Impact of Basel II on Australian Banks

This assignment analyzes the effects of Basel II on Australian banking institutions. It highlights the stricter capital adequacy requirements imposed by the Australian Prudential Regulation Authority (APRA), emphasizing the focus on credit risk quantification and the minimum capital ratios for banks. The document also touches upon the impact of Basel II on loan-loss provisioning practices and disclosure levels within the financial sector.

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FINANCIAL MARKETS AND INSTITUTES
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FINANCIAL MARKETS AND INSTITUTES
Risk management: How is operational and Financial Risk Managed?
(I) Operational Risk (OP) Management:
Operational risk is that likelihood of loss established by unsuccessful/insufficient
internal processes, systems, people or outdoor considerations like legal risk. Thus, operational
risk weighted assets denote the assets amount the reserved by the bank to bar damage where
there is bank’s exposure this risk. This risk is managed via the application of “Basic Indicator
Approach” according to Basel II guidelines about the measurement of operational risk. Here, the
operational risk weighted asset is computed as the gross income function. The stress is applied in
managing this risk by measurement of the influence of feasible damage to physical asset is done.
In instance of stressed scenario, the loss of OP is taken be one percent of regulatory
capital hence plugged into present OP weighted asset to establish an adverse influence on capital
adequacy ratio. Because OP is measured as a gross income’s function in Basic Indicator
Approach (BIA), whereby stress testing shock context is employed to this risk in similar manner,
the risk amount deceases thereby creating a plus influence on ratio of capital adequacy.
Management of this risk is by addition of the damage amount to be assumed in the assets
(physical) to legal capital reserved for OP for measuring influence of this damage upon ratio of
capital adequacy.
(II) Financial Risk Management
Financial risk management focuses on such strategies to tackle for example, the
likelihood of loss which a bank could become exposed to because of failure of credit customers
to meet their obligations of enacted contract and failure to perform such obligations, fully or
partially, in the planned timeframe. Thus, the Credit Risk Weighted Assets is used in managing

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financial risk to denote the amount of assets banks have to reserve to bar damage in case it is
exposed to credit risk.
Where the credit losses increase in the stressed scenario, the credit risk losses surge and
average risk weights remain influenced by worsening classes of risk because of assumed class of
risk mitigations. The bank then uses the internal and external loss and default data alongside
historical as well as scenario macroeconomic data in predicting effects of prevailing credit
portfolios taking into account loss levels and default rates by portfolio and country. This allows
the bank to identify a range of parts of portfolio allowing banks to mage this risk more efficiently
and effectively. The bank also handles the risk of huge exposures via the stimulation of effects of
default by 1 or more of investment grade rating (Rad 2016.).
Capital Adequacy: Basel II and How Capital Adequacy and Risk Management are Linked
(I) About Basel II
Basel II denotes an array of regulations (international) that Basel Committee has put in
place on supervising bank thus levelling the field of global regulation universal guidelines and
rules. It extended the rules for requirement of minimum capital created under its predecessor,
Basel I, 1st regulatory (international) accord, alongside offered the framework for reviewing
regulatory alongside established requirements for disclosure for banks’ requirements of capital
adequacy. The major diversion from Basel I is that the second one has incorporated asset credit
risk the financial institution hold in determining capital ratios of regulatory.
It is the 2nd global banking regulatory consensus which is anchored on 3 major pillars:
regulatory supervision; minimum capital requirement and market discipline. The minimal capital
requirement is playing a key part in Base II thereby further obligating each bank to hold a
minimal of regulatory capital ratio over risk-weighted assets. Since regulations of banking

