The Basel Accord and Basel II Norms
Info: 4703 words (19 pages) Example Literature Review
Published: 6th Dec 2019
The review of expansion in the Nigeria banking and financial system shows that the banking sector has undergone remarkable changes over the years, in terms of ownership structure, the number of institutions, as well as the level of operations. This is mainly motivated by the deregulation of the financial sector in order to obey the rules of international standards. As at the end of June 2006, the number of insured banks stood at 25 with different sizes and degree of soundness (Adams J. A. 2005).
The vitality of the international economic environment demands a more robust skills and tools to reduce risk emanating from the rapid development of the financial sector. In other to meet up with the ever dynamic financial landscape, advancement in, as well as the wide use of communication/information technology, a more effective risk management approach is required.
Although, effective risk management has always been fundamental to safe and sound banking activities. For two main reasons effective risk management has assumed added importance. Firstly technological advancement, product and services innovation, size and speed of financial transactions have transformed the nature of banking. Secondly in other to meet up with international banking standard, there is the need to abide fully with the Basel core principle on supervision and to set up an enabling environment for the implementation of the New Capital Accord.
The above mentioned amongst other formed the basis for the adoption of the Capital Adequacy Standard. Capital Adequacy ratio (CAR) is a robust, proactive and sophisticated supervisory requirement for risk management. It is essentially based on risk profiling of a bank. It enables the regulatory authorities to prioritize effort and focus on significant bank with high risk and low CAR.
The nature of banking business involves risk taking CAR is a risk based system that enables bank to adequately provide the necessary buffer for counterpart risk. The major risk faced by banks in the course of business includes but not limited to market, credit, liquidity, operational, legal and reputational risk. Practically bank business activities come with various combinations of these risks depending on the nature and scope of the particular activity undertaken.
In Nigeria the objectives of the regulatory authorities includes the promotion of stable, secure and sound financial system, ensuring and efficient payment system, necessary for the achievement of the broader economic objective of welfare improvement, ensuring effective consumer protection and the reduction of financial risks among others.
There have been numerous empirical attempts to measure the impact of capital adequacy of the financial reforms in Nigeria (see Alawode and Ikhide 1994, Ikhide 1998, Adekanye and Soyinbo 1992, Subdue and Akiode 1994 among others). There are previous studies that assess the capital ratio of the financial sector reforms in Nigeria in contrast to other countries in Sub-Sahara Africa (for example, Soyinbo 1994, Aryeetey 2000, Emenuga 1998, Aryeetey and Senbel 1998 among others).
Surprisingly, none of these studies has given a comfortable pass mark for the financial sector reforms in Nigeria.
They opined that capitalization may raise liquidity in the short term but will not guaranty a conducive macroeconomic environment necessary to guaranty high asset quality and good profitability.
Capital adequacy has traditionally been regarded as a sign of strength of the financial system in Nigeria. A sound banking system is a system in which each bank accounting for most of the system’s transactions are solvent, and meet capital adequacy requirements (Josefsson M 2002). Ensuring the soundness of individual banks – what regulators (Basel committee on Banking supervision) now call the “micro-prudential perspective” is however, only part of guaranteeing a sound financial system. Bank supervisors also talk of the “macro prudential perspective”, (Ryback 2006) outlines the major characteristics of the macro-prudential perspective as follows:
It intends to limit the distress to whole financial systems rather than to individual institutions
Its principal aim is to circumvent large and burdensome costs to the economy such as expensive bank bailout rather than aiming to protect more narrowly the depositors of an individual bank.
It is based largely on the postulation that at least some of the risk faced by the banking system collectively differ from those faced by individual banks. In other words, the risk to the system is not simply the sum of risk to individual banks
It aims to look at risks arising from the interaction banks as part of a financial system rather than on bank-by-bank basis.
In an effort to assess and predicts the possible impact of the Basel ii criterion of capital adequacy of banks in Nigeria financial system, experience is drawn from related literature for the purpose of this study.
