Over the past, series of crises have struck the global financial markets the latest one occurring in 2007-2008. Such financial crises have occasioned the need for tighter regulation of the financial markets in order to curb any downfall in the markets. The Basel III Accord was developed based on that need. The accord was developed in 2010 and is being implemented in stages with full implementation scheduled for 2019. Since 2010, a number of countries have successfully implemented the accord.
The current paper was designed to investigate the effects of Basel III Accord, especially on investment banks. The available pieces of literature indicate that only a few studies have been conducted to determine the effect of Basel III Accord on the banking sector, which it regulates. In particular, no study has investigated the effects on investment banks.
The current study was based on descriptive research design using quantitative data analysis. The descriptive research design was chosen because of its suitability to the nature of the research problem being investigated. In addition, it was suitable for the type of data used in the analysis. The data were collected about Barclays Investment Bank. The data was downloaded from Bloomberg, covering a period between 2008 and 2017.
The main method used for data analysis was linear regression, which was used to establish the relationship between dependent and independent variables. In addition, the use of regression analysis helped identify how Basel III Accord affects the value, profitability as well as the efficiency of investment banks, using Barclays as the case study. The study’s findings established that it has increased the efficiency of investment banks. However, it has significantly decreased the value as well as the profitability of investment banks.
Abstract
In 2007/8, financial crisis destabilized the financial market across all major global markets. The financial crisis was occasioned by week regulatory measures in the credit sectors. This occasioned the establishment of a committee that came up with the Basel III Accord to regulate the financial markets, majorly banking sector so that future financial crises can be avoided. Based on this background, the study was designed to assess the impact of Basel III Accord on investment banks, using data from Barclays Investment Bank. The primary objective of the study was to determine how the Basel III Accord has affected three aspects of investment banks namely profitability, value and efficiency.
The study was based on descriptive quantitative research design. Data used was downloaded from Bloomberg, a leading provider of financial data. The main method of data analysis was a linear regression. Based on the research objectives, three linear regression models were developed for the bank’s value, profitability and efficiency respectively. Three diagnostic checks were done to determine whether the model fitted the data well namely histogram normality test, heteroscedasticity test, and serial correlation test. The result of the data analysis has provided strong evidence that Basel III Accord has an impact on investment banks. It affects the profitability, value, as well as the efficiency of investment banks. In particular, Basel III Accord improves the efficiency of investment banks. However, it decreases the value and profitability of the bank.
Keywords: Basel III Accord, financial crisis, bank regulations, investment bank
Background Information
The Basel III Accord is a regulatory framework that was designed to strengthen financial institutions through the placement of the specific rules and guidelines relating to the leverage ratios, as well as capital and liquidity needs. For most investors, those rules work by creating confidence that some mistakes made by financial institution such as banks resulting financial crises such as in 2007-2008, never to be repeated. Basel III rules are meant for voluntary efforts and bringing together of several inputs and feedbacks and other regulations meant to prevent any likely future crisis in the financial markets. Most nations have integrated different aspects of Basel III into their individual domestic regulatory statutes for banks and other financial institutions. The main lesson drawn from the financial crisis is that the financial institutions with considerably high leverage ratio need to be regulated in the best way and not be left as a matter of self-regulation. In case banks are left to work on just mere basic survival edge, the risk of the actual financial plunge is increased.
If banks in any case are unrivalled, their individual assets would be sold at higher prices. This would in the way drive down values of all the different types of assets, resulting in values being marked down on healthy bank balance sheets and making banks develop distress. The unique aspect of the banking system is the requirement for a greater confidence in the system at the best centre in order to survive. Some industry stakeholders suggest that Basel III would have a negative impact on the overall economy. For instance, Institute of Internal Financial (IIF) argued that different economies for the both Europe and US have dropped close to 3% after half a decade due to the implementation of Basel III rules (King 2013, p. 4146).
