Economic Capital Allocation with Basel II: Cost, Benefit and Implementation Procedures

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Griffith-Jones and Gottschalk equally questioned the effectiveness of complex Basel rules in helping to avoid bank failures and financial crises in Africa, as well as the sheer scale of resources required, such as large databases, risk assessment models and the number of supervisors required.

The result is a reduction in available credit in the financial system, banks achieving lower ROE rates and even a reduction in investor appetite among suppliers of equity capital to banks. Nevertheless, Miu et al.

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They suggested two improvements: 1 The first deals with the risk sensitivity of the capital requirements and time dimensions in a way that will preserve the forward-looking information content of point-in-time PIT risk parameters while simultaneously dampening procyclicality. Banks operate in volatile economic conditions, requiring continuous compliance with their CARs. In this regard, Cummings and Durrani found evidence of a significantly negative relationship between the internally targeted capital buffers of Australian banks and the state of the business cycle and that banks set higher capital targets compared to regulatory requirements when economic activity is increasing and the demand for loanable funds is on the increase.

Jacobs and Van Vuuren argue that BS should place a greater reliance on economic capital than on regulatory capital and question whether the current regulatory capital requirements are appropriate for the risks financial institutions face. According to Nyantakyi and Sy , African banks have adequate liquidity, but they experience a low level of integration with global finance, lack a derivatives market as well as experience a lack of human resource capacity and information technology in order to implement the complicated Basel accords. However, foreign-owned banks — Barclays Africa and Stanbic Bank — operating in Africa are subject to the Basel accords because of the compliance of their head office operations in South Africa.

African countries are concerned that if they do not adopt the most complex Basel approaches to capital adequacy, their financial institutions could be penalised by means of higher international borrowing costs Beck et al.

FRM: Credit risk mitigation in Basel II

African banks who have to access international finance and who need to finance international trade require greater compliance with the Basel accords; otherwise, only foreign-owned banks would be able to play such a role — at the expense of the locally owned banks. Competition between local and foreign-owned banks, as well as among African countries, increases the pressure to comply with the Basel accords. According to Ernst and Young :4 , the size of the African economy has more than tripled since , and the growth rate of a number of African countries will remain among the fastest in the world for the foreseeable future.

Yet, Africa continues to face challenges with infrastructure deficits, skills mismatches, weak institutions in addition to a weak financial sector and low levels of regional trade and integration, which remain the main inhibitors of employment and entrepreneurship opportunities World Economic Forum [WEF] :xiii. The WEF is concerned that African countries that are dependent on commodities for their economic growth have experienced a decline in the prices of commodities during and , which resulted in a decrease in the liquidity of banks.

Economic Capital Allocation with Basel II

This makes banks more fragile, threatens financial stability and increases the cost of borrowing especially if their governments had increased their borrowing simultaneously in order to fund their budget deficits WEF In the final instance, financial market development and the Global Competitiveness Index of such countries are influenced negatively.

Although such excessive capital levels may assist them in ensuring their economic sustainability, these levels need to be maintained because African banks according to Brownbridge face greater risks than their counterparts in advanced economies. The study used PAR. Evidence was needed for an ongoing process of change, namely the adoption of the Basel III accord by African countries, while promoting learning among the people closest to the change McGarvey McNiff and Whitehead include the use of questionnaires as one of the methods of data collection for action research.

The questionnaire used on which this article reports aimed to determine the features of the ICAAP of banks in east and west Africa and to assess the status quo regarding their Basel implementation. The interest groups comprised representatives from banks and central banks in order to propose an ICAAP framework for them.

The west African countries that participated were Ghana and Nigeria. Five interest groups were held during with representatives from various countries in attendance.

RWA and capital adequacy position for FRBH and its subsidiaries at 30 June (unaudited)

The details are summarised in Table 1. Each of the participants completed the questionnaire at the beginning of each of the sessions during a one-on-one session with the facilitator to ensure interpretations were correct and to extract valid data. Therefore, each of the participants submitted his or her completed questionnaire.

The data collected by means of the questionnaire were summarised using descriptive statistics and discussed in each of the interest groups as a basis for the discussion of an actionable framework for the implementation of an ICAAP. For the purpose of this article, the statistics of the data collected by means of the questionnaires were aggregated. Prof J Marx was exempted because he was responsible for the Literature review and editorial aspects only.

Protection of privacy and, safety of participants as well as confidentiality were maintained throughout the study. At the time of the survey, the participants indicated a varying degree of implementation of Basel accords. A lack of guidance was the most important reason for non-implementation. This ties in with the research of Brownbridge and Nyantakyi and Sy Other reasons were that it was too expensive to undertake, a lack of skills and evidence that implementing ICAAP resulted in a competitive advantage.

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This links up with the research of Cronje and Van Rooyen which points to the decreased profitability of banks because of the substantial increase in expenses as a result of the implementation of the ICAAP requirements of Basel III. The participants were of the opinion that their bank supervision units had insufficient resources, lacked knowledge of ICAAP, did not involve the bank industry and lacked leadership as far as the implementation of ICAAP is concerned see Figure 6.

