BASEL III AND IMPACTS ON CREDIT RISK MANAGEMENT - MBF-EU

BASEL III AND IMPACTS ON CREDIT RISK MANAGEMENT
Student: Thao NGUYEN THI THU
„Alexandru Ioan Cuza” University of Iasi
Iasi, Romania
[email protected]
Abstract
Basel III accord was introduced in 2010 to implement regulation framework especially
in banking industry and credit risk management particularly. It was organized in 3
pillars: minimum capital requirement, supervisor review process and market discipline
as Basel II accord but in a higher level as well as added some new aspects. These
regulations are indispensable for banking system especially to face with one of the most
terrible financial crisis. However, bankers seem to not easily accept these regulations
and claimed for being over-tightened.
Keywords: credit risk, Basel III accord, financial crisis, capital adequacy,
transparency
JEL Classification: G32, F34, G21, E51, E61, E63
1. INTRODUCTION
Credit risk is the most serious and hazardous of all risks facing banking
system. It can be definite as the potential for loss due to failure of a borrower to
meet its contractual obligation to clear a debt in accordance with the established
terms in contract (The GARP risk series). There are 3 major categories of credit
risk (Unicredit Group):
 Default Risk: when the bank considers that the client is incapable to
pay its credit obligations or the delay is longer than 90 days past on any material
credit obligation (principal or interest rate). This kind of risk may have impacts
on all credit transactions like loans, securities and derivatives;
 Concentration Risk: attached with both single or group of exposures at
risk with the potential to produce enough losses to make a bank dangerous
 Sovereign Risk – is caused when a state freezes foreign currency
payments or when it is unable to pay obligations at maturity.
Credit risk management system can consider different sources of losses,
depending on the valuation methodology used, which can be based either on a
mark-to-market (MTM) approach or on a book-value accounting (BVA)
approach (Saita, 2010). In the MTM approach, the value of credit risk sensittive
position is the value at which it could be traded on the market if a market for it
were available. In the BVA approach, the value of the exposure is identified
with its book value, and losses occur only when a reduction in book values has
to be acknowledged by the bank. Therefore, downgrades would not typically
affect the value of the loan, and credit losses would be driven mostly by the
default of the borrower.
2. NECCESITIES OF BASEL III ACCORD
From 2007, the World has suffered the worst global financial crisis since
the Great depression of the 1930s (reuters.com), which has been blamed on
credit risk management and the regulartory failures to guard against excessive
risk-taking in the financial system, especially in the US (Kahn, 2008). Credit
risk was not managed well; in particular, many "securitizations" of credit risk
were unreasonably structured and unable to transfer the risk to a third party. The
most fundamental problem of the risk management profession, thus, was that its
overly narrow focus on traditional market and credit risk positioning which
encouraged the expansion of business activities that looked relatively low risk
but turned out to have massive exposure to loss in a systemic financial crisis.
Figure 1. Nonperforming loans rate (nonperforming loans/total loans)
of some EU countries
(Source: www.bnr.ro)
According to Figure 1, we can observe that the nonperforming loans rates
have increased dramatically in almost all countries from South Eastern Europe
like Romania, Hungary, Bulgaria, Croatia, but reaching at the peak is Greek
with the most ever terrible sovereign debt crisis. However, Western Europe
countries as United Kingdom, France, and Austria except Italy have reasonable
as well as stable levels during the period of time from 2007 to 2012.
Governments have attempted to eliminate or reduce bad effects of financial
crises by putting more accents on regulation of the financial sector. The major
goals are transparency by requiring regular reporting under standardized
accounting procedures and making certain that credit institutions have sufficient
assets to meet their contractual obligations, through reserved requirements,
capital requirements, and other limits on leverage.
However, excessive regulations have also been considered as a possible
cause of financial crisis. In particular, the Basel II Accord has been criticized
for requiring banks to increase their capital when risks rise, which might cause
them to decrease lending precisely when capital is scarce, potentially
aggravating a financial crisis (Gordy and Howells, 2006, p.2) The Basel II
framework also tends to underestimate risk during good time and overestimate
it in difficult period, for example, leverage ratios depend on current market
values. Risk measurement also tends not to be full measures over the business
cycle. Counterparty credit policies have the same problem. The Basel
framework could not resolve the pro-cyclicality accentuated by the IRB
framework which permits banks to estimate their own probability of default,
loss given default and exposure at defaults (Bank of Ghana).
