History of the Bank for International Settlement (BIS) was founded in 1930, making it world’s oldest international financial institution and remains the principal center for international central bank cooperation (Felsenfeld & Bilali, 2004; Toniolo, 2005). On January 20, 1930, the BIS was established at the Hague Conference (Hague Convention of 1930) in the context of the Young Plan or Dawes Loans (the international loans issued to finance reparations) which can dealt with the coordinating settlement of reparation payment by the German government and its allies after First World War (Felsenfeld & Bilali, 2004). The primary intention of Bank’s founders’ was to create a focus for cooperation among central banks. Thus, the BIS act as the bank for central banks to accept deposits of a portion of the foreign exchange reserves of central banks and invest them prudently for a yield in market return (Bank for International Settlements Archive Guide, 2007).

Following the World War II until early 1970s, BIS monetary policy focused on implementing and defending the Bretton Woods system (BISA Guide, 2007). In the 1970s and 1980s, the focus was on managing cross-border capital flow transactions following the oil crises and the international debt crisis. The 1970s crisis also brought the issue of regulatory supervision of internationally active banks to the fore, resulting in the 1988 Basel Capital Accord and its Basel II revision of 2001-2006. More recently, the issue of financial stability in the wake of economic integration and globalization, as highlighted by the 1997 Asian crisis, has received a lot of attention. Next is relating to the monetary unification of Europe. BIS was the key meeting place for European central bankers as they laid the groundwork for monetary union from the mid- 1970s to early 1990s. Since the increase in globalization, deregulation and sophistication of financial markets have focused the attention of the BIS firmly on the issues related to the soundness of the international financial architecture and the threats posed by systemic risks (BISA Guide, 2007).

History of Basel

The Basel Committee on banking supervision (the committee) has been dealing with the creation of a framework to measure capital adequacy on a multinational scale as a guideline for an appropriate capital level of internationally active banks (Bieg & Kramer, 2006). It was commenced in respect that a frighteningly low level of the capital which was held by most banks worldwide. The aim of the Committee was also include that removing the disadvantages in competition between banks which resulted from different capital requirements of different states. The results of the Committee’s work were so called as International Convergence of Capital Measurement and Capital Standard, it also known as Basel Capital Accord, Basel Capital Adequacy Framework or in short Basel I while it is adoption in July 1988 (Bieg & Kramer, 2006). The implementation of Basel I became effective as of the year-end 1992. Meanwhile, Basel I has been changed on a small scale by amendments and revisions that are amendment to the capital accord to incorporate market risks and also called market risk amendment regarding the treatment of market risk in January 1996 (Bieg & Kramer, 2006). The changes were necessary since Basel I just limited only for a bank’s credit risks that will influence losses due to the reason for a bank’s poor performance. The changes to the Basel I framework made by the Market Risk Amendment became effective as of year-end 1997.

Due to the capital framework is no longer up-to-date and is effective in reaching the target of the Basel Committee on Banking Supervision so that the Committee published the first consultative paper concerning Basel II (The New Basel Capital Accord) in June1999. Interested parties (foremost banks) were given the chance to comment on these proposals until the end of March 2000. In January 2001, second consultative paper concerning Basel II was published that contains the revision of the first consultative paper of 1999 concerning the fundamental adjustment of the capital adequacy framework of 1988 and took into consideration many comments and suggestions made by banks within the first comment period (Bieg & Kramer, 2006). In the planned implementation of Basel II at the year-end of 2004 was postponed until the end of 2006. In order to be able to include the suggested comments for improvement in the framework, the Committee decided to postpone the completion of Basel II which should actually have been adopted at the end of 2001 and to publish a third consultative paper in April 2003 (Bieg & Kramer, 2006). The deadline for the third comment period was 31 July 2003.