The greater financial crisis that occurred in 2007-2008 was considerably amplified by the weakness that was witnessed in the banking sector. The particular weakness was due to a number of factors such as much leverage, lack of and low-quality capital among others. In addition, it was caused by the little liquidity buffers across all types of banks (Lee and Hsieh 2013, p. 255). The Basel committee concerned with banking supervision then offered Basel III with the aim of improving the stability of the banking sector by absorbing shocks that comes up due to the stress of the financial and economic issues (Lee and Hsieh 2013, p. 256). The new reforms of the Basel III have the possibility of preventing another crisis occurring in the future. In addition, the committee intends to boost the stability of financial sectors by adjusting the three pillar of systems that were first introduced by Basel II (Valdez and Molyneux 2015, p. 201). A considerably stricter capital and liquidity requirements, specific new ratios of liquidity, leverage ratios and advanced supervisory review process and discipline in the market are some key proposals by the Basel III for enhancing and strengthening financial sectors. However, Lee and Hsieh (2013, p. 258) argued that the stricter capital and the specific requirements of the liquidity have implications for the individual banks. Such requirements impose an opportunity cost on banks that directly affect their profitability and shareholding values in negative ways.
Basel III Accord consists of a variety of changes that are proposed to the actual liquidity as well as the global capital needs and specific requirements. The rules also relate to the role of banking supervisors. Basically, Basel III is a revised version of Basel II Accord, which was developed from Basel I that became official standard in 1988. The Basel committee was created in mid-1970s following the failure of the small German banks (Heskett) thereby sending shudders on the international financial systems (Dietrich, Hess, and Wanzenried 2014, p. 16). It was adopted as a regulation for the adverse coordination that was the case of international banking regulators. It is however composed of other specific banking regulations that originated from other developed nations. Its main members basically are the traditional powers mainly Europe, US, and Japan (Valdez and Molyneux 2015, p. 201).
The new regulations aspire to make the banking systems safer through redress of various crises that has been witnessed. The actual focus on the liquidity management is to spur banks to improve their respective underlying risks of the capabilities in management. The actual aim is that ultimately, in case of banks come to a fundamental revamp in understanding of their respective risks, which would make it better for their respective businesses, clients, investors and governments as well. The core focus of Basel III Accord is on the capital and the funding requirements (Francis and Osborne 2012, p. 80). It specifies the overall new capital actual ratios, defined as core tire 1 requirements of more than seven percent. The larger requirements for the different Tier 1 of 8.5% capital. It involves the core Tier 1 minimum of 7% and the minimum the additional Tier 1 capital of more than 1.5% (Locarno 2011, p. 211). It additionally gives other standards for the shorter financial funding and outlines the specific requirements for the long-term kind of funding. In response to the new regulatory requirements, banks at this Tier are developing their capital and funding stocks as well as taking time off their books in many ways (Locarno 2011, p. 215). In addition to this, there are several other activities to step the process through current Basel III Accord, for instance, better capital and management of liquidity, restructuring of balance and other models of adjustment of business. According to Ramirez (2017, p. 99), Basel III represents a review of framework for regulation and supervision of the future banking industry, focusing on bettering and stabilizing of the financial systems.
The banking crisis can be traced to 1985 and beyond. Since then, there have been over 30 crises in the banking industry in the member countries of the Basel committee (Francis and Osborne 2012, p. 81). As explained by Angelkort and Stuwe (2011, p. 34), the actual advantages accorded by Basel III are considerably better implementation cost and better systems of banking, which are the core foundations of the suitable developments with long-term benefits.
Basel III Timetable
The G-20 heads of states have over time charged the Basel committee with the hope of completing Basel III rules and regulations just in time G-20 conventional meeting that took place in Korea in 2010. The progress resulting from the case that began with the actual consultations files in 2009 outlined the changes and the requirement in the bank liquidity (Vieth 2014, p. 88). This resulted in the soliciting of the comments by mid-2010 and many other parties acting on that responds in length (Vieth 2014, p. 88). However, parallel Basel committees, with assistance from both Bank for International Settlements (BIS) and the Financial Stability Board (FSB), resulted in the Quantitative Impact Study (QIS) aimed at estimating the individual markets and the overall economy key in facilitating the actual changes that have been proposed. The original intention was to implement the Basel III by the end of 2012. The many changes that have occurred in the process have developed clear guidelines that have to be considered by the Basel III committee in regulating the operations of the many financial institutions in all parts of the world (Angelkort and Stuwe, 2011, p. 36).
The Contribution of the Basel III Agreements
According to the promoters of the new agreements that are put forward by the Basel III, it is essential to combine the micro and the macros prudential supervisions. This helps in establishing the risk management framework at both individual levels of banks (which are obtained both from Basel 1 and Basel II Accords) as well as the systematic risk management framework at the whole bank systems levels. The major role of Basel III agreements is largely the regulation of the commercial banks. Further, it is a representation of the improvement of the stable nature of the banking systems by removing the difficulties that have been escalating or occasioning financial crises (King 2013, p. 4151). Basel accords are not in any way formal ties and the members of the committees are not normally fully responsible for the implementation of the rules in the respective national laws and regulations (Ramirez 2017, p. 108).