2.1 The Basel Accord…………………………………………………………………………………………………………………
The Basel committee on banking supervision introduced in 2006 a new risk-based requirement for international active (and other significant) banks. The new accord is meant to replace the existing Basel I
2.2 Basel II Norms
Basel II is the second of the Basel Accords recommendation on banking laws and regulations issued by the Basel Committee on Banking Supervision. The aim of Basel II is to create an international standard that banking regulators should apply when creating regulations about the level of capital banks need to put aside to guard against the types of financial and operational risks to which the banks are likely to suffer should things go wrong. Expose Basel II is a much broader framework of Banking Supervision. It does not deal with Capital to Risk Weighted Asset Ratio CRAR calculation, but has also got provisions for supervisory review and market discipline.
2.3 THE THREE PILLARS OF THE BASEL II NORM
2.3 Three Pillar Approach
The structure of the new Basel Accord-II(Hubert, E 2004) consist of three mutually reinforcing pillars approach. Pillars I dwell on Minimum Capital Requirement (MCR), while Pillars on Supervisory Review Process and Pillar III stands on Market Discipline. Pillar II and III are expected to complement the requirement of Pillar I
2.3.1 PILLAR I
The first pillar established an approach to quantify the MCR. While the new framework maintains both existing capital definition and minimum capital ratio of 8%, (Hubert 2004) significant changes have been introduced in the measurement of the risks. The MCR is worked out for the combined effort of credit, market and operational risk based on a particular approach. The Basel II Accord provides options to measure the risk in reverence to all the three risks as outlined below:
Credit risk is the likelihood that the counterpart fails to honour the financial obligation on agreed terms. There are two approaches for credit risk measurement- the Standardized Approach (SA) and Internal Rating Basel (IRB) Approach. In SA, credit risk is measured in the same method as in Basel I, but in a more sensitive manner, i.e., by linking credit ratings of credit rating agencies to risks of the assets of the individual bank. In IRB approach, banks will be allowed to use their internal estimates of credit risk, subject to supplementary approval to determine the capital charge for a given (Hubert 2004). This world entails estimation of numerous parameters such as the Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Effective Maturity (M) in correspondence to a particular portfolio
Market risk is the likelihood of loss caused by the fluctuations in the market variable. Banks have the option of two approaches to select from, and they are the Standard Approach and Internal Model Based (IMB) approach. Under the SA, interest rate risk, foreign exchange risk, equity position risk, commodity risk and option risk are the distinct sources identified and the accord provides comprehensive treatment to be adopted by the banks depending on the degree of risk to which banks are exposed for each of these sources. Banks have adopted standardized duration method for calculation of capital charge for market risk from March 2006. And IMB approach allows banks to develop their own internal models to calculate capital charge for market risk by using the notion of value at risk (VaR)
Operational risk is defined as the risk of direct or indirect loss as a result of inadequate process or failed internal process, people and systems or from external circumstances. In order to calculate the capital charge for operational risk, three approaches – Advanced Measurement Approach (AMA), Basic Indicator Approach (BIA), and Standard Approach- have been suggested. In BIA, an estimate of the capital charge for operational risk is arrived at by averaging over a fixed percentage of positive annual gross income of the bank over the last three years. In this estimate, negative incomes are excluded under Standard Approach; at first, the banks’ business activities are grouped into eight business lines. For each business line, a capital charge is calculated by multiplying the gross income of the business line by a factor. A capital charge for each business line is thus calculated for three consecutive years. The overall capital charge is calculated as the three year average of the simple summation of the charges across business line in each year. Under Advanced Measurement Approach (AMA), a bank can be subjected to supervisory approval, use its own method for determining capital requirement for operational risk.
2.4 PILLAR II
Pillar II forms part of the supervisory review process (Hubert 2004). The supervisory review process needs supervisors to ensure that each bank has its sound internal processes in place to assess the adequacy of its capital based on a comprehensive evaluation of its risks. The role of supervisory review process is viewed as a critical component of other two pillars capital requirement and market discipline. The new accord stresses the importance and the need for supervisors of bank to take a comprehensive view on how banks have gone about in tackling the risk-sensitive issues, risk management, capital allocation process etc. this internal process would then be supervisory reviewed and intervention wherever is necessary.
2.5 PILLAR III
Pillar III guidelines enhance the disclosure requirement with addition of risk management characteristic to the otherwise monopoly of financial number disclosures. Financial statement disclosure is primarily driven by statute and best practices. The Basel Committee has recommended for market discipline in a way of public disclosure so that market participants take well informed decision as far as banks’ risk and capital structure are concerned. Pillar III consists of disclosure on capital structure, accounting policies concerning valuation of assets, features of capital instruments liabilities, assets classification and provisioning income recognition, qualitative and quantitative information on risk exposure and strategic on risk management, CAR calculation as well as related items. This approach enhances the overall transparency and adequate disclosure of the financial reporting system of banks.
