Reasons for Implementing Basel III and Its Costs Essay

Custom Student Mr. Teacher ENG 1001-04 27 December 2016

Reasons for Implementing Basel III and Its Costs

The global financial crisis (GFC) was a painful wound that marked the twentieth century. It was the greatest crisis the humanity has witnessed since 1930 (the great depression). It first started in the United States and spread then to the entire world and caused a considerable slowdown in most developed countries and has affected the financial markets and the growth prospects in developing countries. It is called the doubled jeopardy crisis as it spread rapidly with a contagious effect to the other countries of the world.

Despite the efforts exerted by governments and central banks to rescue the economy from this huge recession through aggressive fiscal and monetary policies, demand in the macroeconomic level dropped. This huge crisis wasn’t the result of a person’s mistake but it was the result of cumulative effect of poor regulations from the financial institutions and from central banks, unregulated hedge funds, multilayered mortgages and the overrating by the credit firms.

It first started by the bankruptcy of Lehman Brothers in September 2008 due to the large losses they sustained on the US subprime mortgage market and was followed by the failure of the seventeen largest banks in the US “the too big to fail” and six hundred other banks in the US. The federal bank was urged to rescue the too big to fail as their failure would have destroyed the whole world economy. The strong interconnectedness between the world countries through the stock market, foreign exchange and international trade led to a contagious crisis in the other countries.

Houses prices in USA collapsed with a loss of $2. 4 trillion during eight months hitting the balance sheets of banks exposed to the housing sector, which affected the entire US financial sector, and then, in turn, other developed and developing countries. A sharp decrease in the international trade and in the international stock markets by 50% to 75% from their peaks occurred which resulted in a decrease in the rate of investment and an increase in the rate of unemployment. The USA lost equities worth $16. 2 trillion in 2008.

Investment banks collapsed and the IMF began to support countries such as Hungary, Iceland and Ukraine. However the impact of the crisis on developing countries varied depending on their direct or indirect trade links to crisis affected countries. Although governors claim that the global financial crisis didn’t affect Egypt, we discovered that it affected the emerging markets heavily as exports and capital flow have been lower than expected. The real GDP growth of the emerging economies fell from 8. 3% in 2007 to 6. 1% in 2008 and just 2. 4% in 2009.

As we can see in the graph, Egypt’s GDP has witnessed a drop of 2. 5% after the global financial crisis. Also the weak financial systems of the emerging markets will take years and years to restore and fewer funds would be available for investment and innovation. In addition the aid that these countries used to get from the large donors set to fall as well as exports who decreased by 20% which explains the decrease of the GDP. This financial crisis is not a shock that damaged banks and financial institutions but actually it damaged many people’s lives.

Although the worst of it appeared to happen in the past, its effects are sustainable and long lasting. Employment rate decreased sharply which reflected in an increase in the percentage of people living under the poverty line. Around 120 million people are living on less than $2 a day and 89 million more on less than $1. 25 a day. Same scenario applies for Egypt; we can see in the graph that the unemployment rose from 8. 9% in 2007 to 9. 4% in 2009. This high poverty rate led to higher mortality rates, higher number of depressed and ill people.

Another result of this high unemployment rate is a decrease in consumption, businesses will downsize and more unemployed people will be. It is a vicious cycle of recession. That’s why World Bank and financial institutions are urged to find ways out of this crisis and to create stable financial systems that protect the humanity from such disasters. To avoid a reoccurrence of a financial crisis with that expansion and to protect the human beings from its withdrawals the committee of Basel decided to reform the Basel II and to upgrade it to a stricter system with more regulations on the market.

Basel committee consists of a group of banks representatives that meet once every three months to enhance the efficiency of the banking sector in a fair and consistent framework. They started by drafting Basel I in 1988, then upgraded it to a more sophisticated one in 2006 and finally drafted Basel III in 2011. This latter is our concern in this term paper. Basel committee on banking supervision and the financial stability board, which consists of 29 members: 2 non-voting and 27 voting, tailored Basel III accord.