Basel III is a work in progress that is far from completion. Basel III is a consultative document entitled “Strengthening the Resilience of the Banking Sector that was first promulgated on 17 December 2009 by the Basel Committee on Banking Supervision at the BIS (Eubanks, 2010). On December 2010, the Basel Committee released a near final version of its amendments to Basel II that can be referred to as Basel III (Eubanks, 2010). This Basel III is entitled “A Global Regulatory Framework for More Resilient Banks and Banking Systems (Eubanks, 2010). Besides, the Basel Committee issues a final element of the reforms to raise the quality of regulatory capital on January 13, 2011(Eubanks, 2010).

Indicator of Basel I

Basel I is primarily focus on credit risk which is the risk weighted assets of the bank. There are three general purposes of Basel I. Basel I is created to promote the harmonization of regulatory and capital adequacy standards only within the member states of the Basel Committee, to provide adequate capital to guard against risk in the creditworthiness of a bank’s loan book and proposes minimum capital requirements for internationally active banks, and invites sovereign authorities and central banks alike to be more conservative in their banking regulations. (Balin, 2008)

The Basel I Accord divides itself into four “pillars”. The first pillar is The Constituents of Capital which define capital in two board terms which is tier 1 capital and tier 2 capital. (Balin, 2008) Tier 1 capital also known as core capital that are consist of the universally recognized elements of shareholder’s equity, retained earnings and perpetual preferred stock. The elements such as asset revaluation reserve, subordinated debt, general loan-loss reserves and hybrid capital instruments were specified as tier 2 capital. (Fadi Zaher, 2011)

The second pillar is Risk Weighting which creates a comprehensive system to risk-weight a bank’s assets, or in other words, its loan book. In order to allow for different risk profiles, risk weighted capital are placed into 4 categories. The higher the asset’s credit risk, the higher their weight. Category 1 (0% weight) consists of riskless assets which are include cash, claims on central governments and central banks denominated in national currency and funded in that currency, other claims on OECD countries, central governments and central banks, claims collateralized by cash of OECD central government securities or guaranteed by OECD central governments. Category 2 (20% weight) consist of low risk assets .Securities in this category include multilateral development bank debt, bank debt created by banks incorporated in the OECD, non-OECD bank debt with a maturity of less than one year, cash items in collection, and loans guaranteed by OECD public sector entities. Category 3 (50%) consist of moderate risk asset which is only includes residential mortgages. Category 4 (100%) consist of high risk assets. This category include a bank’s claims on the private sector, non-OECD bank debt with a maturity of more than one year, claims on non-OECD dollar-denominated debt or Eurobonds, equity assets held by the bank, and all other assets. (Balin, 2008)

Capital adequacy ratio= Total capital (tier 1+ tier 2)

Risk weighted assets

The third pillar is A Target Standard Ratio. Minimum risk-based capital adequacy or minimum capital requirement which is 8% is specified in Basel I in order to help bank covers unanticipated losses. This is a universal standard that banks should hold. In order to lower credit risk, bank should hold minimum requirement of 8% total capital to its risk-weighted assets ratio. This capital requirement is focus in reducing credit risk. With higher amount of capital, banks have more to lose if they take on too much risk. Capital requirements reduce the probability of banks to take excessive risk. Thus make the bank become more stable. Moreover, Tier 1 capital must cover 4% of a bank’s risk-weighted assets. This ratio is seen as “minimally adequate” to protect against credit risk in deposit insurance-backed international banks in all Basel Committee member states. (Balin, 2008)

The fourth pillar is Transitional and Implementing Agreements which sets the stage for the implementation of the Basel Accords. Each country’s central bank is requested to create strong surveillance and enforcement mechanisms to ensure the Basel Accords are followed, and “transition weights” are given so that Basel Committee banks can adapt over a four-year period to the standards of the accord. (Balin, 2008)

The Basel I Capital Accord aimed to reducing the credit risk through the capital requirement ratio. Although Basel I is successfully issued but most of the people does not know why they need to follow this requirement, they just follow it blindly. Besides that, a focus on bank capital at a point in time may not be effectively in indicating whether a bank is taking on excessive risk in near future. In addition, its over-simplified calculations, and classifications have simultaneously called for appearance of Basel II Capital Accord. The introduction of Basel II is to improve Basel I and teach bank how to manage the risk in order to make the bank become more stable. (Zaher, 2011)