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The areas where guidance regarding ICAAP was needed were mainly for the documentation that had to be used and training programmes. Other areas included greater clarity about implementation deadlines, country-specific standards, assessment criteria and follow-up actions see Figure 8. Those who were of the view that ICAAP should be used as a risk management tool did so because their parent companies required ICAAP and because they believed it contributed some value to their banks.

Those participants who were not convinced ICAAP was useful for risk management purposes felt it was too difficult to implement, acknowledged that they did not have enough knowledge of it and said they lacked guidance from their BS see Figure The participants who were convinced that ICAAP provided a competitive advantage based their observation on the improved sustainability as a result of being well capitalised.

Those who did not regard it as a competitive advantage felt the implementation of ICAAP was too costly, that the playing field was not level for all banks and that their markets were not sophisticated enough see Figure Having taken cognisance of the results of the survey, the interest groups deliberated about an actionable framework for the implementation of ICAAP. The proposed framework is provided in Figure The framework consists of three pillars, namely a risk management pillar, a capital and liquidity pillar, and a business management pillar.

Each of these aspects is explained in the following sections. The ICAAP must assess whether a bank has sufficient capital to absorb unexpected losses caused by transactions exposures undertaken. ICAAP itself is arguably the biggest risk a bank faces. The various identification methods will differ from bank to bank depending on the transactions undertaken by the bank.

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Economic Capital Allocation with Basel II: Cost, Benefit and Implementation Procedures

Central Bank of Nigeria Library. Most regulatory authorities have adopted allocation of capital to risk assets ratio system as the basis of assessment of capital adequacy which takes into account the element of risk associated with various types of assets reflected in the balance sheet as well as in respect of off-balance sheet assets. With due regard to particular features of the existing supervisory and accounting systems in individual member countries, the capital adequacy framework allowed for a degree of national discretion in the way in which it is applied.

It also provided for a transitional period so that the existing circumstances in different countries can be reflected in flexible arrangements that allow time for adjustment. The Basel Capital Accord of July was amended in January with the objective of providing an explicit capital cushion for the price risks to which banks are exposed, particularly those arising from their trading activities BCBS, The novelty of this amendment lied in the fact that it allowed banks to use, as an alternative to the standardized measurement framework originally put forward in April , their internal models to determine the required capital charge for market risk.

The standard approach defines the risk charges associated with each position and specifies how these charges are to be aggregated into an overall market risk capital charge. The internal models approach, in contrast, allows a bank to use its proprietary in-house models to estimate the value-at-risk VaR in its trading account, that is, the maximum loss that the portfolio is likely to experience over a given holding period with a certain probability.

This amendment also defined a Tier 3 capital to cover market risks, and allowed banks to count subordinated debt with an original maturity of at least two years in this tier. The fundamental objective of the Accord has been to develop a framework that would further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks.

The design of the Accord, however, has met with severe criticisms which are discussed in detail in this Section.

Expected Loss Unexpected Loss, Economic Capital case study

First, the standards have not been able to meet one of the central objectives, viz. For example, in a comparison of the competitiveness of banks in the United States and Japan after the implementation of Basel Accord, it was found that the Accord had no impact on competitiveness Scott and Iwahara, The authors also showed that other factors such as taxes, accounting requirements, disclosure laws, implicit and explicit deposit guarantees, social overhead expenditures, employment restrictions, and insolvency laws, also affect the competitiveness of an institution.

Consequently, imposing the same capital standard on all institutions that differ with regard to those other factors is unlikely to enhance competitive equity. The other fundamental objective of the Accord in terms of increasing the soundness and stability of the banking system need not necessarily be met.

Capital adequacy regulation in some contexts could even accentuate systemic risk. Furthermore, a design of capital adequacy requirements, based only on individual bank risk, as the actual proposed in the Basel Accord, is showed to be suboptimal in both papers. All the above arguments suggest the need for an analysis of how banks set their capital to assets ratio. The bank capital adequacy regulation as in Basel I is also criticised for imposing the same rules on all banks even within a country.

The Basel rules encouraged some banks to move to high quality assets off their balance sheet, thereby reducing the average quality of bank loan portfolios. Furthermore, banks took large credit risks in the least creditworthy borrowers who had the highest expected returns in a risk-weighted class Kupiec, Banks are then required to maintain minimum capital proportional to a weighted sum of the amounts of assets in the various risk buckets.

But, most of the times, the risk-weight classes did not match realised losses. In an examination of loan charge-offs and delinquency rates for banks, it was found that the Capital Accord risk weights did not accurately track the credit experience in the US. Collateralised loans had the least risk. Commercial loans appear to be under-burdened by the Basel I weights and mortgages were overburdened. All activities or loans within a particular category do not have the same market-based credit risk.

For example, not all mortgages are exactly or even approximately half as risky as all commercial loans reflecting the assigned risk weights. At first, banks used to sell their mortgage loans, for such loans represented accurately evaluated risks. But since the advent of e-finance, it is now possible to expand this activity to other types of loans, including those made to small businesses.