UMAD5W-15-3: Credit Risk Analysis & Management - Coursework Assessment Answers

Introduction

After the economic disaster of the 2007-2008, banking regulations have been modified to a significant extent across the globe in order to protect the economy of the country and to maintain financial stability by mitigating risk. Severe national and regional regulations were introduced too with the objective of protecting the business organizations and the economy from financial shocks and maintain financial stability. The banking sector of the United Kingdom has been constantly changing over the last 25 years from the year 1989 to 2013 (Gatzert and Wesker, 2012). The scope of banking operations not just changed but expanded from simple deposits and lending to an entirely new model of wholesale funding and trading. This paper identifies the changes happening in the banking sector over the past few decades and the significance of these changes in maintaining financial stability. One of the main regulatory frame work that was introduced to maintain financial stability is Basel I framework. Basel committee put forth this international banking regulations in order to mitigate risk and losses and to protect the economy from surprise financial shocks. The Basel committee also developed Basel II and Basel III framework that expanded Basel I (Gatzert and Wesker, 2012). In addition to this, the report also highlights the impact of Basel III on international banks operating in European market.

Changed Global Regulatory and Financial Stability

In response to the international financial crisis, European Banking Authority was formed in order to maintain the stability of the European Union's financial system. In addition to this, the protection of investors, depositors and to increase the transparency in the financial market of European countries are also among the main objectives of the European Banking Authority. Basel I, II and III were introduced by the banks in order to minims financial risks. There are several type of risks that are present in the banking industry which are as follows:

Types of Bank Risks that Affects Financial Stability

These section will highlight the type of risks that affects the financial stability of operations in the banking system. In order to understand the needs of the regulatory framework, first we need to understand what type of threats are there that may jeopardize the operational stability.

Operational Risk: This is a broad category risks which encompasses several risk categories that includes employee risk, technology risk, customer risk, legal risk, taxation risk, capital asset risk, and strategic and reputational risk (Svilenova, 2011). Technology risk includes system breakdown, capital asset risk includes fire and/or flood, taxation risk refers to tax avoidance and legal risk includes violation of laws and frauds.

Market Risk: There refer to those risks that arise due to the trading activity of the bank. In this risk, the value of the liabilities and assets that are being traded and as a result the income on the portfolio being traded fluctuates because of exchange rate, asset price, interest rates, market liquidity and market volatility (Dowd, 2007).

Credit Risk: or default risk refers to the probability that that counterparty of the contract will not meet the terms of his/her/their obligation because he/she/they is/are unwilling to honour the contract (Gordy, 2000). This type of risk can be eliminated and to the least minimised through effective risk management techniques like monitoring and screening for the most creditworthy applicants of loan, degree of collateral and via diversification of loan portfolio.

Interest Rate Risk: When there is a mismatch maturities between the assets and liabilities of the bank, interest risk may arise. These include two type of risk which are refinancing risk and reinvestment risk.

Liquidity Risk: This includes two components which are market liquidity risk and funding liquidity risk. Market liquidity risk refers to a situation when bank will not be able to sell an asset position at the market price due to market disruptions. On the other hand, funding liquidity risk refers to the situation that bank will not be able to meet collateral obligations when they will be due, and in order to meet those obligations bank will have to incur losses that would affect day to day operations of the bank.

Systematic Risk: These are the risks that negatively affects the entire banking system and its stability. These are the functional disturbance caused due to the realisation of the combination of liquidity risk, credit, market and operational risk.

Basel I and Financial Stability

Basel Committee on Bank Supervision (BCBS) sets outs the minimum capital requirements in order to reduce the credit risk of the financial institutions. The main objectives of Basel I regulations is to improve the financial stability of the financial institutions by improving the quality of banking supervision across the globe (Van Roy, 2005). The Base I accord created a bank asset classification system, in order to minimise credit risk. According to the bank asset classification system, assets of the bank are grouped in 5 different categories which are divided on the basis of percentage: 100%, 50%, 20%, 10% 0%. According to the nature of the debtor, assets of the bank are placed into these categories. These percentages signify the risk categories. The 0% category includes governmental and central bank debt, cash, any debt of organisation for economic cooperation and development. Depending on the debtor, the public sector debt can be put in 0%, 20%, 50% or 10% risk category (Altman and Sabato, 2005). In the 20% category, cash in collection, developmental bank debt, non-OECD bank debt, OECD securities firm deposit, and OECD bank debt. According to Basel I regulations, banks are required to maintain capital equal to 8% of the risk-weighted assets.

