Inadequacies Of Basel II And Introduction Of Basel III: A Critique And Analysis

Inadequacies of Basel II in dealing with contemporary issues faced by financial institutions

1. Discuss the inadequacies of Basel II to deal with the contemporary issues faced by financial institutions around the world?

2. Discuss the reasons Basel III was introduced?

3. Discuss and critique whether Basel III ought to be applied to the Big 4 banks in Australia?

4. Discuss how any one of the Big 4 banks in Australia managed Basel III with respect to how funds are raised?

5. Define project finance in your own words?

6. Explain the reasons public-private partnerships (PPP) are common in project finance?

7. Discuss and critique 4 key risks related to public-private partnerships?

8. Discuss and critique 3 key success factors in public-private partnership?

The “Basel Committee on Banking Supervision” has introduced Basel II in 2004 for ensuring greater transparency in the banking regulations. The framework is designed to minimise the loopholes inherent in Basel I along with protecting the banks against global financial and economic crises (Angelini et al. 2015). However, the implementation of Basel II framework has resulted in huge losses for the big global financial institutions due to the following inadequacies:

Underestimation of risk exposure:

The requirement of bank recapitalisation indicates that the models of internal risk have not performed efficiently due to underestimation of risk exposure. This has compelled the global financial institutions in reassessing and repricing the credit risk (Blundell-Wignall, Atkinson & Roulet, 2014). As a result, it signifies the complexities of accountability for low profitability; however, large events.

Development of perverse incentives:

Another fundamental problem related to Basel II is the dev elopement of perverse incentives in underestimation of credit risk. This is because the banks are permitted to utilise their own models for evaluating risk and ascertaining the amount of regulatory capital (Kou, Peng & Heyde, 2013). As a result, the financial institutions tend to be overoptimistic regarding their risk exposures for minimising the amount of regulatory capital in order to increase the overall return on equity. 

Fall in bank capital asset ratios:

The bank capital asset ratios have declined considerably, which has been around 7% of the overall assets. It has been observed that the “Basel Committee on Banking Supervision” has undertaken several methods over the years for exploring the consequences of moving from Basel I to Basel II framework (Hong, Huang & Wu, 2014). From the results of the undertaken methods, it has been found that the capital requirements of the financial institutions would decline further for many banks, in case; the norms of Basel II are entirely implemented.

Reasons for the introduction of Basel III

Restricted loans to banks and companies with no or lower rating:

With the introduction of Basel II norms, the availability of credit has been reduced for the banks and companies, which have lower credit rating along with addition to the financing cost. The reason behind this is that the Basel II norms have prevented the financial institutions in providing loans to the unrated organisations, as provision of such loans is prone to entire risk-weight.

The “Basel Committee on Banking Supervision” has enforced the Basel III framework to protect the world economy from the negative impact of both financial and economic crises. In this context, Grosse & Schumann (2014) advocated that with the help of Basel III framework, the economic contribution of the financial institutions and banks have increased significantly in terms of added responsibilities for safeguarding the same against any unexpected crisis. The major reasons behind the introduction of the Basel III framework are briefly demonstrated as follows:

Enhanced capital quality:

With the initiation of Basel III, the framework has laid down a stricter capital definition. The enhanced capital quality represents higher capacity of loss absorption (Dermine, 2015). Such greater capacity would enable the banks and further financial institutions to increase their strengths to combat in any periods of distress.

Buffer pertaining to capital conservation:

The banks and financial institutions are needed to maintain a buffer pertaining to capital conservation of 2.5% after the enforcement of the Basel III framework. The intention identified behind such need is to ensure the banks to hold a cushion of capital (Joshi, 2017). Such cushion would enable the banks and other financial institutions to absorb losses effectively in time of financial and economic distress.

Countercyclical buffer:

The countercyclical buffer is the basic characteristic of the framework of Basel III  and it is enforced with the motive to accumulate capital requirements at boom along with reducing the same at distress. In addition, such buffer would reduce the banking operations during overheating and it would support lending during tough periods. Such buffer is projected to differ between the ranges of 0% – 25% that constitute of common equity or capital absorption loss.

Least common equity and Tier 1-capital requirements:

The least requirement for common equity has risen from 2% to 4.5% of the total risk-weighted assets. The Tier-1 capital requirement constitutes of common equity and associated financial instruments have risen to 6% from 4%. Therefore, despite the minimum capital requirement of 8%, the entire capital requirement would rise to 10.5% after mixing with the buffer of conservation.