Limitation/Argument of Basel I

The shortcomings of Basel I included its failure to recognize differing credit quality within the same general asset type as well as its varying the capital charge with the credit exposure’s legal form, such as whether it is on or off balance sheet and its simplistic approach to risk transference and credit risk mitigation (Rutledge, 2005). More generally, Basel I was not structured to keep pace with the rapid rate of financial innovation that we have seen in internationally active banks (Rutledge, 2005). It clearly has created incentives for capital arbitrage, with banks able to structure transactions with the primary goal of minimizing regulatory requirements without a commensurate reduction in risk (Rutledge, 2005). Similarly, it has resulted in distortions in bank activity, by creating a tax on certain activities while understating the risk for others (Rutledge, 2005). These have combined to make the regulatory capital metric less informative to investors, supervisors and counterparties, and have eroded the principle of adequate risk-based capitalization that the Basel Accord was designed to promote.

However, Rutledge, 2005 also argued that the weaknesses of the current regulatory capital framework are much more relevant to the supervision of the largest and most sophisticated banks than they are generally across the industry. For the vast majority of the thousands of U.S. banks, the existing regime largely works. In recognition of this, among other considerations, we expect that in the U.S. most banks will stay on Basel I while the largest and internationally active banks will adopt the advanced Basel II approaches (Rutledge, 2005). Besides, the lack of risk sensitivity and incentives for arbitrage have made Basel I less relevant in our supervision of the largest banks—it is a benchmark requirement to be met, but not, in practice, a critical discriminating factor as we judge their financial condition (Rutledge, 2005).

The current stage of development of economic capital modeling—the differences in model construction, assumptions and coverage—limit our ability to make comparisons of the results across institutions argued by Rutledge, 2005. More generally, economic capital models clearly remain in an early evolutionary stage, most particularly regarding operational risk. Their early stage of development can also be seen in the relative paucity of disclosed economic capital estimates by banking firms. Only very recently have we begun to see that some bankers have sufficient confidence in the quality of their economic capital estimates, even of credit risk, to disclose them publicly (Rutledge, 2005).

Changes of Basel I to Basel II

Due to some criticism in Basel I, the committee believes that the revised Framework will promote the adoption of stronger risk management practices by the banking industry, and views this as one of its major benefits (BIS, 2004). The reason the committee revise the 1988 Accord is to develop a framework that would further strengthen the soundness and stability of the international banking system. Basel I only required bank to achieve the minimum capital adequacy ratio. It only involves the measurement of credit risk and ignores all the risk that will appear in bank as referring to appendix 1. Basel II goes well beyond this, allowing some lenders to use their own risk measurement models to calculate required regulatory capital whilst seeking to ensure that lenders establish a culture with risk management at the heart of the organization up to the highest managerial level.

The main difference is that the Basel I accord mainly focused on capital requirements for banks and in contrast, Basel II adds supervision and market discipline to these capital requirements through the Three Pillar concept (Council of mortgage lenders, 2011).

Indicator of BASEL II

According to commend on Basel II proposal can see that banks and other interested parties have agree and welcome the three pillars approach. Most of them are totally support improve capital regulation and risk management practice. 3 pillars in Basel II which are minimum capital requirements, supervisory review and market discipline.

In Pillar 1, banks are provided a range of options about capital requirements for credit risk and operational risk. So the supervisors of bank may choose the most appropriate according their operations and financial market infrastructure (Francis, 2006). In addition, This framework allows a country to decide where each option can be used in limited ways, to meet the standards of the domestic market in different conditions.Listen This revised Framework is more risk sensitive compare to 1988 Accord. Read phoneticallyThose countries where risks in the local banking market are high nonetheless need to consider if banks should be required to hold additional capital over and above the Basel minimum.

