FRAMEWORK OF BASEL IV.
Klaudia Murányi Assistant Lecturer
University of Miskolc, Faculty of Economic
INTRODUCTION
The prudential conditions of the operation of credit institutions and its development including the structure of credit institutions and emerging financial services, assets, is influenced by several factors: success, failure, crisis or globalization.
In this study, I will deal with the new Basel rules which is published in December 2017 by the Basel Committee on Banking Supervision. In more detail, I present the previous Basel rules,considering that the standards are built on each other and complement each other according to market and economic conditions. In order to introduce the new rules, the Committee has set a later and gradual deadline to make credit institutions can adapt them more smoothly.
WAY TO BASEL IV.
In the second half of the 20th century, during the period of establishment of The Basel Committee on Banking Supervision as an organization, there was a tendency to see financial sector development and internationalization of banks. First of all, this international character and globalization had led to the creation of an international regulatory framework.
The establishment of the Basel Committee on Banking Supervision ('the Committee') took place in 1975, with the acceleration of the emergence of more serious international bankruptcies, such as the bankruptcy of Bankhaus Herstatt based in West Germany. The Committee was set up by the Bank for International Settlements with the participation of the heads of central bank and banking supervisors in 13 countries (Belgium, Canada, France, Federal Republic of Germany, Italy, Japan, Netherlands, Luxembourg, Sweden, Switzerland, USA, United Kingdom, Spain) as an advisory body. The main purpose for which they have been set up is to harmonize the activities of banking supervisors and to improve their quality and efficiency. Its most important task is to formulate recommendations in line with its objectives, but these documents cannot legally be enforced by the Member States, but many Member States apply it for incorporation into their national legal systems. [1]
Currently, the Committee is the primary global norm creator for the prudential regulation of banks and provides a forum for banking supervisory cooperation. His mandate and purpose are fundamentally unchanged, and nowadays it is about strengthening regulation, supervision and the practice of banks to increase financial stability. [2]
The Committee (Cook Committee, named after the President of the Committee, Peter Cook) in 1988 established the first international recommendation on prudent regulation.
[3] With regard to this document, the Committee has set out objectives to ensure the long-term solvency of credit institutions or prudent operation and stability. For each institution, it has established an 8% capital adequacy requirement for credit risk, regardless of the actual risk assumed or the specific features of the credit institution in
MultiScience - XXXIII. microCAD International Multidisciplinary Scientific Conference University of Miskolc, 23-24 May, 2019, ISBN 978-963-358-177-3
DOI: 10.26649/musci.2019.069
operation. [3] Countries accepting the recommendation had to comply with the capital requirement by the end of 1992.
Several criticisms have been made against Basel I, which the Committee had tried to address with the additions. Criticism was mainly due to the fact that, in the case of risk weights, the defined categories were homogeneous, for example, the company was given the same risk weight (100%) within the corporate category as the small company.
The calculation did not deal with portfolio diversification or the risk mitigation tools used in practice, ie the scope of collateral was only limited. The most significant criticism, however, was that only the credit risk was regulated, despite the fact that banks also encounter many other risk factors in their daily business. [4]
Basel II. standard is based primarily on Basel I criticism, which, despite its additions, could not fulfill its expected role properly. Basel II. took a long time to create and publish, a final period from 1999 until 2006, to finalize the material. In this period, documents are already produced that predict the structure of the recommendation, the response to criticism. The Committee itself was aware of the errors and responded to this by developing a much broader, reflective document that was adapted to the changes in the financial system and institutional diversity. In terms of its structure, it consists of Pillar III, specifically discusses the Minimum Capital Requirement in Pillar I in relation to credit, market and operational risk, in Pillar II supervisory supervision and authority, and in Pillar 3 the disciplinary power of the market as the regulatory power of the public.
[5]
1. figure
Structure of Basel II. standard Source: own editing
Basel II. standard provides solutions to, among other things, risk management processes and systems, more flexible because credit institutions can decide for themselves which method to use, the calculations are based on risk, and thus, with more accurate calculations, they are able to determine more accurate capital size, risk mitigation
techniques and tools are expanded and, most importantly, operational risk is highlighted in addition to market risk. [6]
The Basel II. is being adopted in Europe by the European Union as Capital Requirements Directives, which has been introduced as a binding directive in all Member States from 2007. [7] According to a 2008 survey, it was introduced in more than a hundred countries, however, the detailed rules, the applicable methods and the timing of the introduction differed by country.
