The success of banking business essentially depends on leverage management. Generally, banks play a vital role to flow funds from the hands of small savers and market at the lower cost to those entrepreneurs who do need funds to start a business or to expand the capacity of the existing business or to add a new line of business. In practice, the lending amount of a bank considerably exceeds its deposit base, and there is often a variance between the short-term deposits and borrowings from the market which are often repayable on demand or on short notice and the long-term nature of loan portfolios.
To increase market share, banks had rapidly increased their domestic and foreign exposures but some banks are facing the mismatch between these new exposures and the institution’s capital bases. As a result, the minimum capital levels within the global financial system began to decline. Deregulation also allowed globally active banks to take advantage of differences in national treatment of similar assets for capital purposes. Some believed these inconsistencies were exploited across jurisdictions in a manner that was producing unhealthy competition and regulatory arbitrage. Therefore, regulatory accords started to build around a set of global standards that would provide guidance on the proper capital levels for internationally active banks. The result was Basel I (King and Tarbert, 2011).
Basel I consisted of three main components. First, the BCBS standardized the minimum regulatory ratio for globally active banks. Covered banks were required to hold satisfactory regulatory capital to represent at least eight percent of their total assets on a risk-adjusted basis. Second, the BCBS established a basic definition of what was considered regulatory capital. Items qualifying as regulatory capital were divided into Tier 1 and Tier 2 capital. Tier 1 capital usually represents the premier quality of capital, such as common equity and some types of preferred stock. Tier 2 capital generally represents the lower quality instruments often called supplementary capital, such as subordinated debt and certain hybrid instruments. Basel I required that at least fifty percent a bank’s regulatory capital consist of Tier 1 capital. Third, the BCBS introduced a uniform process by which banks calculate their regulatory capital ratios. Put simply, these ratios are calculated by dividing a bank’s capital reserves by its assets. Those reserves, of course, can be deployed in the event that a bank sustains unexpected losses. To account for the different risk levels natural in a wide variety of assets, the BCBS incorporated an elementary concept of risk-weighted assets (RWAs) into the Basel I framework (BCBS, 1998). Basel I focused solely on the credit risk of a bank’s assets when calculating RWAs. As a result, the BCBS revised Basel I in 1996 by adding a market risk element to the RWAs calculation. Risk weighting assets involve classifying a bank’s assets according to credit risk and then weighting each of these categories accordingly.
Basel I capital accord has been criticized on several grounds in the vein of the uniform definition of Tire 1 and Tier 2 capital, limited differentiation of credit risk, a static measure of default risk, the omission of market discipline (Balthazar, 2006). These criticisms have led to the creation of a new Basel capital accord known as Basel II.
The Basel Committee, seeking to offer a more comprehensive and risk-sensitive approach to capital regulation, formally adopted the new framework of Basel II in 2004. Basel II involved three pillars including minimum capital requirements, the supervisory review process, and market discipline (Heid, 2007). Basel II also focused on operational risk as a third factor to be considered when calculating RWAs. Basel II provided three methods of assessing credit risk including a basic standardized approach, foundation internal rating based approach, and advanced internal rating based approach (Danielsson et al., 2001; Decamps et al., 2004)
The last global financial crisis discovered shortcomings of Basel II and forced BCBS to thoroughly revise existing capital adequacy requirements, diversification of credit portfolio, standards of liquidity management, and other spheres of bank activities to mitigate systemic risk. It was revealed that Basel II standards were inadequate to prevent or at least to reduce the effects of the global financial disorder. As a result, BCBS has developed a new edition of the provisions called Basel III (Valitov and Nigmetzyanov, 2014).
In November 2010, the BCBS officially endorsed Basel III, which represents a marked disappearance from the viewpoint and essence of Basel I and Basel II (Blum, 2008). It should come as no surprise that Basel III aims to increase the quality and quantity of capital that banks must maintain. At the side of this development is the BCBS’s broad reassessment of risk coverage assumptions and guidelines.
Basel III accord introduces a set of tools and standards at the macro-prudential level like a countercyclical buffer and a universal leverage ratio to address systemic risk within the global financial system. There is a modest question that the BCBS’s revised framework characterizes a significant step in the right direction. But there are those who believe features of the reforms summarized above will hamper economic recovery. For this reason, the BCBS admits that Basel III will have a modest impact on short-term growth, and has planned an implementation calendar with the hope of decreasing any harmful effects on recovery (Hannoun, 2010). Chalermchatvichien et al. (2014) stated that the Basel III standard for capital stability would have been more effective in countries with better economic development. Rahman et al. (2017) stated that regulatory capital requirements decrease bank risk and, thus, help to make sure financial stability.