After financial crisis of 2008, the oversight of financial markets has been under perusal. Due to the sovereign debt crisis in periphery of Eurozone (EZ), a number of political tensions arouse from various preferences among different countries in order to ensure tight regulation versus short-term economic development. Due to these tensions, a pressure has been created for a delayed implementation of regulation (Sutorova and Teplý, 2013, pp. 226). This regulation was approved within the setting of two financial clubs that are the Basel Committee on Banking Supervision (BCBS) and the Financial Stability Board (FSB). These committees made contributions for shaping the perspectives, methodology, quantification and adjustments of regulations all across various countries. After financial crisis, various amendments in accounting standards have been made in order to ensure reduction in transaction costs (Young, 2013, pp. 465). The implementation of these standards can be done by producers rather than government. The financial crisis resulted in increased panic on markets and as a response to these failures in marker Basel Committee in accordance with Banking Supervision (BCBS) formulated a new regulation for banking sector Basel III. This urged the researcher in finding the influences of Basel III regulations on banking sector that whether or not Basel Committee got success in eliminating effects of failures and financial crisis on countries (Šútorová and Teplý, 2014, pp. 150-153).
The aim of this report is two-fold. This research has been conducted for critically analysing Bank Regulation subject to Basel III. The critical analysis has been done both theoretically and empirically. In theoretical part, detailed analysis of introduction, implementation, aims, importance and failure of Basel III is done. In addition to this, empirical part includes analysis of the relationship between capital requirements identified in Base III framework and market value of European banks.
RQ1: What are the causes and purpose of Basel III framework implementation for banks?
RQ2: What is the impact of higher capital requirements on market value of banks?
H1: There is a positive impact of higher capital requirements on the market value of banks
Basel III is a set of regulations for international banking formulated by Bank for International Settlements for promoting stability in international system of finance. The aim of Basel III is reducing the capability of banks for damaging the economy through taking excess risk. Two global standards were introduced by Basel III to fund liquidity. These two standards are Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). With the help of LCR banks are motivated for holding sufficient liquid assets of high quality for surviving one month stress period (Elleuch and Taktak, 2015, pp. 160-162). The orientation of NSFR is more towards long term. This standard specifies minimum long term stable funding required by banks for holding with respect to liquidity aspects of their assets. In January 2013, an updated version of LCR is published by BCBS due to which some real requirements were significantly relaxed and therefore it has become easier for banks to meet LCR. With this aspect, there is a need of holding more capital by banks against their assets, so that size of balance sheet and their capability of leveraging themselves can be decreased. These regulations were used to discuss before financial crisis, but their need is magnified more after occurrence of these events (Enriques and Zetzsche, 2015, pp. 220).
Due to the implementation of regulations of Basel III, different changes in capital structures of banks were made. The most initial change was in minimum amount of equity as a percentage of assets. This was increased from 2 percent to 4.5 percent. In addition to this, banks require 2.5 percent additional buffer in order to bring requirement of total equity to 7 percent (Teplý and Šútorová, 2014, pp. 670-672). Banks can utilize this buffer during the period of financial stress but banks will also have to face hindrances on their capability of paying dividends and deploying capital. In order to implement these changes, there is a time till 2019 available to banks. There is a delay in implementation of standards of Basel III in order to prevent sudden freeze in lending as struggle is made by banks for improving their balance sheets (Shingjergji and Hyseni, 2015, pp. 5).
There is a possibility that in future less profitability will be shown by banks due to the implication of these regulations of Basel III. The minimum requirement for equity is 7% and banks will strive for maintaining a higher figure. The capability of banks for issuing debts depends on stability of banks. Similarly, a higher P/E multiple might be assigned by the stock market to banks in which capital structure is less risky (Bikker and Hu, 2012, pp. 370).
Acharya and Ryan, 2016, pp. 290) conducted a study for analyzing the relationship between liquidity requirements of Basel III and failure of banks in US by utilizing the discrete time hazard model. It has been found from their research that the main reason behind bank defaults in financial crisis of 2008 was liquidity risk of systematic funding rather than idiosyncratic liquidity risk. In accordance with Boahene, Dasah and Agyei (2012) there is a limited capability of LCR and NSFR for predicting the failure of bank in comparison to measures of traditional liquidity risk. Moreover, Cummings and Durrani (2016) did a research using Probit model for determining the effect of NSFR and leverage of bank on possibility of default. It has been pointed out by them that there was more vulnerability shown by small banks to fail on liquidity issues, while large banks were more vulnerable to fail on incompetent capital buffers. The standards of Basel III are set in such a way through which financial crisis similar to financial crisis of 2008 and 2009 can be prevented. Despite having good intentions of Basel III, it has been criticized by many banks due to its aspect of converging new capital and requirements of liquidity. This aspect is considered to be highly challenging to be implemented in banks.
