Analysing the strengths, weaknesses and effects of Capital adequacy, moral hazard and banking operations using current financial regulations in the UK.

Basel 3

After the recent global financial crisis, the Basel Committee on Banking Supervision (BCBS) decided to revise its previous Basel Accords and reform it; resulting in the implementation of Basel III.
Basel I was considered extremely simple in its application and relatively easy to reduce capital with very little risk, through off-balance sheet activities therefore reducing the value of capital the bank required. There was poor management of the risk taken by banks and the guidelines were subject to “regulatory arbitrage, this is where banks keep on their books assets that have the same risk-based capital requirements but are quite risky i.e loans to companies with high credit ratings.”
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Basel II although was more risk sensitive through its use of three pillars; which were minimum capital requirements, supervisory review and market discipline, it wasn’t adequate enough to prevent the global financial crisis. The first pillar sets capital requirements against the risks; credit risk, market risk, and operational risk. The second pillar allows supervisors to review the banks performance and activities and thus decide whether they require holding more capital than what was calculated within pillar one. The third pillar motivates banks to manage their risks sensibly through increasing the banks transparency and allowing the public to be aware of the banks activities and then decide whether they need to increase their minimum capital requirement.
However the risk-weighting used by Banks were standardised and were cripplingly reliant on credit rating, which were forgeable in the run up to the crisis. Basel II also encouraged banks to increase their retained capital when the economy was weak and reduce the amount when the economy was strong this lead to the Banks credit cycles to bad. Also banks did not face any consequences from failure of meeting the requirements in pillar one.

http://www.slideshare.net/pankajbaid17/basel-iii-capital-adequacy-accord - slide 7 and slide 11

Basel III is intended to fill in the gaps which weren’t included in Basel II and were highlighted by the recent financial crisis. As observed in the table above Basel III should increase both the quality and quantity of capital held by banks in order to have the capacity to absorb losses. It also included liquidity requirements and a leverage ratio. Basel III is estimated to be fully implemented by 2019. The capacity adequacy requirements will be improved with the addition of the leverage ratio, which has been set as a minimum of 3%. This was added because previous to the financial crisis banks held relatively high leverage ratios which had little effect on the capital ratios that banks released but during the crisis is led to a shortage of capital being available to borrowers. The purpose of the leverage ratio is to reduce the abuse of off-balance sheet activities http://tejas.iimb.ac.in/articles/Tejas_December%20Edition_Article%201.pdf and the build-up of excess leverage within banks. http://www.slaughterandmay.com/media/1550585/basel-iii-a-new-capital-adequacy-and-liquidity-framework-for-banks.pdf - page 40

However Basel III may still fail as it does rely upon greatly capital ratios which failed to avoid the financial crisis, even though many banks did have strong ratios. “Lehman Brothers had Tier 1 capital of 11 percent on Sept. 12, 2008, three days before it declared bankruptcy.” http://www.huffingtonpost.com/laurence-j-kotlikoff/the-feds-no-stress-stress_b_1346433.html
Another weakness of Basel III is the risk-weighting of assets calculations have remained unchanged.
As with Basel II “Banks will need to hold more common equity than ever—against their risk-weighted assets. That massively increases the incentive to find low-risk-weight assets with some return, since these assets can be leveraged much more highly than risky assets.” http://www.economist.com/blogs/freeexchange/2010/09/basel_iii this will encourage banks to continue lending to sovereigns most of which carry a zero risk-weighting.