Macro Prudential Policies and Their Impacts on Bank Capital

Introduction

The aftermath of the 2008 Financial Crisis (which commenced in 2007), has witnessed several reforms aimed at facilitating the introduction of legislation relating to higher levels in the quality and quantity of capital which banks are (and will be) required to retain. After it had been discovered that the global crisis had been partly triggered and aggravated as a result of:

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  Insufficient level of capital and inadequate level of quality capital and the need to provide for a definition of capital which would facilitate the absorption of losses (by regulatory instruments) on going and gone concern bases, the implementation of an “enhanced Basel II” framework, which is aimed at consolidating on the efforts achieved through Basel II, and which attempts to realize such an aim by drawing on the lessons learned from the Financial Crisis, is approaching its realization date.

Weaknesses in Basel II – weaknesses which surfaced during the 2008 Financial Crisis, are reflected through the features of the improved and enhanced framework which will be referred to as Basel III. Flaws and gaps in Basel II are largely attributed to banks’ extremely sensitive internal credit risk models which have contributed to pro cyclicality. As well as the need to address pro cyclicality, the second major issue in need of redress relates to the quantity and quality of capital – both issues having surfaced during the Financial Crisis. From this respect, Basel III differs from Basel II in relation to capital and measures aimed at mitigating pro cyclicality. For these reasons, the enhanced framework (Basel III) incorporates elements of improved quality and quantity of capital, as well as conservation buffers, counter cyclical buffers and additional capital requirements for systemically relevant institutions.

This chapter is structured as follows: As well as providing an analysis and evaluation of measures which have been adopted by the Basel Committee and other standard setting bodies as a response to the recent financial crisis, section one is aimed at providing an overview of what Basel III entails as well as a background to why such a framework is necessary.

Section two then provides a comparative analysis between Basel III and its predecessor, Basel II, by way of reference to certain features which distinguish both frameworks. Features such as Tier One Capital, Capital Conservation Buffers, Counter cyclical Buffers and additional capital requirements which have been imposed on systemically relevant financial institutions will be considered within this respect.

The third section will then highlight problems which have been identified in relation to Basel II – as well as its beneficial attributes. It will also seek to justify the recent efforts and decisions which have been approved by the Groups of Governors and Heads of Supervision and which are directed at raising the level of global minimum capital standards.

The final section will then evaluate the Basel III framework and will draw conclusions based on the apparent benefits and gaps which have (so far) been identified and are attributed to Basel III.

Background To The Literature: Basel Iii And Recent Efforts To Address Pro Cyclical Effects Of Basel Ii

In response to the recent Financial Crisis and to the realization that capital levels (which banks operated with) during the period of the Crisis were insufficient and also lacking in quality, the Basel Committee not only responded by raising the quality of capital – but also its level (Hannoun, 2010).

Further consequences of the recent Basel reforms also include (Hannoun, 2010):