Economics Essays – Financial System Banking

Capital Adequacy Directive

Abstract

In the recent years, it seems that the supervisors have increased the attention on the capital adequacy of banking intuitions in order to enhance and maintain the stability of financial system.

The purpose of the present paper is to investigate into the merits as well as disadvantages of the Capital Adequacy Directive implementation in the Switzerland economy for the behaviors of Swiss banks and shed some light on whether and how Swiss bank react to constraints placed by the regulator on their capital.

The analysis and evidences given will clarify the finding is that while the Swiss banks enjoy the typical merits that have been brought by this innovation, some drawbacks they might endure could not be neglected, which implies the need for good policy guidelines of Government and Central Bank.

Chapter 1 Introduction

“We do realize there are better moments to introduce substantial increases in capital requirements.”

Nout Wellink (April, 2008), head of the Basel Committee on Banking Supervision

During the last 30 years, a wide range of countries have introduced the formalized capital requirement. This innovation seemed to be spearheaded by the adoption of minimum capital requirement in some particular states (for instance, the US and the UK in 1981). However, with the first introduction of Basel Accord in 1998, the common minimum capital requirements were actually adopted by G-10. To date, the Accord has been implemented by over 100 countries world-wide (Allen, 2004).

The implementation process of Capital Adequacy Directive (CAD) on the one hand produced many successes in practice as it helps to limit risk-taking relative to capital and to prevent systemic instabilities arising from large-scale banking failures, thereby enhancing the productivity, efficiency, safety and soundness of domestic banking system, in general, global financial system.

On the other hand, it also has generated several important failures and unintended consequences as it might reduce the lending ability of commercial banks which in turn directly influences to their competitiveness relative to other forms of intermediation.

This study attempts to measure the cost and benefits of Capital Adequacy Directive and apply it to the population of commercial banks that operated in Switzerland. The result suggests that even though some negative impacts of CAD is obviously seen, the implementation of CAD in Swiss banking system is essentially and truly needed. As the matter of fact, the advantages that Swiss commercial banks have achieved due to the effectiveness of capital adequacy regulation outweigh the disadvantages they might suffer.

The paper is divided into 4 sections. Chapter 2 introduces the historical review and general theory of Capital Adequacy Directive. Chapter 3 provides firstly the analysis on the both benefits and costs of CAD, followed by the statistic evidences from Swiss commercial banks’ behaviors. Finally, the summary of the main findings of this study and conclusion will be mentioned in the last section.

Chapter 2

Capital Adequacy Directive: Historical Review and General Theory

2.1 Historical review

The Capital Adequacy Directive was firstly and officially introduced as the core part of the 1998 Accord, referred to as Basel Accord (International Convergence of Capital Measurements and Capital Standards) issued by the Basel Committee on Banking Supervision (henceforward Basel Committee) in July 1998 (Hall, 2004). This accord is not formal treaty nor a binding legal rule, however due to the practical effects conveyed with it, the guidelines of this accord have been implemented not only by signatory countries at the beginning but also by over 100 countries world-wide (Lastra, 2004).

Nevertheless, the 1988 Accord has been criticized for its crude assessment of risk and for creating opportunities for regulatory arbitrage (Blum and Hellwig, 1996). Therefore, at the end of June 2004, the “New Capital Accord” (henceforth call Basel II) was finally issued after the endorsement conducted by G10 banks supervisor in order to replace the original accord (now termed “Basel I” agreed in 1988) and solve the problems occurred as the result of Basel I implementation in banking system.

2.2 General Theory of Capital Adequacy Directive

The genesis of Capital Adequacy Directive as well as the capital regulation could be traced back to the concern that bank might hold less capital than is socially optimal “relative to its riskiness as negative externalities resulting from bank default are not reflected in market capital requirements” (Rime, 2001).

In the 1988 Accord, the Basel Committee provided a ratio of capital to risk-weighted assets. In this Basel formula, Capital is divided into Tier 1 (equity capital plus disclosed reserves minus goodwill) and Tier 2 (revaluation reserves, undisclosed reserve, general loan loss reserves, and subordinated term debt). Specifically, Tier 1 capital must to constitute at least 50% of the total capital base. In addition, the denominator of this Basel formula is the sum of risk-adjusted assets plus off-balance sheet items adjusted to risk. (Lastra, 2004)

According to (BIS, 2008) the 1998 Accord in essence prescribed that banks hold capital of at least 8 % of their risk-weighted assets. Although there is no strong argument for the “target” ratio 8%, it still was considered to be “sufficient” due to the empirical application from previous policy applied in some states such as the US/UK bilateral agreement of 1986 regarding capital adequacy (Rime, 2005). Eight percent were the median in exiting good practice at that time: the US as well as the UK around 7.5 %, Switzerland 10%, France and Japan 3 % (Lastra, 2004).