Comparison of capital requirements under Basel II and Basel III

Leverage ratio:

The international financial crisis of 2008 has depicted that the values of assets have declined drastically compared to the past assumptions. Thus, the initiation of leverage ratio for the financial institutions has served as a precautionary measure under the framework of Basel III. As commented by King (2013), leverage ratio is the comparative amount to entire assets; however, there is exclusion of risk-weighted assets. Thus, the framework of Basel III aims to reduce the swelling of leverage in the world banking industry. Thus, 3% of leverage ratio of Tier 1-capital is needed to be tested before the complete enforcement of this ratio.

Liquidity ratios:

The framework of Basel III has developed ways for the financial institutions in handling liquidity risk in an effective fashion. These ways include initiation of “liquidity coverage ratio”: in 2015 and “net stable funding ratio” to be initiated in 2018.

Needs	Basel II	Basel III
Minimum ratio of entire capital to “risk-weighted assets”	8%	10.5%
Minimum ratio of common equity to “risk-weighted assets”	2%	4.5% -7.5%
Tier 1-capital to “risk-weighted assets”	4%	6%
Core Tier 1-capital to “risk-weighted assets”	2%	5%
Buffer of capital conservation to “risk-weighted assets”	–	2.5%
Leverage ratio	–	3%
Countercyclical buffer	–	0% – 2.5%
Liquidity coverage ratio	–	60% (in 2015)
Net stable funding ratio	–	To be initiated in 2018

Table 1: Comparison of capital requirements under the frameworks of Basel II and Basel III

(Source: Morris & Shin, 2016)

The Basel III implementation in the major Australian banks would help in minimising the coverage of high risk and enhance the quality of investment. Along with this, Basel III helps in eliminating any problem previously witnessed on the part of Basel II. The top four Australian banks include “Westpac (WBC)”, National Australia Bank (NAB)”, “Commonwealth Bank (CBA), Australia, and New Zealand Banking Group (ANZ). Hence, the application of Basel III in the above-stated banks is mainly depicted as follows:

Rules related to fixed capital:

Basel III has developed capital rules, which would help the four Australian banks in obtaining bigger loans with sufficient leverage. Moreover, with the help of this framework, the banks could hold pertinent capital and provide loans to the borrowers. Such measure would help the four Australian banks in minimising the negative impact of an economic crisis. Thus, the adoption of rules related to fixed capital would help the banks in providing sufficient capital to the borrowers capable of supporting the financial obligations (Laas & Siegel, 2013).

Minimum needs and buffer inclusion:

Basel III is extremely beneficial to the four Australian banks, since it helps in minimising the entire risk resulting from investment. This is because this framework takes into account appropriate risk-weighted assets, which enable the banks in undertaking relevant investment decisions (Mariathasan & Merrouche, 2014). In addition, the addition of countercyclical buffer is of immense importance for the four Australian banks to find additional cushion during recession, which would ensure smooth operations. Finally, with Basel III application, the four Australian banks might form a department for assessing liquidity risk to identify the investment risk associated with various projects.  

Application of Basel III to the top four banks in Australia

However, there are a number of limitations that could limit the operational strength of the four banks in Australia, if Basel III is applied and they are described as follows:

Focus on capital ratios:

Basel III focuses more on capital ratios, which could restrict the four banks in providing loans to the small-sized firms. In addition, the prevalence of shadow banking system in Australia would restrict the banks in completing their operations in an effective manner,

Excessive trust on credit rating agencies:

Basel III puts emphasis on credit rating from the external agencies. However, the credit rating agencies have certain limitations, which could be detected from the global financial crisis of 2008, in which the values of the assets were inflated. Thus, Basel III is based on amorphous credit rating, which would raise the entire investment risk (Marino, 2014).

CBA uses “APRA Prudential Standard APS 330 Public Disclosure” that aims to enhance the requirements of capital funding. In addition, the bank makes use of Tier 1 and Tier 2 capitals for its fund disclosures. Therefore, the below-mentioned measures have been used for raising funds to support the operational activities of CBA:

Additional instruments of Tier 1 capital:

The bank has adopted Basel III to identify the pertinent borrowers for increasing the return from investment to deliver maximum benefits to its shareholders. As a result, the overall risk of the organisation is minimised, which would eventually lead to increased return from investment.

Instruments of Tier 2 capital:

The instruments of Tier 2 capital would help CBA in identifying the relevant borrowers, which would be helpful in minimising the total investment risk.

