The Key Challenges of the New Bank Regulations

The New Basel Capital Accord (Basel II) influences how financial institutions around the world, and especially European Union institutions, determine the amount of capital to reserve. However, as the recent global crisis has shown, the revision of Basel II is needed to reflect current trends, such as increased volatility and correlation, in the world financial markets. The overall objective of Basel II is to increase the safety and soundness of the international financial system. Basel II builds on three main pillars: Pillar I deals with the minimum capital requirements for credit, market and operational risk, Pillar II focuses on the supervisory review process and finally Pillar III promotes market discipline through enhanced disclosure requirements for banks. The aim of this paper is to provide the historical background, key features and impact of Basel II on financial markets. Moreover, we discuss new proposals for international bank regulation (sometimes referred to as Basel III) which include requirements for higher quality, constituency and transparency of banks ́ capital and risk management, regulation of OTC markets and introduction of new liquidity standards for internationally active banks. Keywords—Basel II, Basel III, risk management, bank regulation I. A HISTORICAL BACKGROUND OF BASEL II bank (or a financial institution in general) is a highly leveraged company, i.e. capital represents only a small portion of bank’s liabilities (usually far below 10%). In other words, most banks’ sources come from the bank’s creditors such as retail and corporate depositors, government agencies and other financial institutions rather than by the bank’ s shareholders. Since the bank’s clients usually cannot monitor the bank’s behaviour properly, thus such a challenging task is to be performed by someone else – a regulator ([16]). There are several reasons why financial markets should be regulated: I. protection of the investor, II. different quality of services offered by different financial firms, Financial support from The Czech Science Foundation (GA 403/10/P278 The Implications of The Global Crisis on Economic Capital Management of Financial Institutions), The Research Institutional Framework Task IES (2005-2010 Integration of The Czech Economy into The European Union and its Development), The Grant Agency of Charles University (GAUK 114109/2009 Alternative Approaches to Valuation of Credit Debt Obligations) and The Czech Science Foundation, project The Institutional Responses to Financial Market Failures, under No. GA P403/10/1235 is gratefully acknowledged. Petr Teply is with Institute of Economic Studies, Faculty of Social Science, Charles University in Prague, Opletalova 26, Prague, Czech Republic (telephone: +420 222 112 305, fax: +420 222 112 303, e-mail: [email protected]). III. illegal activities such as money-laundering, and IV. problems related to externalities (i.e. a failure of one bank can influence the whole banking sector such as the negative consequences of failures of small banks in the Czech Republic in 1990’s). The banking industry closely relies on the confidence of the depositors and hence is relatively fragile. A loss of confidence in a bank can provoke a bank run (big depositor’s withdrawals of their cash from a bank such as runs on IPB bank in the Czech Republic during spring 2000) to other banks in the economy. Such a spread of bank problems from one bank to the banking system is sometimes called contagion [9]. In addition, the presence of contagion contributes to systematic risk (risk that problems in one bank will negatively affect the entire sector). Last but not least, bank failures bring private costs for bank’s shareholders, but there are also social costs – for example many Czech people have lost their savings in credit unions that failed in 1990’s [1], [13]. For the above-mentioned reasons the national banking system are singled out for special regulation, known as prudential regulation, that is more comprehensive and stricter than the other sectors of the economy. The main task of the prudential regulation is to minimize social costs resulting from bank’s failures [9]. As the world and banking industry as well has become more and more global in the last decades, the international coordination of prudential regulation is needed. In 1988, the Basel Committee on Banking Supervision (BCBS) of central banks and banking regulators from the Group of Ten (G10) countries took the first significant step towards international regulation: it introduced global standards for regulating the capital adequacy of internationally active banks. This document is known as Basel I and its guiding principle was the idea that banks should have an adequate "capital cushion" to cover unexpected losses. The deadline for the implementation of Basel I rules were scheduled until the end of 1992. Furthermore, Basel I set out an 8 % minimum requirement of capital to risk-weighted assets (RWA) for banks (known as capital adequacy (CAD) or Cook ratio). i i asset w RWA ∑ ∗ = (1) % 8 ≥ = RWA Capital CAD (2) where wi is i-th risk weight. However, Basel I did reflect only credit risk (risk that an asset or a loan becomes irrecoverable in the case of outright A World Academy of Science, Engineering and Technology 42 2010