As of 31st December, 2012 there is a still need by European banks for investing more € 225 billion in liquid assets for reaching 100% to LCR. In addition to direct costs linked with fulfilment of requirements of liquidity, banks have to face extra indirect costs like measuring and evaluating LCR and NSFR. It is challenging for banks to implement Basel III because of the reason that for evaluating liquidity risks, there is a need of monitoring LCR on daily basis. Moreover, banks also have to ensuring reporting once in a month. The banks face delay in implementation of Basel III, because their system of IT also has to be improved significantly, due to which a lot of data has to be processed. The liquidity management, structure of governance and setting of risk appetite of banks are influenced by implementing new standards of liquidity (Cummings and Wright, 2016, pp. 45-50).
According to Fernando and Ekanayake (2015) banks will have to adapt and significantly improve their IT systems, which will have to process enormous amount of data. Implementation of new liquidity standards will also influence bank´s liquidity management, governance structures and risk appetite setting. In accordance with costs implied by Basel III on banks, it can be seen that regulatory process of banks is influenced and due to this effect of requirements of Basel III are minimized.
In this section, empirical research has been conducted through fixed effect and random effect methodology. For the purpose of conducting empirical research, data was collected from database of BankScope during the time period of 2005-2011. The selection of banks was done in accordance with their specialization and nature of models applied. The modelling involved standard tasks like taking deposits and giving loans. These banks were commercial banks, saving banks, mortgage banks and bank holding firms and cooperative banks. In the database complete needed data related to 172 European banks were given. Those banks were taken that are listed in European Stock Exchanges for the time period of 2005-2011. The data was analysed through fixed effects methodology as it was considered to be more appropriate model. It is significant to note that the situation has been modelled historically and conclusions are based on potential effect of rules related to adequacy of capital provided in Basel III standard. This depicts that it has been assumed in the study that banks’ reaction, variables related to bank and investors will give response to same stimuli in a similar manner in future as done in past. For estimating the impact of levels of capital on value of European banks, a panel data model was used in which market capitalization is used for representing the bank value. In order to model the link between markets value of bank and level of capital four variables are used; capital, risk, value and profitability.
In Table 1 results of fixed effect methodology with all three kinds of capital ratios are reported. It has been indicated from results that negative reaction is shown by investors to higher level of bank capital. This creates a negative impact on banks’ performance with respect to their market capitalization.
Moreover, on the basis of values of estimated coefficients, buying and selling decisions of investors are affected more by level of profitability as compared to the level of risk. The reasons are following;
Table 1: Results of Equation 1
It can be summarized from above analysis that high capital ratios are not appreciated by investors at the time of taking decision related to buying of shares, in spite of knowing that banks have to face lower risks in case of having high level capital. In this research, it has been found that cardinal factor of decision making by investors is profitability level that is negatively affected by capital. This also has a significant impact on value of bank. So, decisions of investors are affected by both of these factors and this creates negative relationship between shares’ performance and hinge in ratios of capital. From our results and findings, it can be concluded that hypothesis will have to be rejected in which a positive relationship between requirements of capital and value of banks was expected. This is due to the reason that it has been expected that investors usually prefer taking lower risks. The results depict that investors prefer high risk taking banks because they expect a high return in this case. So, banks in which balance sheet shows higher risk.
In current study, Basel III baking regulation has been targeted with objective to analyse rules of risk assessment, liquidity, capital and its impact on regulation of banking sector. The analysis shows that Basel III regulation is not enough and do not avoid financial markets from crisis because of the strong pressure, delayed integration and assumed calibration through bank lobbyists. In opposed to the theoretical backdrop, an empirical check of the hypothesis has been given like whether the market would appreciate needs of higher capital, less risky balance sheets and low risk taking under the Basel III proposal. The employment of methodology and fixed influences has been done through analysis of financial data. It has been identified that there is an increment in the equity ratio, total capital ratio and Tier 1 ratio through one percent point in the past results in the negative alteration in the capitalization of market by 4.5%, 3.7% and 13.3%. Because of this, the hypothesis has been rejected explained in the start of the work defining that higher capital needs can be appreciated through market. Dependent on the results, it can be concluded that the influence of Basel III regulation on bank share are negative through market, which can be seen from the drop of shares value of observed banks.
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