In Pillar 2, home country supervisors have a very important role in leading the enhanced cooperation between home and host country supervisors. But it will be required for effective implementation. The AIG is developing practical arrangements for cooperation and coordination that reduce implementation burden on banks and conserve supervisory resources. Based on the work of the Accord Implementation Groups, and based on its interactions with supervisors and the industry, the Committee has issued general principles for the cross-border implementation of the revised Framework and more focused principles for the recognition of operational risk capital charges under advanced measurement approaches for home and host supervisors (BIS, 2004; Kupiec, 2006; Basel Committee, 2001). Besides, the Committee would like to highlight the need for banks and supervisors to give appropriate attention to the second pillar (supervisory review).

The third pillar is about the market discipline (Calomiris, 1998) and it is to complement the minimum capital requirements which stated in Pillar 1 and the supervisory review process stated in Pillar 2. In here, the Committee aims to developed market discipline by come out a set of disclosure requirements which will allow market participants to fully assess all the information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution.

Limitation/Argument of Basel II

Basel II regulations have faced several criticisms since its first release. For example, Jandl & Valverde stated that Basel II have faced the pro-cyclicality problem. According to some academics, the new regulations and exigencies discussed in Basel II will heighten the business cycles. The criticism relies of the fact that whenever is a downturn in the economy, banks’ credit risk assessment models or rating agencies will be prompted to downgrade in advance the credit risk profiles due to a riskier environment. With these downgrades banks will need to increase its capital holdings at increased costs, reducing their lending activity, which in turn will worsen the initial turndown cycle. It is worth mentioning that this does not imply that a cut in lending is unsafe in recession periods; however, the said reduction is strongly related to the “… shadow value of bank capital, which measures the scarcity of bank capital relative to positive-NPV lending opportunities. A higher shadow value of bank capital indicates a greater relative scarcity and hence more severe problems of underinvestment in terms of lending…” (Kashyap & Stein, 2004). Moreover, Basel II regulations to measure credit risks may be not flexible enough to prevent from a heightened increase of the shadow value of bank capital, which will lead to the aforementioned pro-cyclicality said by Kashyap and Stein, 2004.

Secondly, Basel II also faced complex implementation problem (Jandl & Valverde). In many cases, Basel II regulations require the upgrade of supervisor powers in order to fully accomplish the supervisory review process described in Pillar II. Besides, the disclosure requirements of Pillar II largely exceed current practices, which may generate delays in the implementation of Basel II due to negotiations between Supervisors and Banks (Jandl & Valverde). Furthermore, operational risk is still being assessed as far from being accurate (Jandl & Valverde). Other than that, banks needs vast historical data to calculate the default risk, which in many cases is too costly (Jandl & Valverde).

Thirdly, threatens banking competition was once of the problem faced by Basel II (Jandl & Valverde). The application of the IRB approaches will allow the reduction of capital requirements, favouring large banks, which are the more likely to implement them. Different approaches will widen the difference between banks, getting farther from the “standardization” target of Basel Committee. Finally, the adaptation to Basel II requirements will be costly for emerging market, reducing their competitiveness internationally.

Changes of Basel II to Basel III

In order to cover the limitation of basel II, basel III is carried out by Bank for International Settlement. Basel III is more advance than Basel II and it consist of 4 major components which are Quality, consistency and transparency of the capital base (Greater emphasis placed on the common equity component of Tier 1 capital, simplification of Tier 2, elimination of Tier 3, detailed regulatory capital disclosure requirements as compared to basel II), enhancement of risk coverage through enhanced capital requirements for counterparty credit risk (Enhanced risk coverage will address issues that arise in connection with the use of derivatives, repos, and securities financing arrangements), Changes to non-risk adjusted leverage ratio(This ratio will supplement the Basel II risk capital framework) and measures to improve countercyclical capital framework which are not been addressing in Basel II. Further than that, additional capital conversation buffer, additional countercyclical buffer, additional requirements for systemically important financial institutions and leverage ratio has been added to Basel III and these measurement do not exist in Basel II as referring to Appendix 2.

Indicator of Basel III

Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to: improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, improve risk management and governance end eventually strengthen banks’ transparency and disclosures (International regulatory framework for banks: Basel III).