All through 2008 and 2009 they studied and design the Basel III requirement and revised it through extensive consultation over the year 2010. After the global financial crisis and after feeling its huge negative impacts on people lives, the implementation of Basel accord III became mandatory and the country that wont abide by it won’t have access to loans nor from large donors nations, nor from commercial banks, nor from IMF and World Bank. Also these countries won’t be allowed to issue any foreign derivatives.

By the year 2013 each country should be ready to start implementing Basel III requirement and meeting them on 2019. The Basel Committee designed some requirements to be met in order to raise the flexibility of the banking sector and improve its ability to absorb shocks by strengthening the regulatory capital framework, building on the three pillars of the Basel II framework. Basel III mainly consists of raising the quality and level of the capital base, to enhance risk capture and to contain excessive leverage and to introduce new liquidity standards for the global banking system.

Basel III consists of an upgrading for the three pillars of Basel II. The first pillar consists of enhancing the minimum capital and liquidity framework. Banks’ risk exposures should be backed up by a high quality capital base and avoid overrated capital. Concerning capital management, banks are asked to have a minimum of 4. 5% common stocks of their risk-weighted assets (RWA) to ensure that they can absorb risks better, they should also raise their new capital conservation to 2. % of RWA to cover any unanticipated risks and a countercyclical buffer of 0% to 2. 5% by the January 2019. Banks should enhance their risk coverage by strengthening the capital requirements for counterparty credit exposures arising from banks’ derivatives, repo and securities financing activities. These reforms will help reduce systemic risk across the financial system and they provide incentives to strengthen the risk management of counterparty credit exposures. After the global financial crisis, the importance of conserving a countercyclical buffer rose.

That’s why Basel III accounts for crisis by conserving capital to build buffers for individual banks and the banking sector that can be used in stress and serve as a shock absorber instead of transmitter of risk to the financial system and the broader economy. During the financial crisis, a number of banks continued to make large distributions of dividend as a way to reassure investors although the sector was deteriorating which made individual banks and the sector as a whole weaker.

That’s why Basel III introduced a framework that gives supervisors stronger tools to promote capital conservation in the banking sector. Also a leverage ratio requirement is introduced in order to limit leverage in the banking sector and help it to mitigate the risk of deleveraging process that can be harmful to the economy. The second part of the first pillar basically consists of developing two minimum standards for funding liquidity. The first is the liquidity coverage ratio, which promotes the availability of sufficient high quality liquid assets for one-month survival in case of a stress scenario.

Banks will cover these liquidity need through tier 1 assets which comprise of cash, central bank reserves and high- quality sovereign debt, and tier 2 assets which consists of high-quality corporate and covered bonds, with min AA- credit-rating and non-zero-risk-weighted sovereign debt. The second is the net stable funding ratio (NSFR) which aims limit over-reliance on short term funding and encourage banks to fund their activities through longer term with a minimum of a year of stable sources of funding on an ongoing structural basis.

The NSFR should be covered first through tier 1 which is capital and liabilities with effective maturity of one year or longer (corporate), tier 2 which consists of capital and liabilities with effective maturity of one year or longer (non corporate), stable deposits of retailers and small business customers and finally through wholesalers who are the less unstable source of funding. Pillar two that should be followed by banks consists of enhanced supervisory review process for firm wide risk management and capital planning.

Central banks are required to draft a code of governance for their banks and make sure that they abide by this code, that there is a total separation between management and ownership and they should also put a cap for the executives’ remuneration. Finally pillar three requires some disclosure requirements from banks to help improve transparency of regulatory capital and improve market discipline. A full settlement of all regulatory capital elements should be backed to the balance sheet in the audited financial statements. These are basically the requirement of Basel III.

Each country’s banks should show a complete abidance by its requirements by 2019. However these changes will cost countries a deer price. Although the implementation of Basel III will protect the banking system from default and will enhance its efficiency, it will cost the global economy a deer price. We will first discuss the cost of Basel III implementation on the developed nations then on Egypt as a developing country. For the G3 “United States, Euro Area and Japan”, the implementation of Basel III would subtract an annual average of 0. 3 percentage points from their growth path over the full ten-year period (2011-2020).

