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Credit risk to Basel II standard

Discuss about the Money and Capital Market Analysis.

The Basel committee is named on the city of Basel, Switzerland. The Basel rules are recommended over banking regulations. It can be divided into Basel I, Basel II, and Basel III. BCBS which is Basel committee on banking supervision has issued Basel norms. Basel committee consists of a group of ten members apart of Spain and Luxemburg, which includes representatives of central banks and other regulatory authorities. The implementation implemented by the committee members are based on national or European union wide laws and regulations. That is the committee does not recommend anything (Banks for international statements).

Project finance can also be termed as non- recourse finance, limited-resource. In this financing how various specific assets or projects can be financed. However the repayment to such financing will only be done by cash flows generated from the project. Project finance can be done by combining equity and debt (Akintoye, Beck & Hardcastle, 2003).

Basel II was introduced in 2004, which has described about the capital adequacy, disclosure requirements and risk management that can be divided into operational risk and market risk. The main focus of Basel II is to strengthen the regulatory framework of capital. Basel II consists of three pillars those are Pillar 1, Pillar 2, and Pillar 3 (The Basel II accord).

Here Pillar 1 states about the capital adequacy requirements that refer to adequate capital base for risk of credit, market risk and operational risk. Pillar 2 consists of quantitative and qualitative aspects; while Pillar 2 considers only qualitative aspects. Here Pillar 3 consists of additional disclosure requirements regarding capital adequacy and assessment over risk. It brings discipline over market (Gattani, 2014).

Credit risk is the risk of nonpayment of a debt amount. The nonpayment of the debt amount can be in loss of principal, interest, loss of cash flows or increase in cash collection costs. Credit risk can be classified into credit default risk, Concentration risk and country risk. The nonpayment of debt obligations by the borrower is called as credit default risk. The risk, where a bank diversifies its outstanding bank’s account over the number of debtors is called as concentration risk (Bird & Bird, 2006).  To whom the bank or financial institution has lent the money. Country risks are the risk of political and economic factors affects issuer’s securities for doing business in a particular country (Roy, 2005). The approach in Basel II followed in relation to credit risk is called as standardized approach. This approach considers about the techniques of credit risk management as proposed under norms of Basel II capital adequacy for better regulations of banks and financial institution (Benzin, Truck, & Rachev). In this approach, different ratings are required by the banks as done by external credit rating agencies. So that required capital can be quantified for measurement of credit risk. However the Basel norms provide a choice between two broad methodologies so to calculate capital requirements for credit risk (Bank for international settlements, 2015).

Inadequacy of Basel II as issue faced by the financial institutions around the world

Basel II standards were introduced to cover the weaknesses of Basel I. the weakness laid in Basel I were in relation to capital adequacy for banks. This can be covered by reporting detailed information of credit risk and requiring prices for other forms of risks. For all banks and financial institutions, liquidity is the key area to be considered. According to Basel II banks which consists of sophisticated risk management system, can use their own models for risk assessment in order to determine about minimum amount of capital that need to be required by the regulators in case to escape from unexpected losses (APRA, 2016).

However there are some issues related to Basel II. That can be quoted as; the objective of recapitalizing banks is not fulfilled in case of banks. That is in case of recapitalizing banks, internal risk models of various banks have performed very poor, and they were highly exposed to under estimated risk. This has forced banks to reassess and pricing again credit risk. This has caused a difficulty for banks in case of using their own model for underestimating credit risk, sometimes due to their optimistic attitude  regarding risk exposure so to reduce required regulatory capital and increase in return on equity (PWC).

The shortcomings in the Basel II rules and regulations are that it does not lay any regulations on debts. Hence the banks are not instructed to how to take note of debt in their books. Besides this Basel II takes only financial institutions into consideration, and it ignores the systematic risk (Murphy, 2015).

Australia is a member of Basel committee. The shortcomings laid in Basel II resulted into financial crisis in 2008. Basel III was introduced in 2013, and it is estimated that it would be implemented to 31st march, 2019.  It enhances the regulatory framework of Basel I and Basel II. Besides the shortcoming consisted in Basel II, Basel III lays norms on banks and financial institution regarding ensuring the amount of debt.  It is a voluntary and global framework that regulates on banking capital adequacy, market liquidity risk and stress testing. To restrict banks and financial institutions from taking excessive debt, and not to rely much more on short term funds. Besides this it focuses on requirement of different level of reserves for different deposits and borrowings by banks (The conversation, 2015).

APRA which is Australian prudential regulatory authorities has introduced some changes to reporting standards and prudential standards in relation to apply ADIs which is authorized deposit- taking institutions. These changes are required to be implemented as a part of requirement over liquidity which is known as Basel III liquidity issues (McCoach, & Chernishev, 2014).