2.6 Differences between Basel I and II
Basel I and II are the result of Basel committee which consists of a group of eleven nations. The formation was a result of the liquidation of the Cologne-based bank Herstatt. The committee decided to form a cooperation council to harmonize banking standard and regulations between and within all member states. Their objectives as stated in the founding document of the Basel committee is to extend regulatory coverage, promote adequate banking supervision, and ensure that no foreign banking establishment can escape supervision (international convergence 9)
COMPARISM OF BASEL ACCORDS
1998: BASEL I
2004: BASEL II
Focus on single measure capital
Pillar I; minimum capital requirement
Pillar II; supervisory review process
Pillar I; minimum capital requirement
Pillar II; supervisory review process
Pillar III; Market Discipline Requirement
One size fits all
Menu of approaches
Greater of risk sensitivity
The first Basel accord, Basel I was revolution in its own period and did much to promote regulatory harmony and growth of international banking across the region of the G-10 nations and the world alike (Bryan, J 2008). On the other hand, its limited scope gives bank excessive flexibility in their interpretation of its rules and consequently allows financial institution to take improper risk and hold unduly low capital reserves.
Basel II, on the other hand seeks to extend the breath and precision of Basel I, it factors in operational risk, market-based discipline, surveillance and regulatory mandates (Bryan J 2008)
2.7 CAPITAL ADEQUACY STANDARD: THE NIGERIAN EXPERIENCE
Recapitalization of banks in Nigeria is not a new phenomenon (Adegbaju and Olokoyo 2008). Right from 1958 after the first banking ordinance in 1952 the colonial government then raised the capital requirement for banks especially the foreign commercial bank from 200,000 pounds to 400,000 pounds. Rights from then the issue of bank recapitalization have been a continuous occurrence not only in Nigeria but also generally around the global economics especially as the world continues to witness interdependence among national economies
Recapitalization in Nigeria comes with every amendment to the existing banking laws. Capitalization for banks as at 1969 was N1.5million for foreign banks and N600,000 for indigenous commercial banks (Adegbaju and Olokoyo 2008). Thereafter in 1979, when Merchant banks came on board the Nigeria banking scene, it has a capital base of N2million. As from 1988, there had been continuos increase in the capital base, coupled with the liberalization of the financial system and the introduction of Structural Adjustment Programme (SAP) in 1986
In February 1988, the capital base for commercial bank was raised to N5million (NDIC 2000) while that of the Merchant bank was stood at N3million. In October the same year, it was raised up to N10m for commercial bank and N6million for Merchant banks operating within the country. In 1989, there was a further increase to N20m for commercial bank and N12m for Merchant bank.
In acknowledgement of the fact that well-capitalized banks would strengthen the banking system for efficient monetary arrangement, the monetary authority increased the minimum paid-up capital of commercial and merchant banks in February 1990 to N50 and N40 million from N20 and N12 million respectively. Distressed banks whose capital fell below existing requirement were expected to comply by 31st March, 1997 or face liquidation (Adegbaju and Olokoyo 2008). Twenty-six of such banks comprising 13 each of merchant and merchant banks were distressed in January, 1998. Minimum paid up capital of merchant and commercial banks was raised to the equal level of N500 million with effect from 1st January 1997 and by December 1998, all existing banks were to recapitalize.
The CBN brought into force the risk weighted measure of capital adequacy recommended by the Basle Committee of the bank for International Settlements in 1990. Before then capital adequacy was measured by ratio of adjusted capital to total loans and advances outstanding. The CBN in 1990 introduced a set of prudential guidelines for licensed banks, which were complementary to both the capital adequacy requirement and statement of Standard Accounting Practices. The prudential guidelines, among others, designed the criteria to be used by banks for classifying non-performing loans.
In 2001, when the Universal banking was adopted in principle, the capital base was further raised up to N1billion for existing bank and N2billion for new banks. But in July 2004, the new governor of the CBN announced the need for banks to increase their capital base to N25billion all banks are expected to comply by December 2005.
