Recap5 Essay Example
During the inflation/ financial crisis which occurred in the late 2000, many banks closed down as they were not able to withstand losses. Therefore, in order to come up with ways of preventing such an occurrence in the future, the third Base accord was created (also known as the Basel III act). Basel III is a universal voluntary banking regulation on banks in terms of market liquidity risks, stress testing and capital adequacy. The fundamental approach of this act is for banks to have enough capital so as to withstand losses (Slovik & Cournède ,2011).
If these losses can be covered by the capital, then the assets should be sufficient to cover holders of bank liabilities and also the depositors. One function of a bank is to manage its risks loss which is also the fundamental business of a bank which includes; converting its deposits which are short-dated on demand and are seen as being free from any credit risk in to credit-risky assets which are less liquid and also longer-dated and are in the bank’s balance sheet. In summary, the Basel III act was meant to strengthen the capital requirements of a bank through decreasing the bank leverage and then increasing the liquidity of the bank (Craig, 2012).
Key Requirements of the Basel III
The key main requirements of the Basel III act mainly focused on three things; liquidity requirements, leverage ratio and capital requirements; Capital requirements; From 2010,the primary Basel III rule was that banks were required to have a 4.5 % common equity which was 2 % up compared to Basel II, and a 6% Tier I Capital of Risks Weighted Assets. In addition, additional capital buffers were introduced which meant that there was a compulsory capital conversation buffer of 2.5 % and an optional counter-cyclical buffer which in periods of elevated growths offered national regulators to require another 2.5 % of capital..Leverage ratio; In Basel III the leverage ratio was minimum and was calculated by Tier I capital with the average of the total consolidated assets of the bank. In addition, it was a requirement that Banks should maintain a leverage ratio which was in excess of 3 %.For systematically important financial institutions banks the leverage ratio was 6 % while a 5 % was for the bank holding companies. Liquidity requirements; In Basel III there were two liquidity ratios. The liquidity coverage ratio required banks for over 30 days, to have a have a high quality liquid assets which was sufficient enough to cover its outflows for total net cash, while the Net Stable Funding Ratio in a one year period of stress, banks were required to have an available stable funding which would exceed the required stable funding amount (Wyatt, 2011).
In order to understand the potential of interest rates to bring down banks, it is essential to review the importance of interest rates and also management of the interest rates. To comprehend this, the following factors will be reviewed; the yield curves, Duration, swaps and swap curve, interest rate risks, measurement of the interest risks and managing and regulating interest rate risks and the compensations involved in taking interest rate risks.
The yield curve can be related to the risk free rate. In this situation, the yield curve is used to for-see equilibrium as its plots the market yielding curve with each and every bond at every maturity. In case of changes in the market such as new information, preference of participants in the market and changes in the aggregate supply or demand, investors react differently which in turn causes changes to the yield curve. Where longer-dated bonds yield more than shorter-dated bonds, it is technically a positive sloped yield curve also commonly known as “normal”. Consequently, where shorter-dated bonds yield more, it is a negatively sloped curve or rather “inverted”. However in most cases, the yield curve is normal.
Duration is a measure of interest-rate risk of one or more payments. It is calculated by summing the product of each scheduled payment, the interval of receiving payment and net present value factor related with the scheduled payment date. The modified duration is the first derivative of the price-yield curve and as a result it is equivalent to the price change for any change in yield. An interest-rate swap is an agreement calling for the exchange of interest measured on a national major value at the set rate during the time of the swap. The swap curve is the vector of the set prices and rates of a pay-side leg when the receive-side leg pays the index flat. The swap curve reflects the equilibrium of yields across the entire range of maturities. In addition, the swap rate also shows equilibrium, but one that is applicable to a single maturity only. (Slovik, 2012).
Interest rate risk is usually generated when short-dated demand deposits are translated in to longer-dated assets. The main objective of this is usually to make the most use of the return which is relative to the risk by measuring the interest rate risk. This is usually carried out by using the dollar gap method which focuses on the net interest margin or the net interest income. The dollar gap will be negative if a bank tries go through maturity transformation, This means that a bank with a negative dollar gap are more likely to witness increases in interest rate as the liabilities are much shorter and causing an increase in rates and which will in turn lower since funding which are expensive are replaced with cheaper ones Which consequently causes an upward shift in the yield curve and vice versa. Therefore banks can take advantage of the dollar gap method so as to manage risks .This is through borrowing at a short end when the yield curve is positive and lending at a long end when the yield curve is positive (Wyatt,2011)
It is therefore, important for banks to comply with the banking regulations act especially the Basel II act. This is because, incase of the occurrence of another inflation, banks will not be forced to shut down. The losses incurred will be covered by the capital, and the assets will also be sufficient to cover holders of bank liabilities and also the depositors. This means that banks will have enough capital which will be able to withstand losses. In addition, the yield curve helps banks manage its interest rates as it shows any changes in the market.
Craig, S (2012). Bank Regulators to Allow Leeway on Liquidity Rule. New York Times.
Scott, S.H (2011). Testimony of Hal S. Scott before the Committee on Financial Services
Committee on Financial Services, United State House of Representatives. pp. 12–13.
Slovik P(2012). Systemically Important Banks and Capital Regulations Challenges. OECD
Economics Department Working Papers. OECD Publishing
Slovik P & Cournède B(2011). Macroeconomic Impact of Basel III. OECD Economics
Department Working Papers. OECD Publishing.
Suttle P (2011). The Macroeconomic Implications of Basel III. Institute of International Finance.
Wyatt E (2011). Fed Proposes New Capital Rules for Banks. New York Times.
More Important Things