According to the size and the significance of the banking system relative to the economy and the extent to which they will need to adjust to meet the new requirements of Basel III, the Euro Area will be hit the hardest and the Japan the least. Especially during the transition period (2011-2013), there would be an indirect slow down in the employment resulting from the lower GDP growth. First, although the US banking system recovered rapidly after the financial crisis phase in the middle of 2007, the crisis created a considerable increase in its liquidity and capital ratios.

To perform the changes in regulation, the US liquid asset ratio should be increased to 22% in 2012, maintained at that level through 2013, and trimmed steadily back to 18% thereafter. To abide by Basel III requirement this will cost the banking sector net interest margin to be squeezed (a decrease in ROE from 12% to 10. 4% in 2020) which will be reflected in a higher lending rate and as a result a lower demand for bank credit, which will accordingly affect the investment, business will downsize, GDP will decrease and employment as well.

A heavy price for this regulatory change will be paid which is an increase in the number of unemployed people by 4. 6 million by 2015. Also the US should abide by NSFR requirement by greater reliance on longer-term wholesale funding rather than short-term. Second, the Euro Zone, the largest banking system in the world with a total asset of €31. 1 trillion at the end of 2009, will incur huge costs by implementing Basel III. By applying Basel III requirements the nominal GDP of the Euro Zone will end up about €853 billion lower by 2020 with a cumulative loss of 4. 5% of the average annual GDP growth.

As a result the Euro Zone will have about 4. 8 million less jobs being created over the coming years. All these compulsory restraints on the banks are enough to keep the economy in a recession over the year 2014. This implies a loss in the nominal income and consequently a loss in tax revenue about €300 billion (3% of GDP). In addition, when banks boost their holdings of liquid assets and improve their risk weighted capital ratios, this means that they will favor banks lending to governments, which will cause a greater allocation of bank lending toward governments, and crowds out lending to the private sector.

Besides, Basel III proposal will have a negative twist to bank credit flows to Emerging Europe (OECD2) in the years ahead as lending them will incur more charges allocated to credit and because maintaining operations in Emerging Europe would become more and more expensive. The third developed country is Japan which will suffer the less from applying these regulatory changes this is because Japan’s banking system stood relatively stable through crisis and the disorder in the Japanese money market was minimal compared to others as they learnt from their crisis of 1980s.

The regulatory measures that the Japanese took in the last decade would serve as a good road map for applying Basel III. According to Basel III the Japanese banks should increase their capital by issuing extra ? 15 trillion of Tier 1 (common) equity during the five coming years, but they will face a problem which is that Japanese investors prefer buying debt instruments rather than equity and also the low profitability of Japanese banks makes the issuance of more common stocks unattractive to them.

This means that banks would pay a high cost, as they will be forced to cut their balance sheets and downside deflation risks. Banks will also impose higher fees, require additional costs for financial operations, and they may as well reduce their size and their balance sheets by reducing repos, loans, trading assets and securities, which will affect pricing negatively. In addition, the Japanese economy will be negatively affected, as their average cumulative annual growth would decrease by 1. 5% by 2020 and their number of unemployed people will increase.

The cost of Basel III implementation will be multiplied by the effect of the weaker growth in credit and nominal income that will consequently weaken tax revenue (loss of 0. 6% of GDP) and compound the Japanese government’s budget deficit and debt difficulties and will deepen deflation risk in Japan as well. Although Japan is the least country affected by this regulatory changes but the price they will pay seem to be price significant especially for an economy where the banking system did not perform poorly through the recent crisis, or reveal itself to be a source of global systemic risk.

Not only developed countries will incur the costs of Basel III but also developing countries will do as well including Egypt. Most emerging market banking system are going to incur lower costs than mature markets that’s because their banking systems are well capitalized and maintain ratios of regulatory capital to risk-weighted assets well above the current 8% minimum of the Basel II requirements. Egypt exceeded the minimum capital requirements of Basel II (8% of RWA), as its capital requirement was 11. % of RWA, which may help it to have an easier time to abide by Basel III.