Prior to the recent reforms, the state of the Nigeria banking sector was very weak. According to (Soludo, 2004, p.19), “The Nigeria banking system today is fragile and marginal. The system faces enormous challenges which, if not addressed urgently, could snowball into a crisis in the near future. He identified the problems of the bank, especially those seen as weak as persistent illiquidity, unprofitable operations and having a poor assets base”
(Imala, 2005) posited that the objectives of banking system are to guarantee price stability and facilitate swift economic development. Regrettably these objectives have remained basically unattained in Nigeria as a result of various deficiencies in our the banking system, these includes; low capital base, as average capital base of Nigeria banks was $10 million which is very low, poor rating of a number of banks, a large number of small banks with relatively few branches, the dominance of a few banks, insolvency as evidence by negative capital adequacy ratios of some banks, weak corporate governance evidence by inaccurate reporting and non compliance with regulatory requirement, eroded shareholders fund caused by operating losses, over dependence on public deposit and foreign exchange trading and the neglect of small and medium scale private savers (Adegbaju and Olokoyo 2008).
The Nigeria banking sector plays marginal role in the development of the real sector. (Soludo 2005) observed that many banks appear to have neglected their essential intermediation role of saving mobilization and inculcating banking habit at the household and macro enterprise levels. The unresponsiveness of banks towards small savers, particularly at the grass-root level has not only compounded the problems of low domestic saving and high bank lending rates in the country, it has also hindered access to relatively cheap and stable funds that could provide a reliable source of credit to the productive sectors at affordable rates of interest.
(Imala 2005) also observed that the present structure of the banking system has promoted tendencies towards a rather sticky bahaviour of deposit rates, particularly at the retail level, such that while banks lending rates remain high and positive in real terms, most deposit rates, especially those on savings are low and negative. In addition savings mobilization at the grass-root level has been discouraged by the unrealistic requirements by many banks for opening accounts with them.
The issue of recapitalization is a major reforms objective; recapitalization literarily means increasing the amount of long-term finances used in financing the organization and increasing capital adequacy ratio (CAR) of banks.
Recapitalization involves increasing the debt stock of the company or issuing additional shares either through existing shareholders or new shareholders or through a combination of the both. It could even take the form of merger and acquisition or foreign direct investment (FDI). Whichever form it takes the end objectives is that the long term capital stock of the organization is increased substantially and significantly to sustain the current economy trend in the global world.
(Asedionien 2004) posited that “Recapitalization may raise liquidity in short term but will not guaranty a conducive macroeconomic environment required to ensure high asset quality and good profitability” in his comment, (Soludo 2004) said that low capitalization of the banks has made them less able to finance the economy and more prone to unethical and unprofessional practices. These include poor loan quality up to 21 per cent of shareholders’ fund compared with 1-2 percent in Europe and America; overtrading abandoning the true function of banking to focus on quick ventures such as trading in foreign exchange and tilting their funding support in favour of import-export trade instead of manufacturing; reliance on unstable public sector funds for their deposit base; forcing their female marketing staff in unwholesome conduct to meet unjustifiable targets in deposit mobilization; and high cost of funds.
Jika (2004) as cited in Aminu and Aderinokun (2004) maintained that raising the capital base of banks in Nigeria would strengthen them and in process deepen activities within the industry. “Growing the Nigeria economy is about the number of banks that have the capacity to operate in all the states of the federation, fund agriculture and manufacturing concerns and in the process generate employment for Nigerians” quoting Alarape (2005) as cited in Ologbondiya and Aminu (2005), “We see a very rosy future beyond the next two years or 2007 when profitability will grow and all the adjustments that the industry needs to go through in the macro-economy including legislation that would be put in place to support the new type of business especially retail banking would have been put in place”
The importance of the financial in an economy which comprises banks and non-banks financial intermediaries, the regulatory framework and the ever dynamic financial products in stimulating economic growth is widely recognized particularly in developmental economics.
(Uboh, 2005), set the pace for the landslide of other works on the interdependent relationship between banks and economic growth. Stressing further that the pioneering shows that financial intermediaries, monetization and capital formation determine the path and pace of economic development.