In fact, data from a wide range of banks from the Fitch IBCA database and national supervisors as well as the Basle Committee denote increasing trend with the average capital ratio rising from 9.3% in 1988 to 11.2% in 1996. “Most countries experienced increases in their capital ratios although those countries, which were close to, or below, the Basle minimum capital adequacy ratio of 8% in 1988 evidenced a much higher overall increase than those, which had historically high capital ratios”. (Jackson, 1999)

Recently, in the new approach, often referred to as Basel II, specifically in the First Pillar ─ Minimum Capital Requirements, the overall level of regulatory capital currently held by banks is not set to rise or to be lower. The capital ratio is calculated using the definition of regulatory capital and risk-weighted assets and the total capital ratio must be no lower than 8%. In addition, the tier 2 capital is limited to 100% of Tier 1 capital (BIS, 2004). However, it is set to be more risk sensitive (Blum and Bichsel, 2004).

Chapter 3

Costs and Benefits of Capital Adequacy Requirements: The Analysis for Switzerland

3.1 Understanding the Swiss banking system:

To date, the Swiss banking system is typically depicted as one of the leading universal banking system around the world since this type “universal banking” was firstly allowed at the Banking Law of 1930 (Stiroh and Rime, 2003).

In reality, like the most continental European countries, Swiss bank legislation does not distinguish between the commercial and investment banks. In principle, Swiss banks are able to offer a wide range of financial services such as: lending and deposit-taking, underwriting, brokerage, trading and portfolio management (Swiss Bankers Association, 2006).

Furthermore, the Swiss banks might vary in the way they use their options to engage in all types of financial activities as the “truly universal banks co-exist with the institution specializing either in traditional banking or financial market activities”. According to Swiss Bankers Association (2006) the Swiss National Bank (SNB) classifies the banks in Switzerland into ten major categories: big banks, cantonal banks, regional and savings banks, Raiffeisenkassen banks, commercial banks, consumer loan banks, stock exchange banks, other banks, foreign, and private bank.

These bank categories differ with regard to their size, business focus, geographic scope of activities and legal form. Within the banking sector, the big banks maintain a dominant position in every respect.

As the matter of fact, the Swiss economy is characterised by a comparatively large banking sector by international standards, and by the dominance of two banks, Credit Suisse and UBS. At the end of 2006, the banking sector’s total assets exceeded CHF 4,500 billion or nearly ten times the size of Swiss GDP.

This is by far the biggest ratio among the G10 countries, followed by Belgium and the Netherlands where total bank assets are five times the size of GDP. Measured in absolute terms, the US has the largest banking sector. However, total assets of all banks are less than US GDP (Swiss National Bank, 2007)

3.2 Advantages and Disadvantages of Capital Adequacy Directive towards Swiss banks’ behaviour

In this paper’s context, instead of taking assessing advantages as well as disadvantages of CAD for all the participants of financial market, I would like to take the point of view to this issue from the one particular party of market – the banks.

Merits

Almost all financial experts hold the opinion that though capital generally accounts for a small percentage of the financial resources of banking institution; it plays a crucial and important role in their long-term financing and solvency position, which directly influence to their public credibility and reputation.

The inverse relationship between the capital adequacy requirement and bank risk taking has been found in the research of Avery and Berger in 1991. In order to meet the 8% target ratio of Basel formula, banks have not been encouraged and limited to take the high risky activities, which always promises the high payoffs, thereby reducing the likelihood of failures.

In addition, it is undeniable that the implementation of Capital Adequacy Directive leads to the more powerful ability of banks at the event of financial crisis as the more reasonable the capital ratio is set up, the higher the probability that a bank will not fail to pay back its debts.

This fact tends to justify the existence of capital adequacy regulation in order to avoid bankruptcies and negative externalities on the financial system. In other words, it could be said that Capital Adequacy Directive is needed to maintain and enhance the financial stability of banks, generally, for economics.

In the case of Swiss banking system, Switzerland welcomes that the Capital Adequacy Directive has been adopted as an important means to preserve the financial soundness of the Bank and its triple A rating. According to Swiss Banker Association (2008) the Swiss banks are well capitalized by international standards and as an additional safety measure, Swiss law demands capital adequacy standards even higher than those required by the Basel Accord. Swiss banks can therefore certainly be counted amongst the safest in the world. The following table will display the marked-rise in risk-weighted in all bank categories in Switzerland at the year-end of 2006

As been shown from the graph, in 2006, the risk-weighted capital ratios rose in all bank types as it increased from the 13.1 % to 13.9 % in terms of the entire banking sector (exceeded the G-10 countries’ average by more than 2.5% point at the same time). This increase was particularly pronounced at the big banks (from 11.5% in 2005 to 12.4% in 2006).