The many countries have implemented the Basel II for their commercial banks by the time of the major financial crisis. It is however not clear whether this would have eventually worked in implementing the accord (Vieth 2014, p. 89). The reality is that only a few countries opted to implement every timely detail of the Basel III accord thus did not completely protected themselves against the likely financial crisis. According to Lee and Hsieh (2013, p. 255), the accord have led to much greater uniformity of the capital requirements around the world than those that existed prior to Basel I. The uniformity extends beyond different countries that are represented in the Basel committee, as most nations with significant banking sectors have worked in modelling their respective capital regulation on the basis of Basel rules (Ramirez 2017, p. 97).
Capital and Liquidity
As explained by King (2013, p. 4149), capital represents the greater portion of the asset of the bank, which is not in any way associated with the contractual commitments for the purpose of repayments. It, therefore, provides a cushion in case of a decline in the value of specific bank’s assets or in the rise of the liabilities that are linked with the banks at the same time. Banks in most cases attempt to hold a minimum level of capital that works in supplying enough protections. Bank capital is expensive, however, all the parties recognize the specific need for such cushion even when there is a debate for the right amount or any form (Andrle, TomšÍk, and VlčEk 2017, p. 44).
On the other hand, liquidity is the ability of a bank to sell its assets. In other words, it represents what can be converted into cash without any loss in the sale or conversion. Liquidity in most cases increases the longer the period under consideration (Locarno 2011, p. 200). For instance, a house may be very illiquid if an individual needs to sell the house within a span of one week but in other cases, it can be liquid if one is offered five years as the period of managing such sale. In the case of a bank, the liquidity is matching of the respective obligations with the resources, which is used in the process of funding (Vieth 2014, p. 98). A bank with considerably higher liquid asset would, therefore, be considered a fairly more liquid even in the case where the funding sources were of relatively short maturities period.
Research Objectives
The overall objectives of the study are to establish the impacts of Basel III accord on the investment banks. The specific objective of the study include:
1. To determine the impact of Basel III rules on the value of investment banks.
2. To determine the effect the Basel III rules on the profitability of investment banks.
3. To establish the impacts of the Basel III rules on the efficiency of investment banks.
Research Questions
The three research questions explored include:
Does Basel III Accord affect the value (market capitalisation) of investment banks?
Does Basel III Accord effect the profitability (the ROA) of investment banks?
Does Basel III Accord affect the efficiency (efficiency ratio) of investment banks?
Research Aims
The aim of the current study is to develop three regression models that would help identify how Basel III Accord affects the value, profitability as well as the efficiency of investment banks.
The Significance of the Study
The study is significant because it provides useful information that can be used by the government as well as policy planners in developing appropriate implementation plans for the Basel III Accord. In addition, the results of the study can provide useful information for improving various aspects of the Basel III Accord to ensure that it achieves its goal of curbing any likely future financial crisis. Lastly, the information can be used for academic purposes.
Project Structure
The paper is organized into five chapters covering different topics and themes namely the introduction, literature review, methodology, analysis and results, and finally conclusion and recommendations.
Chapter 1: the chapter is an overall introduction to the research study covering the background of the study, objectives, research questions, and project structure.
Chapter 2: it provides details about the literature review that was conducted on the research topic. It provides the empirical findings as well as the theoretical background to the impacts of the Basel III rules.
Chapter 4: the chapter provides descriptions and justifications of the methodology chosen to study the impact of Basel III Accord on investment banks. It involves the different assumptions based on the adopted in the study. It presents the adopted research design, techniques of data collection, data analysis, validity and the specific reliability of the research and finally on the different consideration of ethical practices.
Chapter 4: the is basically a presentation of the result of the data analysis. It also provides interpretations of the statistical results. Lastly, a comparison of the result of previous researchers is also presented here.
Chapter 5: it is the last chapter of the paper providing details on the conclusion from the study and recommendations made based on the findings. The figure provides a pictorial representation of the structure of the paper.
A discussion of the results of the literature review on the topic is presented in this chapter. Various pieces of academic literature were reviewed to establish what other researchers have done and found about the impact of Basel III Accord on the banking sector. The review also provided the theoretical background upon which the current research was grounded on.
