FINANCIAL REGULATIONS AND THE BASEL ACCORDS.
Written by MOSES ORUAZE DICKSON
ABSTRACT
Since the dawn of the twenty first century, the global banking architecture has endured a tsunami of destructive events that have altered the shape of financial regulation in varying ways leading to the creation and subsequent adoption of a new Basel Accord. Basel III emerged amid turmoil in the global financial environment emanating from Subprime Mortgage crisis in the United States. Financial institutions from across the globe from Northern Rock in UK to Lehman Brothers in the US were victims of this crisis. This thesis explored the regulatory response to the subprime mortgage crisis with particular emphasis on the Basel III accord. Basel I and II were subject to a circumspect examination and critiqued in order to identify the failures that contributed to the financial crisis and the extent to which Basel III has resolved them. This research relied on doctrinal approach by examining the core provisions of the Basel III accord such as capital adequacy in a bid to identify the impact the new developments will have on the financial sector and its goal of global financial stability. As a result, a way forward in terms of reforming the Basel Accord and promoting global financial stability provided. Thus, this thesis will inform legal and economic circles on the regulatory failures prior to the financial crisis and the reforms under Basel III as well as its limitations.
DEDICATION.
To a life of learning and hard work.
TABLE OF CONTENT page
Abstract 1
Dedication 2
Chapter one
1.1 Introduction 4
1.2 The background to this research 5
1.3. Research questions 6
1.4. Methodology 7
Chapter two:
Theoretical and Literature Review 9
2.1 The Concept of financial regulation 9
2.2. The Subprime Mortgage Crisis through the lens on an economist 11-12
2.3 The impact on UK 13
2.4 Literature review 14-15
CHAPTER THREE
3.1 The Basel I Accord 1 16
3.2 The rationale behind the Accord 16
3.3 The Basel I limitations on minimum capital requirement 18-19
3.4 The drivers for reform 20-21
CHAPTER FOUR
4.1 The Basel II accord 22
4.2 Minimum capital requirement 23-27
4.3 Supervisory review 28-29
4.4 Market discipline 30
4.5 Global implementation of Basel II 30
4.6 The Basel II flaws and global financial 31
Crisis
4.7 The reform of Basel II 32-33
CHAPTER FIVE
5.1 The proposed Basel III reforms 34
5.2The challenges and limitations 35
5.3Financial stability – capital rules Basel II and III 36
5.4Basel III regulating against future financial instability 37
5.5.A critique of Basel III 37
5.6Future proposals 38
5. 7 Recommendations 39-42
5.8 Conclusion 42-45
5.9 Bibliography 45- 57
1.1. Introduction
The turn of the twentieth century was accompanied by concerns over the future sustainability of the global financial market. The century was welcomed by a dot.com bubble which saw the growth of internet business halted by a sudden bust and corporate governance challenges highlighted in the collapse of Enron.[1] However, both laid the foundation for an even more disastrous event that gripped the global financial economy between 2007-2009 leading to the demise of many household names such as Lehman Brothers and Northern Rock.[2] In essence, the financial crisis was of global proposition and at the time of writing this thesis, countries are still wadding off its effects. However, this thesis focuses mainly on the financial crisis of 2007-2009 as opposed to the collapse of Enron or the busting of the dot.com bubble largely due to the contemporary nature of the topic and the regulatory responses made in recent years to bring harmony into the global market.
Following the collapse of the global financial architecture in 2007, the Basel Committee, which is a global supervisory body, introduced new standards to govern the global financial market.[3] It reformed Basel II with a much-needed Basel III accord that set out to correct the failures of its predecessors. However, despite the reforms, a number of academics remain skeptical on whether real changes can occur and whether Basel III can usher in desired results.[4] One of the underlying concerns relate to the increased complexity of financial products and the impact of securitization on risk taking. For example, the 2007-2009 financial crisis was coined the subprime mortgage crisis to reflect mortgage based debt assets that contributed to the financial crisis. The word subprime simply means subordinate to primary making.[5] It is a loan given to people with bad credit rating who are not eligible for a prime loan, which is usually characterized by higher interest rates, poor quality collateral and less favorable terms, with a view to compensate for higher credit risks.
Although scholars have pointed the finger on a number of factors such as poor corporate governance practices and financial regulation as contributories to the financial crisis, this thesis largely focuses on the regulatory failures especially in relation to the securitization of subprime debt products.[6] Subprime mortgages have a long and rich history that can be traced back to the late 1990s.[7] During that period, there was a broad credit bubble in the United States and largely in Europe with a sustained housing boom in the United States. Gradually, excess liquidity, combined with escalating housing cost and an ineffectively regulated housing market, gave rise to an increase in nontraditional mortgages. These mortgage products were in most cases complex and did not reflect the borrower’s capacity to make repayments.