Furthermore, the reforms are targeting the bank-level, or microprudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress (International regulatory framework for banks: Basel III). Despite from that, macroprudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.

Under Basel III, there will be strengthening of the quality of capital required to be held by banks. The minimum capital ratio for common equity, which is the highest form of loss absorbing capital, will increase to 4.5% from the current level of 2%. The Tier 1 capital ratio (which includes common equity and other qualifying financial instruments based on stricter criteria) will increase from 4% to 6%.

Banks will also be required to hold a separate capital conservation buffer comprising 2.5% of common equity. The intention behind this new requirement is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress (Basel III announced). Banks will be allowed to draw upon the buffer during such periods but, should they do so, they will face constraints on earnings distributions. This framework is intended to reinforce the objective of sound supervision and bank governance, and address the issue of the collective failure of banks to curtail distributions such as discretionary bonuses and high dividends, even

when faced with deteriorating capital positions.

A countercyclical buffer will also be implemented, according to national circumstances (Basel III announced). This buffer will range from 0% to 2.5% of common equity or other fully loss absorbing capital. Its purpose is to achieve the broader macro-prudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, the countercyclical buffer will only be in effect when there is excess credit growth resulting in a system wide build up of risk. Decisions on when economies have entered such periods will be taken by national regulators. Once put into operation, the countercyclical buffer will be introduced as an extension of the capital conservation buffer. The above capital requirements will be supplemented by the introduction of a non-risk based leverage ratio. A minimum Tier 1 leverage ratio of 3% will be tested during the period from 1 January 2013 to 1 January 2017.

Besides, in order to improve risk coverage, higher capital requirements for trading and securitisation activities imposed, Basel III will further highlight the enhancement of capital requirements and risk management standards for counterparty credit risk exposures arising from derivatives, repos and securities financing activities (Basel III rules published, 2010). Basel III contains measures in relation to the use of external credit ratings in the capital framework as well In addition, a combination of a minimum liquidity coverage ratio to enhance short-term cash flow resilience and a structural minimum net stable funding ratio to encourage banks to better match the liquidity profile of their assets and liabilities are to be introduced (Basel III rules published, 2010). Appendix 3 has further shown the phase in arrangement for Basel III.

Basel III is at the core of the G20’s efforts to apply lessons learnt from the global financial crisis. Regulators have said that they hope that the changes will push banks towards less risky business strategies and ensure that they have enough reserves to withstand financial shocks, thus avoiding a repeat of the recent crisis (Basel III announced).

Limitation/Argument of Basel III

Basel III received harsh criticisms from the banking industry and some regulators. The European banks were most critical of the proposal, arguing that Basel III favors U.S. banks because U.S. banks historically maintained a higher level of capital and would more easily meet the quantitative increase in capital. Moreover, it is much harder to raise capital from the private sector in Europe than in America (Eubanks, 2010). The Institute of International Finance, which represents the world’s largest commercial banks, warned in June 2010 that the December 2009 Basel III proposal would require that these larger banks raise $700 billion in common equity and issue $5.4 trillion in long term debt over the next five years to meet the standards. The absorption of capital would cause a 3% decline in the United States’ GDP compared with what it would be otherwise in five years (Pruzin, 2010).

JP Morgan Chase and Morgan Stanley, 2010 argued that the Basel III proposal would significantly reduce the availability of credit to the U.S. economy. The American Securities Forum, 2010 said that Basel III’s liquidity coverage ratio “could have a catastrophic effect on the short-term global capital markets.” The main reason is that the liquidity ratio would require banks at all times to hold a stock of highly liquid assets that equal or exceed their net cash flow calculated over a 30-day period. This liquidity would significantly reduce short-term funds needed to issue short-term debt securities, such as money market instruments and corporate and municipal bonds. The Deutsche Bank’s, 2010 comment was that the timetable was too short to increase common equity because the prospects for future profits, the main source of common equity, are not good in the short run. The French Bankers Association, 2010 assessment was that the adjustment to Basel III was unworkable because it would result in a Tier 1 capital shortage of between $2.7 trillion and $4.7 trillion for the Euro-zone countries alone.