The requirement of Basel III in Australia

According to APRA, new disclosure requirement that is in relation to Basel committee to improve the banking institutions comparability various reforms have been formed.  On risk profiles and facilitating market discipline leverage ratios, liquidity coverage ratio and an identification of potential G-SIBs that is global systematically – important banks need to be provided.   In case of leverage ratio an approval from APRA need to be taken in case of internal model approach for the risk based capital adequacy framework that required disclosing about quantitative and qualitative information. In case of liquidity coverage ratios, ADIs must report that whether they are able to provide liquidity short term stress which is of 30 days. This requirement excludes foreign banks. While in case of identification of potential G-SIBs banks are required to report 12 indicators according to Basel committee. This is required by those banks those are considered as important on global scale (Davis & Lawrence, 2015).

According to Wayne Byres who is APRA’s chairman quoted about big four Australian banks that they need to hold more capital in case of an emergency occurred. However banks are against of this proposal as the cost of holding large amount of capital would lead to increase in the cost as borne by shareholders and customers. However the Big four banks have accepted some of the proposals like an increase in weighted risk of mortgages. Big four banks are required to comply with Basel III norms. These banks are commonwealth bank of Australia, Australia and New Zealand banking group limited, Westpac banking corporation, and national Australia banking group limited (Regulation impact statement).

Australian banks had got a break from new Basel III norms so to manage liquidity. As there are some deviations in the Australian debt system because of having highly liquid assets which can be termed as long term government bonds, so that it can be easy to manage an immediate run on a bank. For making debt system easier the RBA and APRA have combined together to arrive at a solution called as CLF which is committed liquidity facility (Reserve bank of Australia, 2013).

In case of one of the big four Australian banks commonwealth bank of Australia has capital ratio of tier 1 capital of common wealth bank of Australia as on 30th September, 2016 is calculated as 9.4%, while the leverage ratio comes out to be 4.8% (Commonwealth bank, 2016).

The big four banks of Australia are commonwealth bank of Australia, Australia and new Zealand banking group limited, Westpac banking corporation, and national Australia banking group limited. These are considered as G-SIBs and they will be requiring reporting about 12 indicators as required by the Basel committee. By understanding the challenges as faced by the Australian banks, it can be said that capital planning, investor relations, and risk management will be continued by the banks. An appropriate internal organization and analytical tools would lead to organizational success. Besides this a roadmap need to be prepared for educating board regarding demonstration of complexity for the next 5-10 years describing about capital. That is how and when the capital target level would be defined so to improve the financial performances. Apart from this according to APRA banks require to set internal target capital level (Mccoach, 2014).

Funds raising under Basel III

Under Basel III requirements the regulatory capital includes Tier 1 capital and Tier 2 capital. Tier 1 capital includes bank core capital that is share capital and retained earnings, while the tier 2 capital consists of hybrid capital instruments, revaluation reserves, term debt, loan reserve general and undisclosed reserves. It is required under Basel III norms to have 6% tier 1 capital ratio, whereas tier 2 capital requires 8% total capital ratio.

It is very difficult to gauge that whether implementation to Basel III standards have affected significantly banks in relation to pricing and funding limitation either internationally or from domestically. The new reforms of Basel III have affected the banks in terms of restrictions on holding capital and liquidity ratios. For this bank has to use more capital funding as compare to previously applicable norms. This has restricted banks in financing for new projects and by this rate of fixed capital formation has been slowed down. However using more capital and having more liquidity has lead to increase in stability of financial system and has given more confidence to depositors and investors.

According to International project finance association (IPFA) project finance is done for financing long term projects like industrial products or financing of infrastructure. This finance usually depends upon cash flows generated from the project. In this financing it is secured by the project asset, which includes the contracts producing revenues. Here all the assets are surrendered to the loan providers. It is done to safeguard the creditors in case of non repayment of loan. In project finance the parties involved are lenders, sponsors, financial advisors, technical advisors, legal advisors, debt financiers, equity investors, regulatory agencies, multilateral agencies. Project financing is usually attractive to private sector, because major projects can be funded off balance sheet items (World Bank group, 2016).

