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Banking sector

Basel capital requirements and the continuing conflict with the right to development

Below you can find link to a paper released by Smitha Francis, “Basel capital requirements and the continuing conflict with the right to development.”

Countries in a financial crisis have experienced declines in economic growth, increases in poverty due to the loss of jobs and livelihoods, and thus erosion in several socio-economic and cultural rights previously achieved. Such direct and indirect negative human rights impacts from economic crises have been exacerbated by the subsequent tax payer-financed bailouts of private firms and fiscal austerity which negatively impacts on the economic and social rights of middle- and low-income groups.

Post-crisis responses to improve financial regulation have often been to reform capital requirements imposed on banks to absorb unexpected losses.

Established out of developed country bank failures in the early 1970s, the Basel Committee on Banking Supervision sought to improve bank supervision at the international level for banks with cross-border operations. The Basel Accords have been one such method to reduce the risk of bank failures and improve financial stability within and across countries.

The Basel Accord I (“Basel I”), released in 1988 and enforced in G-10 countries by 1992, was focused on protecting banks from credit risk by assessing the riskiness of each class of borrowers and forming a capital requirement based on such assessments. However, Basel I became subject to a wide array of problems including poorly defined regulatory capital, failing to account for the risk weight of specific assets, and regulatory biases that affected financing for development by favoring short-term over long-term lending to developing countries. Overall, Basel I was too simplistic to address the needs of the banking system.

By 1999 plans were set to completely revise the original norms to address developments for the more complex and sophisticated banks. The fully revised capital accord finally enacted in 2004, “Basel II,” retained key elements of the 1988 Accord while expanding capital coverage to include operational risk, in addition to credit risk and market risk. The global financial crisis was evidence that the refinement and greater sophistication in Basel II as compared to Basel I would not contain the growing financial fragility in the banking sector upon liberalization. The global financial crisis exposed the Accord’s weaknesses, namely that it underestimated the losses that regulatory capital should absorb, failed to account for liquidity risk, did not consider the greater risk that systemically important financial institutions pose to the stability of financial systems, and did not pay enough attention to the pro- cyclicality produced by capital requirements.

The Basel III norms introduced by the Basel Committee on Banking Supervision in November 2012 are scheduled for phase-in between January 2013 and 2019. The accord aims to raise the quantity, quality, consistency and transparency of the capital base while strengthening the risk coverage of the capital framework. Basel III has also introduced an additional capital conservation buffer that can be drawn down in periods of financial stress. It will include a countercyclical capital buffer, a new leverage ratio aimed at reducing the risk of excessive leverage at the bank level and systemic levels, and two new liquidity ratios meant to promote short-term resilience to potential liquidity disruptions.

However, Basel III retains fundamental problems in its framework. The complex risk assessment methodology continues to rely on ratings generated by banks’ internal models which use non-transparent transactions between banks and other financial institutions. Also, the increasingly detailed and incremental regulation adds considerable complexity and imposes huge demands and costs of implementation on financial regulation and supervision. And yet there is no guarantee that the higher, more refined capital requirements imposed by Basel III will ensure reduced financial fragility and prevent another financial crisis.

At the same time, the higher capital requirements on banks will have an adverse impact on the progressive achievement of economic, social and cultural rights by reducing the financial sector’s ability to support the work and livelihoods of small producers, women with lack of assets, and other disadvantaged sections of societies.

The way forward calls for a systemic change in financial operations through the structural separation of commercial banking and investment banking. This would limit the potential for innovative financial engineering in increasing systemic risks and leading to financial crisis, which as we saw, hinders the realization of several rights through its consequences on sustained economic growth, development finance and social spending. Also, developing countries should limit the scope for entry of foreign financial service providers into their economies as the presence of foreign players increases fragility and magnifies the problem of financial instability.

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March 2017
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