The Basel Committee on Banking Supervision made its own assessment of the Basel III proposal’s impact on the global economies. It reported its findings in a document entitled, An Assessment of the Long-term Impact of Stronger Capital and Liquidity Requirements, on August 18, 2010. The finding of the Basel Committee’s assessment was that higher capital and liquidity requirements can significantly reduce the probability of a banking crisis. Taking a different approach to assessing the benefits of Basel III, the committee found that the incremental benefits decline at the margin. Consequently, the benefits are relatively large when capital ratios are increased from low levels and progressively decline as standards tighten. For example, the committee found that the decrease in the likelihood of a crisis is three times larger when capital is increased from 7% to 8% than when capital is raised from 10% to 11%. The assessment concluded that better capitalization reduces both the likelihood of crises and the severity of crises when they occur.

Recommendation

The first recommendation is accelerate the work on redefining capital (Banking on Basel, 2008). The Basel Committee proposed that there is a need to revise the definition of the tier 1 and tier 2 capitals. Thus the first recommendation is approval of the committee’s agenda rather than a call for a change of itinerary. However, the rather deliberate pace with which the committee has begun this review should be speed up. From the subprime crisis we can know that the importance of ensuring that regulatory capital in fact possesses the steady buffering characteristics that should define core capital.

Besides, communication of the leverage ratio with the higher levels of liquid assets should be taken into concerned, which probably can increase the ratio calculation (Consultative proposals to strengthen the resilience of the banking sector, 2010). They also impose a doubt in whether the same leverage ratio level can be applied for essentially dissimilar business models. For example, there is a difference between fully securitizing mortgages and make it become off balance sheet and use mortgage-backed bonds for funding but leaving them on balance sheet. They recommend that the Committee consider differential calibration levels that take these differences into account.

In Consultative proposals to strengthen the resilience of the banking sector (2010) also state that supervisors should oppose the comprehensible result to relate extremely conservative capital requirements to trading activities. The trading book prudential framework and capital requirements need to be risk sensitive in order to minimize arbitrage opportunities, and remain effective in the long run. That is a need to be transparent to financial market participants that trading book capital is generally correlated with the level of economic risk, although overlaid with justifiable conservatism.

Lastly, planning in advance for orderly resolution is the most important issue (Report and Recommendations of the Cross-border Bank Resolution Group, 2010). In 2007 crisis, it can demonstrate there are many challenges in order to have orderly resolution of complex cross-border financial institutions in a global financial crisis. The crisis has identified that thorough crisis prevention must take into account to corporate form and the operation of nationally based insolvency procedures. Even some large financial institutions provide functions that are systemically important, similar in some sense to infrastructures or public utilities, their business connection and contingency planning preparations have not typically been required to include resolution contingencies. While no successful business conducts in a wind-down mode, resolution contingency planning should become a part of the supervisory process for large and complex cross-border institutions.

Conclusion

As a conclusion, the Basel agreement is useful. The new agreement, the bank has developed a new capital standards to ensure that banks hold sufficient reserves to not rely on Government assistance independent of future financial crises can occur and can avoid the banks in real estate loans, commercial loans, credit card business in a large number of risks and obligations, to create a more stable Ugg Classic financial system (The Independent,2010).Besides, The European Central Bank President Trichet mentioned that the Basel Agreement is the fundamental to strengthening global bank capital ratios, and it could helped to sustain the long-term financial stability and economic growth (European Central Bank,2011). In addition, In the United States, Canada, the United Kingdom, the Bank has raised a number of new capitals, which reduced their debt level (The Independent, 2010).

Based on our own opinion in order to develop Basel III in our country, the pre-testing (pilot test) should be conducted before it. This pilot test is to testing the effect of the new regulation which may influence the country economic. We need to test that any effect that could affect country consumption, investment, government spending and export and import. Besides, before implement the Basel III the new solution for any problem caused by implemented Basel III should be well prepare. In other words, the solutions need to come out before the Basel III is implemented.

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