Figure 2. Time of implementing Basel III accord by main regions
(Source: www.moodysanalytics.com)
Many problems found in Basel II especially in management of credit risks
area, forced the Committee to reconsider. European regulators have introduced
Basel III regulations framework for banks. Basel III was established as an
improvement in some aspects comparing with its earlier predecessor-Basel II
agreement on that many analysts claimed for a fundamental contribution to the
credit bubble (BCBS, 2010). For that reason, several changes relating to
minimum capital requirements, risk coverage, ranking system as well as
introducing the leverage ratios, were set on the new Accord. (Tebogo, 2012).
3. AN OVERVIEW OF BASEL III ACCORD AND ITS IMPACTS ON
CREDIT RISK MANAGEMENT
First of all, Basel III has provided a framework for stricter and better
capital quality, risk coverage, measures to promote the build-up of capital that
can be disregarded in periods of crisis or boom. Secondly, it introduced the ratio
of leverage (>=3%) and reconsider the raking system. These changes aim to
raise banks’ capability of facing systemic shocks due to economic crisis.
More detailed, the regulators have strengthened the liquidity framework by
erecting two minimum requirements for liquidity:
Liquidity Coverage Ratio will command banks to meet a level of highquality assets to withstand a 30-day-sttressed funding scenario set by
supervisors.
Net Stable Funding Ratio: is a long-term structural ratio established to
address liquidity “mismatches”. It insures the whole balance sheet and provides
simulation for banks to use stable facilities of financing. The Basel III Accord is
composed of three fundamental “pillars” as Figure 3 shows.
Figure 3. From Basel II to Basel III
(Source: according to Moody’s Analytics)
Improvements of Basel III in compare to Basel II (see table 1) can be
summarized in the following aspects (Auer and von Pfoestl, 2012):
• Simplifying the structure of bank capital
 Going-concern and loss absorbing, contingent, capital;




Tier 1 capital levels to increase from 2% to 4.5%;
Capital conservation buffer of 2.5%;
Tier 2 capital becomes contingent, loss absorbing capital;
Risk-invariant leverage ratio of initially 3% of Tier 1 between
2013 – 2016;
• Expanding the risk coverage of the capital base
 Counterparty credit risk considerations based on stressed inputs;
• Reducing the pro-cyclicality
 Counter-cyclical capital and credit buffers of 0 - 2.5%.
The objective is to strengthen bank-level, or micro-prudential, eegulation
through increase in regulatory capital requirements to 10.5% by 2019.
Table 1. The transition of Basel III accord from 2011 to 2019
(Source: Group of Governors and Heads of Supervision, www.bis.org)
Pillar 1 is an obligatory standard for minimum capital requirements. The
fundamental objective of Pillar 1 is improving the structure of capital
requirements. Under the this Accord, all commercial lending is subject to the
same 8% capital requirement regardless of the creditworthiness of the borrower
and collateral strength of the loan (Gordy and Howells, 2006).
The Basel Committee has added two supplement capital necessities for the
trading book: the “incremental risk capital” charge and the “stressed value-atrisk”. The first one (IRC) catches credit risks in risky trading instruments which
can lead to the insolvency risk and credit concentration. Their aim is to direct
the exposure at risk framework for the trading book by observing the securities
price movements up to 10 trading days.
Figure 4. Credit portfolio management (Credit treasury)
(Source: according to Unicredit Group)
We can be aware that shocks can last much longer and due to lack of
liquidity, banks may be stuck at their bad situations and have no way to stop
losses. From that point, the supplement of investment alignment cause real
exposure to credit risk. The IRC address to evaluate the credit risk in a trading
portfolio over 1 year (Varotto, 2011).
One of the results contributed by Basel III accord is restructuring of
balance sheet. During the crisis, bankers were failed to classify commercial
loans on degrees of credit risk, consequently created the incentives to move
low-risk instruments off balance sheet and keep more high-risk instruments.
The financial innovations that arose in response to this stimulus have provided
banks with the means to “arbitrage” differences between regulatory and
economic capital (Gordy and Howells, 2006) which aimed to minimize banks’
incompetency in credit markets. Had banks not been capable of circumventing
the current accord at a low cost, they would have been applied competitive
restricts against non-bank lenders for high quality credit portfolio. In another
view, regulatory capital arbitrage has reduced the efficiency of the old Accord
(from 1998). At least, for major banks, the capital ratios under the Basel III
Accord are no longer trustworthy assessment of capital adequacy.
Figure 4. Comparative evolution of the components of the capital ratios*
(Source: www.bis.org)
(*) Group 1 includes banks having Tier 1 capital more than 3 billion euro and are
internationally active. The rest banks are classified in Group 2.