Commonwealth Bank uses the constituents of Basel III like focus on capital, leverage and buffering ratios.  As a result, it has helped in enhancing the allocation of assets and loans to the potential borrowers. In this regard, Nguyen (2014) stated that the implementation of Basel III would enable the financial institutions in enhancing the operational efficacy through increased cash reserves.

The Commonwealth Bank of Australia has implemented the “Pillar 1 minimal capital” need for internal models in assessing the risks associated with market and interest rate. Moreover, the organisation is having a CET1 ratio of 4.5% along with a buffer of capital conservation of 3.5%. This has helped the bank in managing its capital management activities effectively. Thus, the implementation of Basel III measures has helped CBA in ensuring sufficient distribution of capital. However, Sutorova & Teplý (2013) argued that Basel III framework focuses on certain guidelines, which could help the financial institutions, if they adopt ethical measures. 

Figure 1: Capital adequacy ratio of Commonwealth Bank in 2015 and 2016

(Source: Commbank.com.au, 2017)

From the above figure, it has been found that the capital adequacy ratio of Commonwealth Bank has declined, which has enabled the bank to enhance its ability in generating greater loan advances to manage its capital effectively.

Project finance is a complex and interesting financial area, which assists in the economic advancement of a country. However, project finance takes into account the attributes of relative risk, since longer timeframe is required for project completion (Gatti, 2013). For instance, development of tunnels, power stations and toll roads are few project examples. Along with this, project finance enables the organisations in identifying project feasibility to enhance the future profitability level. As commented by Weber, Staub-Bisang & Alfen (2016), the yearly return from investment and financial performance could be identified through project finance. However, as argued by Subramanian & Tung (2016), if the organisation fails to comprehend the cost assumption, project finance might lose its friction.

The detection of risk and effective allocation of the same is the main constituent of project finance. It has been observed that a project contains a number of risks, which include technological, environmental, economic and political risks in the developing countries. The financial institutions and project sponsors are of the belief that the risks pertaining to operations and project development could not be funded. Thus, the financing of these projects is needed to be shared amongst different parties for sharing risk and assuring profit for all the parties.

Project finance is primarily associated with bigger projects, which aims to public infrastructure. Therefore, public-private partnership is of immense importance in finishing the public projects within the specified schedule. These projects include development of hospitals, roads and schools. As depicted by Lee, Choi & Kim (2014), the financial projects require huge capital needs and resources, which are obtained from the public-listed companies. On the other hand, Magni (2016) remarked that project finance is conducted for assisting the public projects, which fail to deliver appropriate income from investment. The main reasons of commonness of public-private partnerships in project finance are demonstrated as follows:

Enhanced infrastructural quality:

The interference of private organisations in public projects helps in enhancing the overall infrastructural quality through continual innovation. In the words of Yescombe (2013), the private organisations adopt modern technologies and innovative methods to minimise the overall project cost and time. The adoption of modern technology for public projects might increase the project cost, which urges the need for public-private partnerships. Due to such intervention, the overall cost is minimised due to the specialisation of private organisations in the projects. As indicated by Gatti et al., (2013), the public-private partnerships help the government in selecting the right tender with better quality and cheaper prices to enhance the infrastructural quality.

Enhanced project quality and design:

With the help of private intervention in government projects, the project quality and design could be enhanced greatly. The incorporation of private organisations enables to improve the design by minimising expenditures and increasing overall project benefits. Moreover, the government could enhance the quality of the project by choosing the right project during the process of bidding. As a result, the overall quality and efficiency of the concerned project is maximised. However, Clews (2016) argued that interference of government funding primarily raises the probability of delayed completion, which might minimise the overall project benefits.

Minimised performance and operating risk:

The financial projects primarily carry undue risks, which influence both the performance and operations of the projects. Thus, public-private partnerships are beneficial in minimising the overall project risk. The private organisations could adopt cost-effective methods, while the public organisations could deploy capital for reducing the operational risk of the concerned project. In addition, the operational ability could be enhanced by using the latest technologies of the private sector. As mentioned by Pinto & Alves (2016), due to greater risk in project finance from increasing inflation the project benefits might be reduced.

Enhanced project planning and budgeting:

The government aims to complete project finance effectively at a sufficient budget. The incorporation of private organisations would help in improving the operation. This is because the private organisations possess relevant experience of skilled personnel in developing budgets to complete the project within the specified schedule at controlled costs. This sufficient experience of the private organisations relating to project budget is necessary for the public sector to conduct cooperative arrangements for enhancing project planning and budgeting. As cited by Eisenbach et al., (2014), the cost-effective method of the private organisations helps the government in minimising its debt burden. However, as argued by Cooper & Nyborg (2016), the unethical measures of the government mainly reduce the overall benefits of public-private partnerships.

