Balin (2008) indicates Later there were further discussions between member nations aimed at the fact that certain banks hide under their country’s laws when international disputes and settlements and regulatory bodies are not able to make them accountable for these acts. This led to the creation of the “International Convergence of Capital Measurements and Capital Standards” more commonly known as Basel I in the year 1988 which introduced a capital measurement system that provided basis for regulating a credit risk measurement framework and set out requirements for banking institutions to maintain minimum capital requirements comprising of allowable Tier I and Tier II capital with restrictions. In addition to Tier I and Tier II the accord also incorporate two other pillars. According to the third pillar classification of banks assets was introduced that led to grouping of assets in five categories according to the credit risk. Assets were assigned risks weights of zero, ten, twenty, fifty, and up to one hundred percent. A capital requirement for banks with international presence was set at 8% of their risk-weighted assets. Finally the fourth pillar Transitional and Implementing Agreements laid out the grounds for implementation of rules of Basel Accords with banking system of member countries (Balin, 2008). Furthermore, in 1998 to accommodate banks’ market risk exposure related to their assets a Tier III capital was proposed to be maintained with national discretion allowed. The weaknesses of Basel I including lack of addressing issues pertaining to less developed or emerging economies as they were ignored during the its formation process and not tackling those risks related with recession or exchange rate fluctuations. The major criticism came from the use of jargon that was difficult to decipher. These allowed banks to use their interpretation of its rules and unduly maintain low capital reserves and entering into positions which were risky (Balin, 2008). As Basel I became less desirable for implementation and as a way for addressing the inbuilt weaknesses of Basel I the Basel Committee took the lead in the year 1999 to formulate A Revised Framework on International Convergence of Capital Measurement and Capital Standards simply known as Basel II (BIS, 2009). The revised accord expanded the scope, technicality and depth of the regulatory framework. It was constituted around three pillars identified as minimum capital requirements for credit, market and operations risk; supervisory review of an institutions internal assessment process and enhanced market discipline through effective use of disclosure. The first one comprising of major portion of guidelines of Basel II strengthened the sensitive measurement of a bank’s weighted assets and attempted to remove the ambiguity of Basel I. The remaining two are simpler and are aimed improving regulator-bank relationship and market discipline within a country’s banking sector (Balin, 2008). These were viewed as a way to improve regulatory capital requirement, risk management and better address the financial innovation that has taken place in recent years (Noyer, 2008). The development process did not stop after drafting and Basel II remained under further consideration and improvement process as a result of which two revisions were carried out in 2005 with changes in the three pillars of the framework and finally consensus between G10 countries was achieved with a condition set out by the U.S., U.K. and Canada to restrict its application to large banks only. The result of introduction of Basel II was a change in the approach that where Basel I restricted the lending authorities to apply one risk set to the restricted amount of asset categories to calculate a minimum level of capital. On the other hand, Basel II allows a choice of unique paradigms for calculation of minimum capital by adding details to risk identification process and ensures that financial institutions adopt a monitoring framework that takes the issue of risk management to all levels of the hierarchy (Dr Hall, 2002).