Specifically, let take UBS – one of two largest banks in Switzerland as a typical example for the benefits of Capital Adequacy Directive in order to maintain the financial stability. The capital that UBS is required to hold based on Swiss Federal Banking Commission (SFBC) regulations, which differ in some certain respects from the calculation under the Basel Capital Accord (BIS guidelines). As a result of the differences in regulatory rules, UBS’s risk-weighted assets are higher, and its ratios of total capital and Tier 1 capital to risk-weighted assets, are lower, when calculated under the SFBC regulations than under BIS guidelines. However, UBS has always had total capital and Tier 1 capital well in excess of the minimum requirements of both the BIS and the SFBC.

Capital adequacy

The success of USB in doing business as well as maintaining financial stability has been measured and confirmed by the largest and most famous credit rating agency such as Fitch Ratings, Standard & Poor’s and Moody’s. In February 2006, the rating agency Standard & Poor’s affirmed UBS’s AA+ long-term and A-1 + short-term ratings and commented: “The key strengths of USB business profile are the strong cash flow, high returns, and the sound capital base.” In which, the last one has been brought by the presence of successful implementation of Capital Adequacy Directive.

Not surprisingly, to date, the capital base of the Swiss banking sector appears to be sound as all banks reported excess capital at the end of 2006 ( Swiss National Bank, 2007)

To sum up, the Capital Adequacy Directive framework is truly needed for Swiss banks in order to avoid bankruptcies and negative externalities on the financial system, enhancing and maintaining the financial stability.

Disadvantages

Despite what has been shown, nothing could be further from the truth that capital adequacy might affect the banking system’s ability to extend credit. Under the circumstance that the regulatory are set too high, that might leads to the risk-adjusted market return on bank loans will be insufficient so as to cover this artificially high cost of capital, therefore decreasing bank-lending activities. This so-called credit-crunch, which will directly impact not only to the financial stability of banking system but also the aggregate level of economics activities (Allen, 2004).

Furthermore, there are various concern have been raised over whether the presence of capital requirement directive undermine the long-run competitiveness of banks. Jackson at the year-end 1999, and Blanco and Barrios in their research at 2003 have shown that these concerns could be separated into two types:

(i) Whether banks have been disadvantaged compared with securities markets or securities firms

(ii) Whether the overall profitability of banks has been affected and their competitiveness has been harmed

According to Jackson (1999), there is a controversial issue that whether banks, due to the capital adequacy regulation have found it difficult to compete against the securities markets as provider of funds. Many countries have witnessed “a shift from provision of funding to prime corporates by banks to provision of funding by commercial paper markets or securities markets more generally” but it is difficult to assess how much of this shift was driven by the capital requirements of the banks and how much by innovation and greater sophistication of the borrowers.

Furthermore, there is no strong theory as well as empirical evidence to conclude from the profound changes in banks’ long-term share of various markets that they have been driven by the influences of capital requirements on banks’ competitiveness.

In the case of Swiss banking system, by using the empirical methods and model to evaluate the relationship between the capital adequacy regulation and the share prices of banks as well as using the data come from 4 big banks, 25 cantonal banks and 125 regional banks in existence from 1989 to 1995 which represents 82% of Swiss banking system, Rime (2001) has shown that there is no evidence about capital adequacy requirement implementation reduce the Swiss banks’ share price. Moreover, Wagster revealed the same result at 1996 when he did the research in the situation of Switzerland, Germany, and Netherlands.

It is possible that the introduction of minimum regulatory capital requirements may have harmed the competitiveness of the banking industry. If capital standards require a bank to maintain an equity position in excess of what it would hold voluntarily, or in response to market pressure, then these standards constitute an external constraint on a bank’s operations.

In theory, any kind of external interference with the activities of a business firm could harm its short-run profitability or growth and possibly undercut its long-run viability (Jackson, 1999). However, it does seem that the exactly answer for this question whether implementation of capital adequacy regulation harms the competitiveness of banks has not been found yet because the long-term competitiveness of banking is driven by a wide range of factors.

As been shown in the above part, the implementation of CAD has been conducted successfully in terms of Swiss banking system. That helps banks to enhance the financial stability not only in their own system but also for entire economy. Hence, the Swiss banking system are now depicted as the universal banking system, being classified amongst the safest and highest profit all over the world.

Conclusion

In this study, we have just investigated into the costs and benefits of Capital Adequacy Directive towards Swiss banks’ behaviors. Our main message is that Capital Adequacy Directive is truly desirable as it provides an extremely efficient financial mechanism for maintaining the financial stability as well as prestige for Swiss banking system.

However, despite the typical merits that have been conveyed by Capital Adequacy Directive, some drawbacks it might create such as unexpected credit crunch phenomenon, is obviously seen. This does require the act of Government and Swiss National bank with more caution as the more efficiency CAD present the more benefits that Government and Swiss banks can achieve.

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