One of the major advantages in project financing used in public private partnership is that it provides an off balance sheet financing for the project. Another advantage is that it will not impact on shareholders or the government, or the contracting authority. In this financing a part of the risk is transferred to the lenders, as in return they get a higher margin of profit as compare to lending provided in normal course. Another reason of public private ownership is that it keeps project financing and liabilities off balance sheet. Usually the debt on project as contained by the subsidiary are not included in the balance sheet. Hence by this it reduces the impact on shareholders of existing debt. Apart from this project financing can also be used by government. This is done to keep debt and liabilities off balance sheet. However by this it will not reduce the actual liabilities over the firm or government. It is prescribed to use off balance sheet items more carefully and a proper mechanism should be followed. It offers a better tax treatment so that it can benefit the project as well as the sponsor.

This is a critic to project finance that it requires greater disclosure in relation to proprietary information and strategic deals. There is lot many risks involved in the project financing. It is not necessary that all the risks are contained in each and every project, as it differs from region to region. Like in case of domestic project financing there is not any currency risk involved. However some of them are discusses as below:

  • Policy risk: this risk is the risk in which due to change in the policy of the project, the profitability also got changed. By having policy support not only the PPP model can be applied in the project but also it can scatter policy risk of the partner of project up to a certain degree.
  • Exchange risk: this type of risk shows about cash receipts in domestic terms. These receipts cannot be converted into international currency. To make stable this risk, government takes some measures to undertake some portion of risk. This is done to make stable exchange rate of foreign currency and ensuring the amount of foreign exchange reserve and besides this the availability and convertibility of currency for example dollar.
  • Financing risk: These are those risks in which cash flow of the project are not sufficient to repay the amount on debt and interest amount. This can lead to turn the project into insolvent, which will also lead to the PPP project turn into loss. However by managing finance risk the companies are able to manage their finance risk in a better way by making required capital structure (World Bank group, 2016).
  • Operational risk: it is that risk that mainly arises from the uncertainty factor in the financial income of the project. By applying PPP model in a logical manner the private partner can control and transfer the risk (Zhang, Shen, Zhang, & Zhang, 2015).

A success in PPP can be ensured by clear contractual rules, comprehensive planning, credible contract enforcement and competitive procurement. The success can be attributed by having adequate feasibility studies on traffic forecasts and contribution of funds. There is not any research conducted by which key success factors can be determined (Geroniks, & Lejnieks, 2015). However on the basis of comparative analysis and local social economic environment, success on PPP model can be determined as follows:

  • The availability of a competent person: it need to be ensured for the project success that there is an availability of a competent person or an expert at all the levels of project like project planning, project implementation, project control. By involvement of public sector in PPP model can also lead to project success. In such involvement by government, chances of reputation at large scale and issues related to trust can be ensured. However the ability of the projects can lead to assurance of success that can be in relation to stability, competence level and experience level of project partner (Lukac, 2008).
  • Stability in macro-economic environment: it is a considerable factor that can lead to success in a project finance of PPP model. It has a dual impact on development decision on large scale and project implementation. It can help the project partners in commitments in long terms. It can also lead to reduce cost by decrement in implementation cost, low financing cost and less risk provisions of country specific (Chan  & Cheung, 2014).
  • Cost benefit analysis: an assessment need to be done of cost- benefit analysis. It acts as a foundation of decisions related to PPP model. For proper cost and return analysis a proper risk allocation and sharing of risk must be done. That is proper distribution of risk to be done between the project partners and public sector. If the analysis would not be done in an appropriate manner it can lead to increase in operational cost, a major cash outflow (Yescombe, 2011).

Conclusion

Adoption to Basel III norms has lead to increase in financial stability for financial institutions and banks in terms of required adequate capital and maintain liquidity. In this enormous amount of consumers can withdraw their deposits from banks and at the same time they can demand cash or can transfer to other safe institution as per they believe.

Having project financing the financial risk will be reduced or isolated. It would lead to analysis of risk that can lead to structure of project, scrutiny of project, reducing the level of risk and would enable the parties in appropriate allocation of risk. However the critics to it are that it lays more complex transactions as compare to public financing, it also levies higher transaction costs hence due diligence process has to be processed  by the parties in relation to high in development cost. Besides this negotiation between parties can be done above than expectation, this required a proper monitoring control for expostulate guarantees specially.

References

Akintoye,A. Beck, M & Hardcastle,C. 2003. Public- private partnerships: Managing risks and opportunities. Cornwall

APRA. 2016. Discussion paper: Basel III liquidity- the net stable funding ratio and the liquid assets requirement for foreign ADIs. Retrieved at https://www.apra.gov.au/adi/PrudentialFramework/Documents/160329%20DP%20Liquidity%20NSFR%20FINAL%20CLEAN.pdf (Accessed: 27th January, 2017).

Bank for international settlements. 2015.  Basel committee on banking supervision consultative document standards revisions to the standardized approach for credit risk. Retrieved at https://www.bis.org/bcbs/publ/d307.pdf (Accessed: 27th January, 2017).