Despite the increasing complexity of mortgage products, there was little in terms of regulatory reform done to address the issue. This was partly due to a number of factors; mainly the lack of coordinated global approach to financial regulation and the mortgages mainly originated in the US rather than being a global issues in which case the Basel Committee would have been required to intervene. However, the collapse of Enron in 2001 laid the foundation for a global disaster and it is not surprising therefore that despite the adoption of Basel II in the late 2006 in response to the Enron disaster, we ended up facing a global financial crisis in 2007. It should be noted from the outset that at the time of financial crisis, Basel II was not yet fully implemented and it is arguable whether even if it was implemented, it could have halted the subsequent financial crisis.[8]
1.2 The background to this research
The subprime mortgage crisis left in its wake a smocking wreckage of companies destined for insolvency and brought the global financial system to its knees.[9] However, caution must be exercised here given that it was mainly the western economies such US, UK and Greece that suffered the most from the crisis.[10] Third world countries such as Nigeria and Bangladesh were not overly affected except for a few organizations such banks and mortgage firms that were caught up in the US mortgage debacle. Thus, most of the changes proposed under Basel III were aimed at western banks.[11] The financial crisis became global largely due to the buying and selling of collateralized debt products such as subprime loans.[12] It meant a bank in US would sell a mortgage instrument to a bank in china in real value and the bank in china would ride out the risk of borrowing by hoping for a full repayment plus the interest. Despite being a lucrative source of finance for banks and the ability to allow immobile and risky mortgages to be transformed into valuable assets, non-repayment would mean major losses for the foreign bank. The mass default during the financial crisis resulted in billions being wiped off bank’s registers leading to a sustained financial crisis which has global spread.
Thus, given the growing internationalization of debt and the dangers it raises to the global financial architecture, it meant that global regulatory changes had to be put in place even as the regulators had many problems to address following the subprime mortgage crisis. First and foremost, to ensure that banks carry out due diligence rather than offering loans to individuals without the capacity to repay. Prior to the crisis, borrowers got high risk mortgages such as option-ARMs, and qualified for mortgages with little or in most cases no documentation.[13] This created a situation where individuals with bad credit qualified for subprime loans with the bank solely glued to the high interest rate on offer. This practice gave birth to a serious glut of liquidity around the world that suddenly dried up at the height of the mortgage crises. The effect is that people, governments and businesses had monies to invest and they all developed a sudden appetite for mortgage related investments as a more secure way to earn more.
Secondly, banks continued to nurse mortgages in their books.[14] It meant that if a person borrowed from let us say bank A, the person would need to make all the repayments to bank A and as such they are inevitably going to lose money if there is a default. However, if bank A sells the loan to bank B another bank who in turn goes on to resell this loan to possibly many other investors, unknown to the first original mortgagee, it increase complexity and alleviates the risk on bank A by transferring it to other banks. This made collateralized debt products such as subprime mortgages a very complex arrangement so much so that many investors only relied on rating agencies without even understanding the nature of their investment.
Furthermore, most of the collateralized mortgage products were in the form of Mortgage-Backed securities (MBS).[15] These are investments that are to a large extent similar stocks and mutual funds whose values are mostly secured, backed or guaranteed by the joint values of the mortgages. This means that whenever an investor buys a MBS, he or she is not buying the actual mortgage but a simple promise to be paid the return on the joint value. This makes MBS a derivative since its value is derived from its assets. The risk is that in many cases, the borrower may default thereby depriving the investor of his initial investment. These complex security products created the ‘asset bubble’ which burst in 2006 with the subprime mortgage crises.
The Basel Committee had to intervene and its subsequent product is what is known as the Basel III. This thesis will not only explore the consequences flowing from the financial crisis but also the regulatory intervention. The thesis is largely premised on exploring the changes brought about by the Basel Committee under Basel III and the extent to which they have resolved the challenges that contribute to the subprime mortgage crisis. Thus, the aim of this research is to explore the causes of the financial crisis and reforms to the global financial architecture.
1.3. Research questions
This is an economic-legal research into the nature of financial regulation and the extent to which securitization played a part in the subprime mortgage crisis. On the aspect of financial regulation, the Basel Committee reforms are the focal point of this research premised on highlighting the failures of the Basel I and II regime and the subsequent changes brought about under the Basel III accord. Thus some of questions that would be addressed is as follows:
a) What were the failures under Basel I and II and the reforms brought about by the financial crisis
In addressing that question, a key point that would be raised is that Basel II was implemented six months before the financial crisis. Thus, whereas Basel II was implemented in February, by September we had a financial crisis. It means Basel I was in play during the financial crisis. Thus the provisions of Basel I will be subject to a circumspect review to determine their shortfall and the contribution it made to the financial crisis.