One of the main lessons of the 2007 economic crisis is that the existing international banking prudential regulatory framework, Basel II. standard was not able to prevent serious systemic problems. The loss-absorbing capacity of the solvency margin as set out in the Basel II standard proved to be weak. It has become clear that the importance of maintaining adequate liquidity levels for individual banks, managing liquidity and identifying risks is essential for the sound operation of credit institutions.
Since 2009, the Basel Committee on Banking Supervision has launched a number of innovations to reduce bank resilience and reduce systemic risk. At the G20 Summit in November 2010, the participants agreed on the planned reforms.
The Basel III goal is twofold: At the micro-prudential level, the resilience and stability of individual banks, even in a stress situation and at the macro-prudential level, systemic risks and procyclicality need to be addressed. In order to achieve these goals, it has formulated many new regulatory elements:
• Introduces an anti-cyclical and capital maintenance capital reserve for safer operation and shock-tolerance.
• Introduces the concept of leverage ratio, which regulates the ratio of primary equity to off-balance sheet items and total assets.
• Two indicators to manage liquidity: Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NFSR).
• In order to explore systemic risks more effectively, banks are assigned to this category by defining five different indicators: International impact, size, degree of concentration with other banks, substitutability, complexity. [8]
BASEL III: FINALISING POST-CRISIS REFORMS
As the standard name shows - Basel III: Finalising post-crisis reforms - the Basel III rules are supplemented with the new regulation package. This standard was released in December 2017. One of the main objectives of the amendments is to reduce the excessive volatility of risk-weighted assets (RWAs). The Committee's own empirical analyzes have highlighted the variety of RWAs computed by banks. So the Committee has published several documents containing minimum capital adequacy limits and revised requirements for RWA calculation.
What does it mean RWA and where we can find it?
The essence is that the expected capital requirements will be met for all risk sectors. The prudent and credible calculation of RWAs is an integral part of the risk-weighted capital structure. The risk weighted capital ratios reported by banks must be sufficiently transparent and comparable to allow stakeholders to assess their risk profile. The legislator assigns different risk weights to the exposure and coverage used in the capital calculation, so it is difficult to be comperable. [9]
In accordance with the rules effective from 1 January 2019 three different calculations have been developed for the three different risks (operational risk, market risk and credir risk).
„Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.” [10] To calculate the operational risk capital requirements, the banks can choose from three methods:
(1) the Basic Indicator Approach: must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income.
(2) the Standardised Approach: it is based on banks’ activities, which can be classified into 8 categories, business lines: corporate finance, trading and sales, retail banking, commercial banking, payment and settlement, agency services, asset management, and retail brokerage.
(3) Advanced Measurement Approaches: the regulatory capital requirement will equal the risk measure generated. The AMA has qualitative and quantitative criteria too. Use of the AMA is subject to supervisory approval.
The risk-weighted assets for operational risk under this three methods are determined by multiplying the capital requirements calculated as set out in this chapter by 12.5. [11]
„Market risk is defined as the risk of losses in on and off-balance-sheet positions arising from movements in market prices.” [12] There are two types of the market risk capital requirement: general market risk and specific risk. The risk-weighted assets (RWA) for market risk are also determined - as I mentioned above - by multiplying the capital requirements calculated as set out in this chapter by 12.5. [13]
Banks can choose between two broad methodologies for calculating their risk-based capital requirements for credit risk. The first is the standardised approach assigns standardised risk weights to exposures. Risk weighted assets are calculated as the product of the standardised risk weights and the exposure amount. To determine the risk weights in the standardised approach for certain exposure classes, banks may use assessments by external credit assessment institutions that are recognised as eligible for capital purposes by national supervisors. The second risk-weighted capital treatment for measuring credit risk, is the internal ratings-based (IRB) approach, allows banks to use their internal rating systems for credit risk, subject to the explicit approval of the bank’s supervisor. Banks use a number of techniques to mitigate the credit risks to which they are exposed. [14]
The Basel III framework set out the following capital requirement relative to the risk- weighted assets in percentage and at all times:
- Common Equity Tier 1 must be at least 4.5%, - Tier 1 capital must be at least 6.0%,
- Total Capital must be at least 8.0%.