Figure 4 shows the evolution of the components of the capital ratios over
time for the same consistent set of banks. The components are Tier 1 capital,
risk-weighted assets and leverage total exposure. For Group 1 banks, capital and
exposure have been steadily increasing during this time period. However, riskweighted assets at Group 1 banks have been steadily declining. At the same
time, the trend at group 2 is more stably increasing despite some fluctuation.
In the first pillar, the New Basel Accord also let banks choose themselves
between two methodologies for measuring the risk weighted assets and
following, the capital requirement for covering credit risk:
• Standard approach: banks use external rating agencies to rank their
borrowers in seven classes associated with risk weights. The capital required is
simply 8% of the total exposure, the over-trusting sentiment of bankers led them
to some terrible consequences which are mentioned at the next part.
• An internal rating based model (IRB): banks define in intern mode, the
following risks components (BSCB, 2010):
 The Probability of Default (PD)
 The Loss Given Default (LGD)
 The Exposure at Default (EAD)
 The effective maturity (M).
The probability of default evaluated based on their rating results are
presented in figure 5.
The capital requirement for covering credit risk correspondent to the
expected loss which is calculated by the following formulation:
EL = PD * EAD * FGD
Figure 5. Probability of default
(Source: Altman, E. I. (2002) Managing credit risk: the challenge for the new
Millennium, p. 7)
Pillar 2 is supervisory review process. The Basel III Accord sets some
appropriate guidelines to control capital structure which force not only banks
but also supervisors to apply and satisfy requirements proposed in Pillar 1.
Banks can establish their own internal processes for managing capital adequacy
correspondent to portfolio risk. Each international bank will choose for its own
reasons a level of creditworthiness (approx. A- or BBB+).
Moreover, banks’ internal processes should investigate interest rate risk,
liquidity risk, and other risks not discussed in Pillar 1 as well. Obligatory capital
requirements should be conceived as a combination of Pillar 1 rules and Pillar 2
buffers, so the volatility of it over the business cycle will depend practically on
whether supervisors guide Pillar 2 buffers in a manner that offsets or augments
changes in Pillar 1 requirements (Gordy and Howells, 2006). This is one of the
big steps from Basel II avoiding pro-cyclicality.
In summary, Pillar 2 direct to firm-wide governance and risk management;
captures the risk of off-balance sheet exposures and securitization activities. It
manages risk concentrations; supplies facilities for banks to better manage risk
and returns over the long term like stress testing; accounting standards for
financial instruments; corporate governance; and supervisory colleges.
Pillar 3 is market discipline. For enhancing the transparency of banks to
other participants in the market, banks will be demanded to publish their
detailed information on risk rates and capital structure.
Figure 6. The comparative evolution of solvency report in a series of EU
countries
(Source: BNR, Financial Stability Report 2013, www.bnr.ro)
They supposed that the important success of Pillar 1 could not come out
without the disclosures set by Pillar 3. Naturally, healthy banks will hold capital
even beyond the minimum requirement without any difficulty. For those
institutions, the published capital ratio obviously provides a credible measure of
economic capital adequacy (Gordy and Howells, 2006, p.2). Investors will more
easily evaluate credit worthiness and realize which ones should be eliminated
from the competition.
Most of the information and indexes have been published by diverse kinds
of multimedia like central bank or multinational organizations (IMF, World
Bank etc.) From figure 6 we can see that Solvency report has been accorded a
low level in Greek and Italy – the countries have been suffered a sovereign debt
crisis for a long time. The others have an acceptable level and tend to increase
in recent years.
4. ARGUMENTS AND RECOMMENDATIONS
We can deny the huge contributions of Basel III accord to risk management
in banking industry but there are still some problems to implement and improve
these regulations. Although we have not yet seen clearly the expected results
especially from the countries directly suffering from financial crisis, learning
from the Basel II lesson, analysts recommend that banking systems should not
be too optimist or get any illusion.
This accord is supposed to reduce bank profitability which reflects a main
misunderstanding of how a market economy functions. Raising barriers of
entrance will reduce competition. At least, large banks which can meet the
obligatory requirements should be even more profitable than before because of
fewer competitors. In other side, less capital in total was allocated to the
banking sector which makes individual banks necessary to attract investors,
especially common-equity investors than ever, though those investors will
demand a more competitive rate of return (economists.com). Basel III seems to
benefit large banks and kill the small ones which will establish a monopoly in
banking system.
Moreover, some critics argue that Basel III does not solve the problem of
faulty risk-weightings. A series of Banks suffered losses from AAA rated
accorded by external agencies. Lending to AAA-rated sovereigns has a riskweight of zero (as Figure 5 shows) which caused the increase of lending to
governments and inevitably leading to the next crisis. Saying in another word,
these regulations have led to excessive lending to risky governments which is
proved through the most serious ever European sovereign debt crisis and the
ECB accepts even more credits as the solution (For example: Greek, Portugal,
Spain, etc.)
