Credit Risk in Banking in Agreement With the Basel Accords Thesis

Credit Risk Management

Banks are an important part of the economy of any nation. Traditionally, the banks operate as financial intermediaries serving to satisfy the demand of people in need of various forms of financing. Through this, banks enable people to purchase home and businesses to expand. These financial institutions therefore facilitate investment and spending that are responsible for fueling the growth of the economy. In spite of their vital role in the economy, they are nevertheless prone to failure and just like other types of businesses, they also go bankrupt. Unfortunately, the failure of banks can have many and significant implications than any other type of business. As witnessed during the great depression, and in recent times following the global economic crisis and recession, the stability or lack of it in the banking system could trigger economic epidemics that would impact millions of people. With respect to this, it is important for banks to operate in sound and safe manner to avoid failing by any means. One of the means of achieving this is ensuring that government has put in place practical and strict regulations for the banks. On the other hand, with the presence of globalization, the activities of the banks are no longer restricted within the border of individual countries. As a result, there is an increasing need for international cooperation in the regulation of the banking system (Larson, 2011).

There appears to be some light at the end of the tunnel as the Basel Committee on Bank Supervision is ready to meet this need. As an international advisory authority on regulation of bank, the BCBS has launched guidance on matters crucial to ensuring the healthy operations of the banks across the globe. An example of such pressing issue is regulation of bank capital. The process of dealing with this issue has been on for the past 20 years and has led to the promulgation of capital adequacy standards that can be implemented by regulators of individual countries. Collectively, these standards are referred to as the Basel Accords. At times, these Accords have resulted in disagreements yet remain critical to the formulation of regulatory policy associated with bank capital. The BCBS has so far generated three such Accords, Basel III, which was published in 2010, is the most recent of them all. Each of these Accords purports to improve on the specifics of the previous one. However, there are indications that the last Accord is not without flaws and perhaps will not be last one (Larson, 2011).

The Banking Sector

Introduction

Instead of thinking about the stability of the bank and the Basel, focus should be concentrated on thinking about whether the Basel committee has addressed even the smallest details of the new Accord in the right manner. This is a task that could greatly impact the bottom lines of banks. It is therefore more prudent for the current purposes to focus on some more general and fundamental questions. For instance answers to questions such as, to what extent has the first Basel been successful in the accomplishment of the stated goals? How successful is the Basel II expected to be in achieving its goals? Are the stated goals desirable? Perhaps, the most basic yet important question of them all; is the Basel Accord, specifically, the international harmonization of bank capital standards, necessary or desirable to enjoy stability in the financial system? (Rodriguez, 2003)

History

After several years of deliberations following the Latin American sovereign defaults (of 1982), the BCBS, finally managed to complete the Basel capital Accord in 1988. It was established with two main objectives, to strengthen the stability and soundness of the international banking system as well as obtain a high level of consistency in its application to the banks across separate nations with an aim of reducing an existing source of unequal competition among international banks. To this end, the Basel Accord demands that the banks satisfy a predetermined minimum capital ratio mandatorily equivalent to at least eight percent of the total risk-weighted assets (Rodriguez, 2003).

The BCSB focus on capital standards for two major reasons; Firstly, since congress ordered the banking regulators to work with those regulators from other nations to ensure that banks had sufficient capital bases (Kapstein 1991; Oatley & Nabors 1998) and secondly because capital acts as a buffer for protecting bank deposits in case of losses on the side of assets (Rodriguez, 2003). Financial Intermediaries

Are banks any special?

For the longest time, banks and other financial institutions have been exposed to greater government control than majority of many other sectors in the economy.Bank regulations have always been presented in the form of entry restrictions, limitations on activities, reserve requirement, geographical limitations and capital requirements (Benston 1998, 27-85; Kroszner 1998, 421; Kane 1997; & Goodhart et al.1998: Chapter 9). Nowadays, most of the regulation lies in the rationale of safety and soundness or consumer protection considerations.

According to Kroszner, the main reason for regulating banks and financial institutions by the government has always been to fund wars (1998, 419). However, a long standing tradition among the economists, dating back to the times of Adam Smith, maintained that the banking system is different from other companies in the very sense of the activities they engage in. It is for this reason that a form of regulation and supervision must be put in place.

Smith was of course eluding the existing instability of banks that are operating under a fractional reserve system, in which case, if it is true, justifies the need for regulation (Smith [1776] 1937: 285, 308). Banks acts as financial intermediaries and makes profits by taking deposits, then offer loans and invests in marketable securities and other profitable financial assets. In the process, for the entire system, what happens is a multiple expansion of the supply of money in the economy. The liabilities of the banks are normally fixed in terms of value and are payable on demand. On the other hand, the value of the banks' assets is variable and not collectable on demand. For these two reasons, a general belief is that banks are more prone to failure and runs, especially in the event that an out of blue withdrawal of funds by considerably huge number of depositors if they lost trust in the bank. Consequently, this could adversely affect the solvent institutions via a contagion effect which would in turn negatively impact the financial system in whole. This largely explains why the regulation of the banking industry is vital in recent years (Rodriguez, 2003).

Federal Deposit Insurance and Bank Runs

Banks operating under the fractional reserve banking system are practically fragile and at risk of runs, if the depositors have minimal information about the activities of the bank and the financial health (Diamond et al., 1983; Dowd, 2001). Moreover, a run on a bank can theoretically cause de-stability on the banks.

On the other hand, the private sector has historically been adept at managing this fragility prior to the government sponsored deposit insurance started taking various steps to address the issue. At first, the banks would make their capital levels known to depositors and investors to boost their confidence on the safety of their deposits and investments. As Benston (1998, 39) states, banks were in the habit of advertising prominently the size of their capital and surplus in the newspapers as well as inside their branches. Nevertheless, it is worth keeping into consideration that the capital and surplus levels at that time used to be considerably higher than in present days (Kaufmann, 1988).

Secondly, depositors and investors continuously monitors the banks' activities and demanded higher rates of return on investments and higher rates of interest on their deposits if they suspected that their banks were picking investments that appeared extremely risky. Thirdly, prior to the coming of the government sponsored deposit insurance, banks used to create private clubs as well as clearing houses to assist one another. Timberlake explains that a bank that wanted to attain membership in such associations had to meet specified requirements with respect to capital levels, activities it engaged in and the risk profiles (1993, Chapter 14). Fourthly, there were option clauses in the contracts that permitted them to defer payments for a certain period of time so as to get a higher interest rate on the debt. These option clauses were mostly utilized in the free banking period of the Scottish in the 18th century and had the impact of eliminating panic runs while providing banks with a room to breathe, reorganize their assets without engaging in fire sales. Lastly, the debt holders of the banks signed covenants with the banks restricting the activities and investments that banks would participate in.

The market disciplines by shareholders and depositors worked really well in preventing runs and in case they occurred, focus was on preventing them from spreading to the rest of the banks. In the period between the end of civil war and the end of the World War….....