Banks for international statements. Retrieved at https://www.bis.org/(Accessed: 28th January, 2017).

Benzin, A. Truck, S & Rachev, S, T. Approaches to credit risk in the new Basel capital accord. Retrieved at https://www.pstat.ucsb.edu/research/papers/benzin_trueck.pdf (Accessed: 27th January, 2017).

Bird & Bird. 2006.  Basel II: Credit risk mitigation. Retrieved at https://www.twobirds.com/en/news/articles/2006/basel-ii-credit-risk-mitigation (Accessed: 27th January, 2017).

Chan,A,P,C & Cheung,E. 2014.  Public private partnership in international construction: learning from case studies, Routledge, Abingdon

Commonwealth bank. 2016.  Basel III Pillar 3: Capital adequacy and risks disclosure as at 30th September 2016. Retrieved at https://www.commbank.com.au/content/dam/commbank/about-us/shareholders/pdfs/shareholder-information/commbank-basel-iii-pillar-3-capital-adequacy-risk-disclosures-30-sept-2016.pdf (Accessed: 28th January, 2017).

Davis, K & Lawrence, K, M. 2015.  Basel III and IV and Australian banking. Retrieved at https://australiancentre.com.au/wp-content/uploads/2016/04/Day1Paper1-Davis-Lawrence.pdf (Accessed: 27th January, 2017).

Gattani, V. 2014. Quora. What are BASEL 1, 2, 3 norms? What are the basic differences between these norms? Retrieved at https://www.quora.com/What-are-BASEL-1-2-and-3-norms-What-are-the-basic-differences-between-these-norms (Accessed: 27th January, 2017).

Geroniks,A & Lejnieks,P. 2015. Critical success factors for private public partnership (PPP) implementation in Latvia. SSE Riga student research papers (Accessed: 26th January, 2017)

Lukac, D. (2008) Key success factors for foreign direct investment (FDI): the case of FDI in western Balkan, Hamburg

McCoach, L & Chernishev,A. 2014. Mondaq. APRA’s final Basel III liquidity rules now in force. Retreived at https://www.mondaq.com/australia/x/292010/capital+adequacy+BASEL/APRAs+final+Basel+III+liquidity+rules+now+in+force (Accessed: 27th January, 2017).

Mccoach,L. 2014. Round-up of regulatory capital requirements for Australian ADI. Post- basel III. Retrieved at https://www.claytonutz.com/knowledge/2014/may/round-up-of-regulatory-capital-requirements-for-australian-adis-post-basel-iii (Accessed: 28th January, 2017)

Murphy, J. 2015.  Parliament of Australia. Murray financial system inquiry recommends raising capital requirements for Australian ADIs. Retrieved at https://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Library/FlagPost/2015/February/Basel_III_banking_reforms (Accessed: 27th January, 2017)

PWC. Basel III: an Australian perspective on a global challenge. Retrieved at https://www.pwc.com.au/financial-services/basel.html (Accessed: 27th January, 2017)

Regulation impact statement. Implementing Basel III capital reforms in Australia. Retrieved at https://www.apra.gov.au/Policy/Documents/September-2012-Basel-III-capital-regulation-impact-statement.pdf (Accessed: 26th January, 2017)

Reserve bank of Australia. 2013. The Basel III capital reforms in Australia. Retrieved at https://www.rba.gov.au/publications/fsr/2013/sep/box-b.html (Accessed: 27th January, 2017)

Roy,P,V. 2005. Credit ratings and the standardized approach to credit risk in Basel II. Retrieved at https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp517.pdf?6d91d46f21c928dd5508592da2ab3027 (Accessed: 27th January, 2017)

The Basel II accord. Retrieved at https://www.basel-ii-accord.com/Basel_ii_Credit_Risk_Standardised_Approach__50_to_65.htm (Accessed: 28th January, 2017)

The conversation. 2015. Australian banks are still too big to fail. Retrieved at https://theconversation.com/australian-banks-are-still-too-big-to-fail-44913 (Accessed: 27th January, 2017)

World Bank group. 2016. Public private partnership in infrastructure resource centre. Retrieved at https://ppp.worldbank.org/public-private-partnership/financing/project-finance-concepts (Accessed: 27th January, 2017)

Yescombe,E,R. 2011. Public- private partnership: Principles of policy and finance, Butterworth- Heinemann

Zhang, Z. Shen, Z, M. Zhang, J & Zhang, R. 2015. LISS 2014: Proceedings of 4th international conference on logistics, informatics and service science, Springer Heidelberg, New York.

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