Basel II and Financial Stability

Basel II accord is based on three main principle of market discipline, minimum capital requirements and regulatory supervision. The minimum capital requirement accord in Basel II is same as Basel I. The financial institutions are required to maintain at least 8% of the over risk weighted assets. The second and third pillar of Basel II are market discipline and regulatory supervision (Berger, 2006). According to Basel II accord, financial institutions are required to satisfy various disclosure requirements for checking capital adequacy and for risk assessment process. In addition to this, Basel II also provides the framework for regulatory bodies; both regional and national so that they can deal with legal risks, systematic risks, and liquidity risks.

Basel III and Financial Stability

Basel III can be called an extension of Basel I and II that strives to strengthen the transparency in banking system, deal with financial stress and to improve risk management procedures (Slovik and Cournede, 2011). One of the main objectives of Basel III is to maintain stability at an individual bank level so that financial stability can be maintained by reducing the risk of system wide harms and shocks. The first pillar of Basel accord was modified in Basel III accord, as when compared to Basel II, Basel III increased minimum Tier 1 capital to 6% from 4% and common equity Tier 1 to 5% from 4%. The overall capital requirement was unchanged to 8% as it was in Basel II accord. In addition to this, countercyclical measures were introduced in the Basel III accord. Banks will have to remove additional capital during credit expansion and on the contrary, capital requirements can be loosen during the contraction of credit (Elliott, 2010). Furthermore, liquidity and leverage measures were introduced in Basel III in order to protect from excessive borrowings and to ensure that at the time financial stress banks have sufficient liquidity.

Overall it can be analysed here that regulatory changes have helped in the maintaining the financial stability as they reduce credit risk, legal risk, systematic risk, and liquidity risk. In addition to this, these regulatory changes have helped in improving the transparency in financial system, in improving the reporting procedure and in maintaining disclosures that further helped in preventing financial shocks and facilitating financial stability.

Impact of Basel III on International Banks

The impact of Basel III on international banks will vary according to the location of that bank and the size of the banking industry of that country. In case of the United States of America, the deduction of mortgage service rights play a vital role than it does in the Europe. In case of Middle Eastern countries, assuming current growth rates of Middle eastern countries, the banking sector will have a capital shortfall of approximately 25% of the regulatory capital required in the year 2019. Banks in the Middle Eastern countries might think of Basel III as a punishment however, it is not as Basel III provides an opportunity to Middle Eastern banks to embrace new regulations and hence improve the risk return profile of the banks and their asset quality. It can be analysed here that in the long run Basel III will have a positive impact on the expansion of any Middle Eastern bank into the European market.

In case of Asian banks, several issues have been identified which include additional capital issue, growth barrier, systematic risk, risk management, countercyclical capital buffer implementation and profitability of banks. In India, in case of MSME's, the outstanding gap is estimated to be 62% which will probably reduce to 43% (Jayadev, 2013). The largest banks across the globe will increase their lending rates so that they can increase their liquidity to asset ratio as it is required according to the Basel III regulations to maintain weighted asset ratio to 7%. The increase in the lending rate will result in reduction in loan growth in the long run. It should be noted here that when the risk based internal ratings-based capital requirements interact with leverage requirements, then it may lead to increased lending to high risk loan applicants and less landing to low risk loan applicants (Kushwaha, Gadankush, and Das, 2013). Such allocation may affect adversely the financial stability. Along with this, Basel III accord will also affect the profitability of Indian banks.

The value of leverage multiplier will reduce, since, the leverage ratio is set at 3% according to Basel III. which would ultimately result in the reduction of return on equity or bank's profitability. Another challenge that is to be faced by an Indian bank is the implementation of countercyclical capital buffer. According to this measure, banks are required to maintain high capital when in good times in order minimise operational risk during economic crisis (Jayadev, 2013). In order to do so, the central bank of India has to recognise the inflexion point that initiates the release of buffers which will make the entire process very complex for Indian government, the central bank and the ministry of finance (Kushwaha, Gadankush, and Das, 2013). It can be analysed here that it is not wise neither feasible for Indian banks to expand in the European market today because implementation of Basel III will affect t he profitability of the banks and will increase operational risks too.

Conclusion

It can be concluded from the above discussion that the regulatory changes that have taken place over the past several years have positively affected the financial and banking market of Europe and several other nations. The banking regulations like Basel I, II and III has helped in minimising different types of risks that includes operational risk, market risk and credit risk. In addition to this, interest risk, systematic risk and liquidity risk has also been minimised because of Basel I, II and III accord. It should be noted here that accord of Basel III has helped in increasing the transparency between the regulatory bodies and financial institutions that helps in preventing financial shocks and facilitates financial stability. Along with this, it can also be concluded that there are three pillars of Basel accord which are market discipline, minimum capital requirements and regulatory supervision.

Moreover, it has also been found that in case of expansion of Asian banks to European financial institutions, several issues can arise like barrier to growth and profitability, systematic and operational risks and additional capital requirements. In this regard, it can also be concluded that expanding into European finance and banking market is not feasible for Asian banks.