In addition, a Common Equity Tier 1 capital conservation buffer is set at 2.5% of risk- weighted assets for all banks.
The risk-weighted assets that banks must use to determine compliance with the requirements must be calculated as the maximum of: the total risk-weighted assets calculated using the approaches that the bank has supervisory approval to use in accordance with the Basel capital framework; and 72.5% of the total risk weighted assets – the standard mentioned it as output floor.
For each risk, it can be established that the standardized approach is the priority to use.
The Committee provides a temporary period for the introduction and revision of this standards. The deadline for each of the different risk calculation methods is 1 January 2022, but in the case of compliance of the output floor
in the case of the appropriate output, there is an incremental growth is observed from 1 January 2022 to 1 January 2026 by +5% each year.And the final 72.5% will have to reach credit institutions by 1 January 2027. [15]
CONCLUSION
In drawing up the standard, the Committee focused on three main principles. First of all, the Committee is strongly committed to strengthening banks' global regulation, supervision and practice in order to increase financial stability. A resilient banking system will be able to support the real economy and contribute positively to sustainable economic growth in the medium term. Secondly, in the standard creation process, the stakeholders' views were important, because they have the most sour effect on them.
Thirdly, the Committee examined a comprehensive and consistent assessment of the impact of the reviews on the banking system and the broader macroeconomy. [16]
As the standard name shows - Basel III: Finalising post-crisis reforms – it is fully based on the Basel III. The Committee allows the creator of national law to define the specific content of the framework it defines. Considering that this standard only has binding force if it is implemented, it is possible for jurisdictions to decide on more conservative requirements and / or accelerated transitional measures, as the Basel framework provides only minimal factors. Due to the gradual introduction, we are not able to determine the impact of the standard yet, and conclusions can only be drawn after the complete introduction.
ACKNOWLEDGMENTS
This research was supported by the project nr. EFOP-3.6.2-16-2017-00007, titled Aspects on the development of intelligent, sustainable and inclusive society: social, technological, innovation networks in employment and digital economy. The project has been supported by the European Union, co-financed by the European Social Fund and the budget of Hungary.
REFERENCE LIST
[1] RADNAI, M. – VONNÁK, D.: Banki tőkemegfelelési kézikönyv, Alinea Kiadó – Ramasoft, Budapest, 2010., p 18.
[2] History of the Basel Committee https://www.bis.org/bcbs/history.htm (2019.03.22.) [3] TAJTI, Zs.: A bázeli ajánlások és a tőkemegfelelési direktívák (CRD) formálódása. In: Hitelintézeti Szemle 2011/5. p. 499.
[4] RADNAI, M. – VONNÁK, D.: quoted work, p. 19-20.
[5] LAMANDA, G.– ZSOLNAI, A.: Mozgó célpont- a tőkemegfelelési direktíva első pillére. In: Pénzügyi Szemle, 2010/1.,155. o.
[6] RADNAI, M. – VONNÁK, D.: quoted work, p. 22.
[7] DIRECTIVE 2006/48/EC OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions
[8] Basel III: A global regulatory framework for more resilient banks and banking systems https://www.bis.org/publ/bcbs189.pdf (2019.03.20.)
[9] Basel III: Finalising post-crisis reforms, p 1. https://www.bis.org/bcbs/publ/d424.pdf (2019.03.20.)
[10] Calculation of RWA for operation risk, 10.1 point, 1. line https://www.bis.org/basel_framework/standard/OPE.htm?type=all (2019.04.15.)
[11] Calculation of RWA for operation risk,
https://www.bis.org/basel_framework/standard/OPE.htm?type=all (2019.04.15.)
[12] Calculation of RWA for market risk 10.1 point, 1. line https://www.bis.org/basel_framework/standard/MAR.htm?type=all (2019.04.15.)
[13] Calculation of RWA for market risk
https://www.bis.org/basel_framework/standard/MAR.htm?type=all (2019.04.15.)
[14] Calculation of RWA for credit risk
https://www.bis.org/basel_framework/standard/CRE.htm?type=all (2019.04.15.)
[15] Basel III: Finalising post-crisis reforms, p. 137-139.
https://www.bis.org/bcbs/publ/d424.pdf p (2019.03.20.) [16] Basel III: Finalising post-crisis reforms, p. 1.
https://www.bis.org/bcbs/publ/d424.pdf (2019.03.20.)