The positive and negative effects of Basel III Accord
The full implementation of the Basel III Accord is expected to have both negative and positive effects on the banking sector. Some effects have not been experienced but are anticipated in the near future given that according to the schedule, the Accord will be fully implemented in 2019. As explained by King (2013, p. 4150), full implementation of Basel III Accord is expected to affect both the liquidity and capital of various banks. An empirical study by Dietrich, Hess, and Wanzenried (2014, p. 18) showed that Return on Investment indicators before the tax imposed on the European banks would, as result of the Basel III Accord, decrease by 3.7% to 4.3 % from the currents 15% level.
According to Lee and Hsieh (2013, p. 260), the analysis of the different transitions period showed that the reducing value of the ROI due to Basel III Accord would after sometime hit 1.6 points, thereby affecting the performance of commercial banks. The value reduction, therefore, follows another different requirement, which is desired to enhance the nature of actual capital base by introducing the leverage effects and the actual least level of liquidity of standards at the international extent (Valdez and Molyneux 2015, p. 101). Another research study by Francis and Osborne (2012, p. 808) showed that the actual responsibility of banks is considerably a committing task because banks do face key challenges in achieving the technical compliance of the actual standards with the major goal of achieving the best results. The rules were developed to restrict both the frequency as well as an intensity of the financial related crisis which were faced by the financial organizations.
Another study by Locarno (2011, p. 111) indicated that the agreement would reduce the significant cost of economic crises. However, he further showed that the actual effect of the Basel III rules on several systems of banking segments, corporations and banks are considerably not the same. Most banking systems and corporate activities are in this way affected by individual provisions of Basel III Accord considerably in bad ways to the financial institution. Angelkort and Stuwe (2011, p. 38) specified that the accord particularly negatively affects the capital as well as the liquidity requirements of banks. Most of the retail establishments are affected by the measures that the accord imposes on the base capital requirements. According to Francis and Osborne (2012, p. 809), in the situations of the retails products, the main effects of the Basel III are considerably not severe; the new requirement, however, will affect many standard processes of banking products that are dedicated to the corporate industry thereby increasing the cost of banking.
In another post-Basel III empirical study, Lee and Hsieh (2013, p. 260) showed that the capital of the individual investment banks tends to alter due to the impacts of the new regions dealing in the capital of the retail banks. According to the research by Valdez and Molyneux (2015, p. 101), despite being in an advanced stage, the US retail banks are equally affected by the Basel III rules. This is attributed to the considerably smaller size of the US banks especially in terms of the asset value as compared to the Europeans. In another study, Locarno (2011, p. 115) showed that the deductions of the actual mortgage rights have a considerably greater role in the US than that witnessed in Europe. According to Andrle, Tomsk, and VlcEk (2017, p. 47), considering that a lot of the US banks have not yet put into full the implementation Basel III, the specific capital ratios of the banks may in this way be affected by key transitions of Basel III rules and this is respective to the rules.
Impacts of Basel III on Bank Capital
According to Ramirez (2017, p. 104), Basel III Accord will increase the level of the capital shortfall, which is as a result of the considerably high sensitivity to the assumed target ratio. This has been used from the regulatory ratios of over 4.5% for the main Tier 1 and 6% for all Tier 1, which is why together with the other required 2.5 % of the core Tier 1 conservations buffer. Vieth (2014, p. 55) argued that together with the cushion of 2-2.5% they do accounts for over 55% of the capital shortfall in the banking sector. In addition to this, Härle et al. (2010, p 120) estimated that historically retail banks on average have accumulated close to very 4% of the points which is slightly above the actual mandatory buffer. However, this is with the view that individual banks tend to hold at least 1% points of the cushion, while others may have accumulated or held up to 3-4% points especially if the addition that is considered to be of ‘too big fail requirement’ is placed on the big banks (Angelkort and Stuwe 2011, p. 40).
