What are the possible effects of setting a high bank recapitalisation requirement in a developing economy? Does it affect profitability? Does it promote mergers and acquisition of banks, does it have any effect on interest rate or base rate? Is it good for young banking firms? Does it promote oligopoly?
Your views are certainly welcome!
Basel I and Basel III sets limits within each of the three considered risk categories (market, credit, and operational risks) and thus does not include a holistic risk perspective or a specific desired default probability. Therefore, an explicit objective of Pillar 2 of Basel I and Basel III is to strengthen and encourage efficient and advanced risk management in order to ensure capital adequacy. As result of introducing these reforms, innovations and extensions the impact on capital requirements, capital requirements were progressively and significantly increased and the cost of capital would be monitored closely.
With the much evolving dynamic world markets, these regulations might have to be changed and standards expanded over time as the accords are put to work to evolve in to a different set of regulation, to respond to the changes demanded by the markets. With the ever increasing financial innovation, the intensity of regulation might be on an upward trend, with risk management as a priority of board members and upper management.
Con: banking system becomes mroe expensive (since capital is costly)
Pro: banking system becomes supposedly more robust.
However, banking system does not have to become more robust. These requirements might lead to having just few large banks, which in turn enjoy too-big-to-fail status, and therefore they might take more risks.
In general, this is too complex question that cannot be answered without knowing much more detailed information about particular case.
High Capital rises entry barriers into the banking system. High capital also locks up funds that should otherwise flow into equity in other sectors.
Ultimately. banking risk can be managed by several factors and capital should be seen as a less important tool than other factors.
I agree with most of the comments above, that the trade off of higher Capital ratio’s is less commercial bank lending and the growth of a shadow unregulated bank market, now inhabited by many Hedge Funds.
Basel III was established to supposedly assist in providing circuit breakers in the event of large systemic credit contagion. It is also supposed to align bank management objectives with bank owners and regulators. In my view this [behavioural] aspect is its most important impact.
The problem with this analysis is that credit risk is a highly asymmetric risk, one that does not go away under Basel III or IV new capital ratio requirements. The asymmetry is that once confidence is broken, the value of credit gaps down to 0-10% of face value almost overnight. This is for two fundamental reasons.
1. Credit risk is a put option against the enterprise value of a bank. [Enterprise value is Value of firm equity plus long term amortizing debt. The definition of long term is usually1 year, but I would prefer 5 years]. A worsening credit market is very hard to predict and price [AIG credit default swap pricing} and can lead to a complete lock up of short term overnight bank lending, as occurred in 2008.
2. In an event like 2008 [GFC] again, bank long term debt senior and subordinated, will trade like firm equity: it will be extremely volatile. There is nothing in Basel III capital requirements that can prevent contagion. All Basel has done is deleverage bank balance sheets at a time when the EU in particular needed to have more lending at the bottom of the credit cycle.
Without the implied Government put option “bail out” for banks with systemic impact on the economy, it is unlikely that Basel III will be sufficient in a credit crisis. Which means that Banks with political clout will game the system again. In my view banks exercise disproportionate market power and should be broken up. I do not want any of my money to go to them again, and believe if we have a good liquidation mechanism for banks that fail we would be far better off.
Basel III introduced standards and guidelines are an attempt to close the gaps identified in Basel II. With the much evolving dynamic world markets, these regulations might have to be changed and standards expanded over time as the accords are put to work to evolve in to a different set of regulation, to respond to the changes demanded by the markets. With the ever increasing financial innovation, the intensity of regulation might be on an upward trend, with risk management as a priority of board members and upper management...
yes risk management is the obvious tool that Basel is pushing. However the risk that is supposed to be managed is extremely difficult to price. Financial innovation does not come with a definitive risk pricing risk management tool set that can be blanket applied.
Contrary to what the investment banks told us in 2008, risk management know how develops slowly over time. Credit in particular is an asymmetric risk as I mentioned in earlier post. It is not as well understood as interest rate risk/duratiOn. So in a credit crisis, (see what is happening in Italy now), the lock up of interbank lending accelerates the impact of lower bank enterprise values... When ch furthe stresses the system. This Basel tries to protect against by the various tiers of capital and risk based weighting of types of assets. However, the nature of the assets is not static over time. It is like a Kalman loop. New information, pricing has to be processed. But this assumes a predictable distribution of risk. Credit risk is asymmetric.
.If you can show me a regulatory risk pricing midel that can accurately price this, you will have solved the main risk problem in bank regulation.
I appreciate your immense contribution to my question Philip. Thanks a million.
Glad to help. I lived through 2008 and I witnessed first hand how values disappear. I was watching the Morgan Stanley ticker and it went below $2 for a while. It was touch and go as to whether the oldest and most prestigious firm on Wall Street would make it. All debt was trading as equity. We were all acutely aware that if AIG went under, we would be all flipping hamburgers. :-)
I think if you have lived through something like this, you truly understand what asymmetrical risk means. How to apply this understanding in building risk Managment models that is a very important and difficult question. By the time the asymmetry manifests even at early stage, it may be too late. The current crisis in Italy is very serioust and is a potential transmitter of credit risk througout EU banking system.
Pro: Bigger, stronger and safer banks
Cons:
Fewer liquidity in the financial system.
Banks need to find alternative source of income other than income from loans since capital is now tied down.
The Volker rules should apply so that banks become a regulated utility, something they resist. The business model had been comingling risk of different businesses while being able to access cheap funds from Central banks. It is the liability side that is regulated. Source of capital. what needs to be done is for risky businesses to be funded separately, so cheap subsidizes govermnent funding does not fund hedge funds
Thanks again Philip. Actually I want to do a paper on the current Bank recapitilization scenario in Ghana, West Africa though am out of the country now, so your responses gives me more in-depth understanding of what is happening elsewhere in Italy, so I really appreciate your contributions Philip. Thanks a million.
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