Almost 95 nations other than original sponsoring G10 countries have agreed to enforce Basel II in their regulatory frameworks by the year 2015. However, the idea of making the Basel Accords a globally accepted framework is far from achievable. The reason for this remains the exclusion of emerging countries from the context of these Accords. Emerging countries in particular China has been out with no immediate plans for enforcing Basel II. The intended harmonization of banking regulatory standards has been pushed back by reluctance of emerging countries to adopt something which has completely ignored them. However, emphasis of Basel II on the credit risks has its impact on the financial transactions to and from emerging countries which has resulted in voluntary acceptance of Basel II in these countries (Liebig, Porath, Weder di Mauro, & Wedow, 2004). Therefore, it is clear that Basel II like its predecessor is faced with major criticism for its exclusion of developing economies and at the same time financial institutions in those countries that do use the accords even face the risk of being disbarred from international transactions. However, it is recognized by the Basel Committee that to increase the assurance of regulatory framework in emerging countries will not be an easy task and two revisions to remove disagreements on various issues in the accord have already been made before a unanimous agreement was made (Balin, 2008). This therefore suggests that the Basel Committee has to continuously monitor and highlight the risk issues pertaining to developing economies to further improve its contents. The process of evolvement of better and broader guidelines is likely to continue even after the acceptance of regulatory frameworks. In addition to the problems faced with its implementation in emerging economies the current financial crisis situation which rooted in the banking system of the U.S. and forces driven from mismanagement of subprime loans has once again jeopardize the whole process of harmonization of banking standards. This is based on the fact that financial crisis in the banking industry has become a hallmark and the current crisis which has its rooting in excessive liquidity and credit irregularities by financial institutions has once again raised concerns for regulators regarding the completeness and surety which capital regulatory framework asserts. The Basel Committee has to reinstate the basis of its formulation and needs central banks in member countries to take up much more stronger and controlling position to prevent the spread of the current crisis through their banking systems.
The success of Basel II requires careful planning of the capital adequacy reform and implementation by financial institutions. As the banking business spreads over a spectrum of transactions becomes complex covering a large array of risks the management becomes extremely difficult and is not possible to be achieved with a short term strategy and requires supervision, necessary legislative and regulatory changes and acquiring human resources. Furthermore, banks with international presence in different countries need to adopt the Basel Accord in a systematic and comprehensive manner to ensure that comparability is achievable. It is completely understood that the process is of ongoing nature where improvements are carried out as new issues are unraveled. This is the reason that Basel II beside its unanimous acceptance in 2006 has gone through yet two updates for finalization of its supervisory role and is expected to go through further revision because of its major criticisms and others such as dependence on rating agencies, estimation of risk weights on bank’s future performance and retention of sovereign ceiling (Balin, 2008). The current crisis in financial sector has raised questions about several provisions of Basel II which do require the Committee response. This is not in any way undermining the benefits from the accord however it has been argued that to improve the efficiency and better assessment and management of risks linked to securitization transactions significant progress needs to be made in several areas covering credit, market and liquidity risks and also risks related to activities such as asset management and valuation methods used for some instruments (Noyer, 2008). This situation has overall implications over the implementation of Basel II that still is faced with numerous challenges and banking supervisors will have to continue their discussions towards the robust and sound implementation of new framework.
The Basel Committee continues to holds meetings four times in a year and has four other working groups which meet regularly to carry out concurrent efforts to form agendas for discussions and achieve a consensus on banking issues which arise from time to time. The most difficult aspects of implementing an international agreement such as Basel II is to converge views from countries having different cultures, structural models, public policy and existing regulation which requires a global policy from the Basel Committee to transcend beyond its limited scope. The ways of assisting banks to operate with multiple reporting requirements needs further improvement. Also the regional central banks and accounting bodies of member countries have to take on much stricter supervisory efforts to avoid occurrence of such financial crisis. Also the financial institutions continue to bring at par their operations and ensure compliance to the guidelines provided under the Basel II through a continuous learning and implementation process. Thus, the introduction of the capital accord in countries could be marked as a journey and not a destination.
References
Balin, B. (2008). Basel I, Basel II, and Emerging Markets: A Nontechnical Analysis. Washington DC: The Johns Hopkins University School of Advanced International Studies (SAIS).
BIS. (2009). International Convergence of Capital Measurement and Capital Standards. Retrieved March 17, 2009, from Basle Committee on Banking Supervision.: http://www.bis.org/bcbs/history.htm
Dr Hall, M. J. (2002). Bank Capital Regulation Under Basel II a Critique. Loughborough: Department of Economics, Loughborough University.
Liebig, T., Porath, D., Weder di Mauro, B., & Wedow, M. (2004). How will Basel II Affect Bank Lending to Emerging markets? An Analysis Based on German Bank Level Data. Frankfurt: Deutsche Bundesbank.
Noyer, C. (2008). Basel II – New Challenges. Algiers: BIS - Bank for International Settlements.