MACROECONOMIC DEVELOPMENT VS FINANCIAL VULNERABILITY
2.8 Macroeconomic implication of capital adequacy
Quantifying financial soundness within the framework of banking regulation and supervision has generated more questions than answers (Mingo)’. Although soundness is often interpreted to correspond to several measurements of capital adequacy as set out in the Basel Accord, it has equally been observed that capital adequacy depends on the ratio of capital to the risk it should be prepared to absorb (Estraita*, et al Berger’, el al). At least four types of risk exist for banks; interest rate risk (market risk), operational risk credit risk and reputational risk.
Historically, the major area of risk for bank losses exists in credit losses (Cantor, R 2001). Credit risk is difficult to evaluate, an argument can be made that the loan default disclosure alternative for credit risk may also give an indication of operational risk related to management decision making. However, it has been observed that managerial weakness for failed banks include inadequate supervision of loan portfolios and overly insistent strategies for growth in loans and deposits. It is shown in Djiwandono that efforts to strengthen the banking system would be guided by four principles.
*the soundness of a bank is primarily the responsibility of its owners and managers and yet the soundness of a banking system is a public policy concern.
*bank soundness is significantly linked to sound macroeconomic policies
*sound banking framework must include structures to support internal governance and market discipline as well as official regulation and supervision.
*an international cooperation can play a vital role not only in strengthen the global financial system but also in improving the soundness of the national banking system. However, many researches have clearly indicated the close link between banking system soundness and monetary policy. It is sited in Djiwandono that good monetary policy for achieving monetary stability or well, managed macroeconomic policies for achieving growth and stability, cannot be sustainable without the existence of a sound banking system. It is further argued that banking soundness should be treated as an objective for monetary policy together with price and exchange rate stability.
In this view point system bank soundness is now seen as an element of monetary management as a complement to macroeconomic policy in general and as a policy objective in its own right or the pursuit of economic stability and balance.
2.9 ADOPTING BASEL II ACCORD
The Governor of Central Bank of Nigeria, Soludo, after resuming office in 2004 announced a 133 point reform program for the Nigerian banks. The primarily objective of the reform is to meet the Basel II criterion of capital adequacy and guarantee an efficient and sound financial system. The reform are designed to enable the banking system develop the required flexibility to support the economic development of the nation by efficiently performing its function as the pivot of financial intermediation (Lemo, 2005) Thus the reforms were to ensure a diversified, strong and reliable banking industry where there is safety of depositors’ fund and position banks to play active developmental roles in the Nigeria economy.
According to (Soludo 2004) The key elements of the reform programme include:
*Minimum capital base of N25 with a deadline of 31st December 2005
*Consolidation of banking institutions through merger and acquisitions
*Phased withdrawal of public sector funds from banks beginning from July 2004
*Adoption of a risk-focused and ruled-based regulatory framework
*Zero tolerance for weak corporate governance misconduct and lack of transparency
The reform in the banking sector proceeded against the back drop of banking crisis due to highly undercapitalization deposit taken banks, witness in the regulatory and supervisory framework, weak management practice and the tolerance of deficiencies in the corporate governance behavior of banks (Uchendu 2005)
Banking sector reform and capital adequacy have resulted from deliberate policy response to correct apparent or loaning banking sector crisis and subsequent failure. A banking crisis can be triggered by weakness in banking system characterized by persistent illiquidity, insolvency, undercapitalization, high level of nonperforming loans and weak corporate governance, among others.
Similarly, extremely open economies like Nigeria, with weak financial infrastructure can be vulnerable to banking crisis emanating from other countries through ineffectively.
Banking crisis frequently starts with inability of the bank to honour its financial obligation to its stake holders (Adegbaju 2008). These in most cases precipitate runs on banks, the banks and their customers engage in massive credit recalls and withdrawals which sometimes force central bank liquidity support to the affected banks.
Some terminal intervention mechanisms may occur in the form of consolidation (mergers and acquisitions) recapitalization use of bridge banks, establishment of assets management companies to assume control and recovery of banks assets and outright liquidation of non redeemable banks.
Bank capitalization, which is at the core of most banking system reform programmes, occurs some of the time independent of any banking crisis irrespective of the cause, however bank capitalization is implemented to reinforce the banking system, embrace globalization, improve healthy competition, exploit economies of large scale, adopt advanced technologies, raise efficiency and improve profitability. Ultimately, the goal is to strengthen the intermediation role of banks and to ensure that they are able to perform their developmental role of enhancing economic growth, which subsequently leads to improved overall economic performance and societal welfare.
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