As my own research of actual situation, leading US and foreign banks are
fighting back against US proposal to implement Basel III accord, arguing the
measures are ill-conceived and will harm the industry, increase systemic risk
and limit credit availability. JPMorgan Chase said the proposals could result in
“significant limitations” on US banks’ abilities to compete globally. Goldman
Sachs argued the proposed rules may limit financial groups’ incentive to invest
in critical utilities that serve as the backbone of the market’s trading
infrastructure. Higher risk weights generally require banks to hold more equity
capital, though Goldman already is considered well capitalized by regulatory
standards. Deutsche Bank argued that US regulators should give “due
consideration” to approvals made by foreign banks’ home country supervisors.
Smaller US banks are also trying to be exempted from the rules too. More than
half of the US Senate warned the Fed that its attempt to apply the Basel accords
to “community banks” could reduce lending and economic growth. (Nasiripour,
2013)
Strong but smooth at the same time is the best way to deal with any
problem, not only economic one. In this situation, it is still true! Regulators
need to be careful with Basel III accord and to be focus on the reality to
anticipate exactly their good and bad effects caused after implement these rules.
A more flexible approach will work well, sometimes…
5. CONCLUSIONS
Credit risk is considered as the most grave and “difficult to deal with”
problem by most of the bank managers and also is blamed for the most
devastated financial crisis of the world. Both insufficient and excessive
regulators are known to be main reasons of inefficient risk management in
banking systems which makes regulators be aware of necessities to build a new
regulation framework. Therefore, Basel III was born…
Basel III has three pillars: standards for minimum capital requirements,
supervisory review process and market discipline. The minimum capital tier I
was raised from 2.5% to 4.5% and even reached to 6.0% from 2015. Regulators
also introduced capital conservation buffer of 2.5% in 2019. Furthermore, Basel
III increases transparency of banking systems and bring a new image for clients:
more safe, more perspective. Eastern Europe is one of the regions that register
the most serious situation of credit risk. Nonperforming loans rate has been
more than 10% for years, thus the Basel III accord is indispensable to prevent
those countries from a “credit explosion” in a near future.
However, once again, Basel III is too strong to follow. It was criticized to
harm the industry, increase systemic risk and limit credit availability. In context
of stagnated situation after crisis, a regulation that may reduce lending and
economic growth is somehow unacceptable especially with some American
banks. Therefore, the responsibility is one more time put on the regulators to
find out a way to lead global economy to move on: strong but flexible.
References
[1] Altman, E. I., (2002). Managing credit risk: the challenge for the new Millennium.
Retrieved
from
http://people.stern.nyu.edu/ealtman/2%20CopManagingCreditRisk.pdf
[2] Auer, M., von Pfoestl, G., (2011). Basel III Handbook. Accenture. Retrieved from
http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture-Basel-IIIHandbook.pdf
[3] Bank of Ghana. (2011). Was Basel III necessary and will it bring about prudent risk
management in banking. Working paper No. 01. Retrieved from
http://www.bog.gov.gh/privatecontent/Publications/Staff_Working_Papers/2011/W
as%20Basel%20III%20necessary%20and%20will%20it%20bring%20about%20pr
udent%20risk%20management%20in%20banking.pdf
[4] GARP. The credit risk management, chapter 1- Credit risk assessment, the GARP
risk
series.
Retrieved
from
http://www.garp.org/media/665955/icbrrcredit0711preview.pdf
[5] Gordy, M., B. Howells, B., (2006). Procyclicality in Basel II: Can We Treat the
Disease Without Killing the Patient? Journal of Financial Intermediation, 15(3),
395-417.
[6] Kahn, D. S., (2008). A system crisis demands systemic solutions. The Financial
Times, 25/09.
[7] Nasiripour, S., (2012). Banks attack Fed’s plans on Basel III rules. Retrieved from
https://www.ft.com/cms/s/0/ffee062a-2db6-11e2-8ece-00144feabdc0.html
[8] Saita, F., (2007). Value at Risk and Bank Capital Management. USA: Elsevier.
[9] Tebogo, B., (2012). Basel III and Risk management in banking. Retrieved from
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2060756
[10] Varotto, S., (2011). Liquidity Risk, Credit Risk, Market risk and Bank capital.
International Journal of Managerial Finance, 7(2), 134-152.
[11] www.bis.org
[12] www.bnr.ro
[13] www.economist.com
[14] www.moodysanalytics.com
[15] www.reuters.com
[16] www.unicreditgroup.eu

Download Report