However, other non-regulatory factors will also be considered in this research. It should be noted that following the dot.com bubble and bust in 2001, the U.S Federal Reserve system, under Chairman Alan Greenspen went on aggressively to expand credit (money supply).[16] This expansion was followed by repeated lowering of its target for federal funds from 2001 at 6.25 percent ending at 1.75 percent that same year and reaching a low in the middle of 2003 at 1 per cent. In all of this, the actual federal funds were negative which meant that nominal rates were lower compared to real inflation rates for two and half years. However, regulatory authorities also played a role in the eventual collapse of the global financial system. The repeal of the Glass-Steagall Act of 1933 by the Clinton Administration in the US was another huge factor contributory to the financial crises.[17] The repeal lifted the limitation on the creation of collateralized debt products and their proliferation at the turn of the twentieth century was largely due to this legal reform.[18] Given that Basel III sought to reform these shortfalls, another question this research intends to address is whether Basel III will succeed.
b) To what extent have Basel III accord corrected the failures that led to the 2007 global financial crises and future concerns.
Thus, this question will inform legal scholars, banks and economists on the extent to which Basel III has corrected the failures of yesteryear. It is imperative to note however that Basel III only came into effect in 2015 with an implementation deadline stretching to 2025. It raises the question whether by the time most of the countries wake up to take into account these reforms, would another financial crisis be on the horizon? It is difficult to neither predict the outcome of a financial crisis nor forecast the impact the reforms would have on the banking sector, however the Basel accord introduces a revised version of rules designed to shepherd companies through rough economic conditions. Thus this research will also consider the question of whether the reforms are contemporary and would address contemporary issues rather than a reaction to problems of the past.
c) How can we reform the financial architecture to meet the demands of a new age to keep up with contemporary evolving global market?
This question will help to shed light on the failures of Basel III. Many issues have been highlighted by financial economists and legal scholars. Thus this research intends to inform legal scholarship on the extent to which the Basel III accord has reformed the failures of its predecessors and brought security and stability to the global financial system.
1.4. Methodology
This is an economic -legal study which examines the operation and effects of Basel III and other reforms on the global financial system.[19] Economic-legal research has its theoretical and methodological base primarily in social sciences with the premise on finding efficiency. It aims to understand law as a driver of economic efficiency. This distinguishes it from black letter legal analysis which is premised on interpretation and analysis of case law and statutory provisions. This is why the methodologies used in this research are mainly empirical and social-theoretical rather than purely doctrinal. This study draws on economic theory in understanding the nature of financial regulation and whether the new reforms would secure the global financial architecture for many years to come.
Both theoretical conceptualisation and doctrinal analysis approaches are used in this study. First and foremost, conceptualisation of theory helps to understand how different study areas are linked together in order to form theory.[20] According to Leshem and Trafford, it “provides theoretical cohesion to the evidence and conclusions from theory-building research”[21] This is where concepts are contextualised in order to gain a deeper understanding and meaning behind them. Moving from the particular to the general helps to get a wider understanding of the issue. This is critical for theory development because it enables the researcher to make predictions and structure relationships between different variables being studied.
Secondly, this study aims to answer questions of how and why. Thus a doctrinal approach is necessary in order to interpret the provisions of relevant statutory instruments and reach a circumspect conclusion on the future of the global financial system. This study will look at the Basel III accord with a view to analyse and where possible critique the accord and see to what extent the problems of Basel I and II (issues of minimum capital requirement, supervisory review and market discipline) are addressed by Basel III. This methodology is mainly used in legal research and it allows for analysis of case law and provisions in order to find relationships or inconsistencies which can feed calls for reform. In this case, Basel II and I will be scrutinised in order to determine whether calls for reform were justified and also whether Basel III has adequately responded to these calls.
Other methodologies were deemed unsuitable for this type of research.[22] For example, a case study approach is premised on identifying more than one case, such as bank crises and comparing them in order to find relationships and build or support literature as a result. A case study approach would have meant using banks such as Lehman Brothers and Northern Rock to determine whether similar factors were at play in their collapse. According to Yin, a case study design should be used when the study aims to answer ‘how’ and ‘why’ questions.[23] Similarly, it could mean comparing different financial crises in order to identify similar issues or causes. However, this research is mainly legal thus it focuses on the rules rather than causes and the extent to which failures attributed to rules in Basel I and II have been addressed. It means however, delving into the economic and social-scientific field in order to determine the causes and consequences flowing from the inadequate rules found under the Basel accord.