That’s why an increase in the minimum requirement of two percentage points, to 10% of risk- weighted assets would not appear to be a significant burden on the Egyptian banking systems that is currently quite well capitalized. However a price should also be paid by the Egyptian banking system, as it has to increase it common stock from 3. 6% of RWA to 4. 5% of RWA which means that investors will get a lower return in comparison their high risk (lower profit by share).

As the majority of banks won’t be able to issue more capital, they will be obliged to decrease their RWA by having less banking services, by downsizing their branches, reducing their assets, decreasing their lending and imposing higher fees. Also Egypt will be challenged to meet the net stable funding rule requirements (NSFR), which may lead to an increase in its banks’ overall funding costs. Besides, the potential application of a leverage ratio to off-balance sheet assets such as letters of credit and guarantee for small and medium- sized enterprises and trade finance instruments could have a penalizing effect.

Moreover, because Egypt has unstable economic conditions it needs to increase its countercyclical buffer from 0% to 2. 5% of RWA in order to account for any recession and it needs to raise its new conservation buffer from 0% to 2. 5% of RWA. These figures mean that Egypt would be obliged to raise its total capital by around 3. 5% of RWA in additional capital which will reflect in a decrease of Egypt’s GDP by 6% over 2013 to 2019. Egypt will incur an additional cost of Basel III because of the compounded effects generated by the indirect effects of Basel III application.

Lending to emerging markets such as Egypt became a costly job for mature markets economies (lending to NON OECD costs 50% risk), which may result in a shortage of Egypt’s liquidity and indirectly inflation pressure would be untamable for food prices. Unfortunately, I have to say that after the glamorous revolution of the 25th of January Egypt’s costs of implementing Basel III will dramatically increase. Because the revolution resulted in a decrease in the Egyptian GDP y 6% in few months, the central bank is using aggressive monetary policy to increase consumption by “increasing lending” which will consequently cause a higher RWA and will put Egypt in a deeper trouble to apply Basel III requirements. Egypt will pay a triple cost, first the above stated costs of Basel III implementation, then the indirect costs caused by the mature markets who will decrease their lending to Egypt and finally the cost of the revolution that lowered our credit rating from a BB- to BBB+ (junk) which will increase our cost of borrowing from other nations.

In my own opinion, Egyptians should wake up, stop riding and start building their economy by hard work, which should be reflected in a high productivity rate that allows firms to increase their sizes instead of downsizing and generating job opportunities. I think the central bank of Egypt (CBE) should start by giving all its attention to solve the current crisis and should seek the Basel committee and beg them to giving Egypt a larger period of implementation in order to be able to meet their requirements.

To restructure the current situation of Egypt, the CBE should start by seeking a source of funding in order to satisfy the basic human needs of food and shelter. The CBE could seek the IMF and large donors and urge them to take long term loans in order to rescue the current situation and avoid hunger. Another way to raise funding is to issue bonds in the stock market (unconventional monetary policy tool).

This way CBE could obtain some necessary liquidity to import the needed food and to pump more money in the market to create a money illusion so that people start spending. Second, the CBE should start solving the real problem of the Egyptians, which is poor income distribution by giving higher return for post office depositors and by extending their loans. Another way to have a better redistribution of wealth is to enhance the SMES to enlarge their investment and open up new job opportunities by enhancing commercial banks to lend them with low credit rate.

I personally think that pumping money in the hand of poor people, although it is a costly process to raise salaries, but it is a rewarding one as the poor population is the one that will use the increase in wealth in consumption rather than savings and hence increase GDP growth. On the long run, after stability takes place in Egypt, huge reforms will be needed in order to rebuild the Egyptian economic system. A decrease in the inflation rate would be recommended.

сCBE could use its two conventional monetary olicy tools, which are to decrease the discount rate and the LRR to encourage banks to give loans with lower interest rates, and to minimize the inflation rise hence enhancing consumption and increasing investment and as a result a rise in the GDP will take place. Using aggressive monetary policy can help alleviate the current situation but only a fundamental reform of the educational system, and an efficient allocation of resources would help Egypt to take place among developed countries one day. Egypt is a country with rich resources and with a high labor force that if used efficiently could form a developed nation.

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