Basel1 assets of banks were classified in five categories according to credit risk carrying risk weights of 0, 10, 20, 50, and 100 percent and no