Various risk factors might dampen the association related to public-private partnerships. As depicted by Feldman, Lowder & Schwabe (2016), the organisations make use of the net present value approach to determine the “time value of money” derived from long-term projects. Such detection of the monetary value has helped the organisations in undertaking effective decision to assess the project feasibility. On the other hand, Bodmer (2014) is of the view that the greater risks influencing the project feasibility might decline the benefits to be realised form public-private partnerships. The below-depicted factors could be identified as the major risks, which could arise out of public-private partnerships:

Political risk:

The political risk is one of the major risks, which could arise due to modification in political agenda controlling the project operations. The uncertainty associated with the government agenda and modifications in the same frequently might hamper the project operations, since the funds are expected to flow from government interference. Any change in the ruling party might delay the completion time of the project and minimise the fund flows. As a result, the risk of the private sector is increased largely.

Along with this, any modification in the government regulations like increased tax rate and inflation might negatively influence the overall project benefits. In the words of Higham, Bridge & Farrell (2016), the budget valuation id mainly reliant on the rate of inflation and financial regulations, this could be evaluated during the duration of the project.

Risks related to increasing costs:

The increasi8ng construction cost in the global arena could be treated as a significant risk factor that might limit the captivities of public-private partnerships. The hike in labour costs and that of material would raise the overall expenditure of the government, in which the authorisation of public companies is necessary. In addition, delay in collecting the letter of approval along with lack of sufficient communication could enhance the construction risk. The government of a nation lays stress on bidding process and tenders for minimising the risk related to construction in the mid-half of the project.

Operational risk:

The change in tax rate and costs could increase the expense of the organisation, which is estimated on the part of the private organisations. This increased cost might result in increased operational risk, since the private sector carry on with its operations for earning profits. Hence, a modification in the cost structure might minimise the projected profits, which might increase the completion time of the project. However, the increasing debt burden of the government could minimise the probability of project continuation and hinder profit margin of the private organisations.

Risk related to extended work:

The public-private partnership is undertaken for long-term projects and thus, it is necessary to obtain prior consent of the stakeholders. This is because the private organisations mainly rely on profit margins before the initiation of operation. Along with this, the private organisations focus on projects, which could add to the capacity of revenue generation in delivering maximum benefits to the shareholders. Hence, the risk from extended work needs to be taken into account before entering into public-private partnerships.  

The mixed operations of public-private partnerships could deliver benefits to both the parties. The public-private partnership is inherent in the global marketplace due to a wide range of success factors. As commented by Morrison (2016), the incorporation of private organisations in public projects detects the lowest cost, which is needed in order to complete the project while ensuring higher quality. The main success factors associated with public-private partnerships are briefly represented as follows:

Strong private conglomerate:

The public-private partnerships have engaged the private sector in improving the nation’s infrastructure. The reason behind this is that the link between the private and the public sectors would result in enhanced value of public services and amenities. Along with this, the private sector engagement in the construction of public services would reduce the government spending of the nation. However, the private sector plays the major role in fulfilling the needs of the project. Due to this, it might lead to high level of stakeholder dissatisfaction, which would enhance the completion time of the project while reducing the infrastructural quality. Thus, it is vital to obtain the permission of the stakeholders to complete the project within time before the partnership of the public and private sectors.

Technical project feasibility:

As the private sector is involved with the creation of innovative methods, the technical viability of the project could be improved further. Moreover, the private organisations have appropriate personnel expertise possessing all the necessary skills and experiences. Hence, the technical requirements of the project could be ascertained in an effective manner. However, the private sector might adopt unethical practices in minimising its level of expenses that might reduce the potential project prospects. Furthermore, it has been evaluated that the private sector is responsible for maintaining the operating expenditures during the project phases. Hence, ascertainment of the technical feasibility is the main success factor related to public-private partnerships.

Effective apportionment and risk distribution:

Under the public-private partnership projects, both the public and private organisations divide the entire project risks. However, majority of the risks are passed on to the private sector under such partnerships. The risks pertaining to operating activities and construction works are handled on the part of the private organisations. Moreover, the government of the country would be able to receive the advantages realised from the project, in case, the private sector fails to satisfy the contractual obligations. Hence, after the accumulation of income, the government of a country could utilise the amount generated in future public projects by engaging into public-private partnerships. However, the private sector does not bear the risk of increased tax rates. Hence, under such circumstances, the project sustainability and range could be restricted largely.  

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