As explained by King (2013, p. 4149), from the two main Swiss banks it is assumed that 12% core tier 1 ratios, as well as the 20% total Tier 1 ratios, includes the contingent’s capitals. It represents considerably smaller cushion of 1% point on the top of the minimum recently developed by the Swiss experts. In case of other banks in the UK, it takes a value of over 12% core Tier 1 ratio and 15% Tier ratio in light of the actual statements by the UK regulators. The UK regulator pledged that they would in the best way need more than Basel III rules to minimize capital risks. This is one aspect of the Basel III rules which was intensively discussed in the G20 summit in Korea (Locarno 2011, p. 110). According to Ramirez (2017, p. 104), when all the assumptions have been considered, the total shortfall in Europe in 2019 can only be approximated at 1.1 trillion euros. He further explained that the leverage ratios which embodied on this rules will not be in any way a mature constrain by that time. On the other hand, an empirical study by Vieth (2014, p. 58) argued that the requirement for risk-based ratios imposed by Basel III Accord does not work effectively.
According to Härle et al. ( 2010, p 120), many weaknesses in the management, as well as the capitalization of the counterparty risk, affect the effectiveness of the Basel III rules. However, they noticed that the Basel III Accord has introduced several measures aimed at improving the requirement on capital for this counterparty credits exposers especially for those coming from the commercial banks. The result of an empirical study by Angelkort and Stuwe (2011, p. 39) showed that such measures have the potential of reducing procyclicality and offering additional incentives of promoting the derivatives of OTC constricts to the main counterparties. This plays a crucial role in assisting them in the reduction of the systematic risks that are associated with financial systems in the global commercial banks (Lee and Hsieh 2013, p. 262).
Basel III Impacts on Liquidity
Liquidity is central in the creation of the operation of the different markets and categorically in banks. According to Valdez and Molyneux (2015, p. 101), the regulation of the liquidity failed to receive adequate attention until very recently through the introduction of Basel III Accord. Previously, there was a lack of conventional and harmonized standard of liquidity controls. Regulations of liquidity in the banking sector over the past 20 years was largely moved by the Basel I and Base II rules of the capital that was not of global standards. Such rules worked in limiting the maturity kind of mismatch leading to increasing portions of the assets that have been long dated in the past. Over the past financial crises have highlighted the specific importance of maintaining robust liquidity on the aspect of management of risk by the institutions (Francis and Osborne 2012, p. 808). According to Andrle, TomsI´k, and VlcEk (2017, p. 48), the 2007-2008 financial crisis was a demonstration of the fact that the liquidity and the solvency over time have been deeply dissociated.
The Basel III has over time introduced considerably two new standards of liquidity in improving that the resilience of the commercial banks to the shocks of the liquidity. In the overall short term, the commercial banks are required to maintain it buffers if highly liquidity securities assume the value of Liquidity Coverage Ratio (LCR). As explained by Vieth (2014, p. 55), such buffer of liquidity are meant to promote resilience to the actual potential liquidity disruptions over a period of close to 30 days. This has been established to be key in ensuring that the global banks have enough unencumbered, high quality of liquid assets from the start of the new case outflows. Dietrich, Hess, and Wanzenried (2014, p. 18) showed that the specific scenario could include a considerably significant downgrade of the different institution’s credits rating of the public, which is seen as the funding of haircuts and improving the actual collateral and the calls on the real contract. It can also be seen as the cases where there are no contractual balance sheet exposers that involve the credit and the actual capital relating to the liquidity (Ramirez 2017, p. 104).
The other measure of liquidity is known as the Net Stable Funding Ratio (NSFR). This measure of liquidity calls for a specific level of the stable source in getting a commercial bank relative to the liquidity profiles of the assets. It is the case of the continent liquidity requirement that arises from the off-balance on the short-term wholesale funding over the ties of the market buoyancy on the liquidity in encouraging a key assessment of the risk that occurs on the specific items. The main aim of NSFR is promotions of the resilience for the creation of extras intensities for the commercial banks in funding of the different cases (Locarno 2011, p. 117).
Macroeconomic Effects of the Basel III Rules
Angelini et al. (2015, p. 99) explained that commercial banks might be able to increase the capital requirements under the same Basel III rules in the said market. Basing on the above, research has in the past developed questions as to the actual impact of the rule on the economic growth and the bank’s profitability. The results of a research study by Härle et al. (2010, p 129) showed that the increase in the equity and the capital requirements are most likely to enhance the cost of the actual capital. As such the lending equilibrium rates are in essence get higher and as result, the value of the credits growth could also be little lower compared to the case in the previous years (Angelkort and Stuwe 2011, p. 42).
However, the important aspect following the implementation of the Basel III rules is whether the associated cost would go down. Most researches have also assessed the impact on the economy of the transitions to relatively highest values of the capitals and the liquidity (Marczyk, Dematteo, and Festinger 2005, p. 111).