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substantially differed amongst nations prior to inception of Basel consensuses, a universal Basel
I framework, and, accordingly, Basel II assisted nations in alleviating anxiety over the regulatory
competitiveness as well as drastically different national banks’ capital requirements.
Basel II offers guideline for computing minimum regulatory capital ratios. It further
confirms the regulatory capital definition and eight percent minimal co-efficient for the
regulatory capital over-weighted assets. It apportions eligible banks’ regulatory capital in 3 tiers.
The greater a tier is, the fewer is securities (subordinated) of bank are permitted to entail in it.
Every tier has to be of some minimal % of whole regulatory capital as well as is utilized as the
numerator in computing ratios of such regulatory capital (Mascia, Keasey and Vallascas 2016).
Tier one capital stays the highly stringent regulatory capital definition which is secondary
to each additional capital instruments. It entails shareholder equity, disclosed reserve, earnings
retained, and some capital (innovative) instruments. Tier two remains Tier one instruments added
to additional reserves of bank, instruments (hybrid) alongside medium run and long-run loans
(subordinated). Tier three entails Tier two added to short run loans (subordinated).
The other significant portion in Basel Two stays sanitizing risk-weighted assets’
definition that are utilized as a the ratios of regulatory capital denominator, as well as remain
computed by utilizing amount of assets which are subsequently multiplied by corresponding risk
weights for every asset kind. The riskier an asset is, higher is the assets’ weight (Targino, Peters
and Shevchenko 2015). The idea of risk-weighted assets is purposed to penalize banks for having
assets that are risky that substantially boost risk-weighted assets as well as lowers regulatory
ratios of regulatory capital. The major Basel II innovation in contrast to Basel I remains that it
considers credit rating of assets when determining risk weights. The higher credit rating is the
lower will be the risk weight (Kinateder 2016).

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Pillar 1 risks remained a key element of banking sector important in measuring capital
adequacy ratio as well as determining the performance of the banks under stress. The pillar 1 risk
remains key because of the fact that they outline rules by which regulatory capital is determined.
Thus, Pillar 1 risks are usable as an indicator in understanding some risks to banks and how to
manage them (Roy 2016). The banks are increasingly sensitive to shocks sensitive to shocks
proceeded by economic turmoil like a plunge in prices of houses and a surge in bad loans due to
the bankruptcy based on capital adequacy ratio and its elements (credit risk, capital, operational
and market risk) and a surge in rates of currency (de Jesus Santos, da Silva Macedo and
Rodrigues 2014).
(ii) Relationship between Capital Adequacy and Risk Management
As provided for in Basel II, capital adequacy and risk management are interlinked. The
foundation for capital adequacy is the need to manage risk in banks. The Pillar risks and Basel II
regulations have shown that Basel II remains essential for both surveillance and supervision of
banks whereby regulations are established to respond to swift-changing financial contexts. The
measurement of concentration risk has been studied and shown that it is essential for regulatory
capital in credit portfolios and hence appreciating the significance of assured rules of Basel II
(Cummings and Durrani 2016).
Basel II has increased capital charges sensitivity and has an effect on lending. Thus,
Basel II assists financial institutions like banks to manage high credit levels via their funds from
loans and bonds by maintaining capital adequacy requirement. The capital adequacy ratio has led
to banks modifying their portfolios into less risk assets instead of heavily weighted risky ones as
a strategy to manage risks. The necessary capital amount which must be held by banks under
Basel II is arrived at in twofold: borrowers’ institutional nature alongside borrower’s riskiness.

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Thus, capital adequacy requirements affect the rates of lending in banks hence determining
investment as well as output. The change in capital adequacy ratio is determined by the risk the
bank is exposed to in order to effectively manage risk (Beltratti and Paladino 2016).
(iii) Relating to Post-GFC Reforms in Australian Financial Markets
The financial institutions in Australia are also operated in a global context, and, hence
interact with global entities and have operations in other countries. Thus it would be
counterproductive and impracticable for Australia to embrace, “go it alone” policy, by failing to
implement the agreed global reforms. Thus, Australian is interested in adopting high standards in
supervising and regulating. The Australian banking system has adopted novel global standards
with certain adaptation to domestic conditions. This has included the implementation of the
capital adequacy requirement that has helped in risk management during the risk exposure. For
this reason, the Australian has strengthened prudential regulatory standards with respect to
capital adequacy requirement.
The quality and amount of Australian banking sector’s capital has considerably surged
after GFC as a risks management mechanism. This is because GFC has promoted both regulators
and markets and this has helped the Australian banking sector in reappraising their views on the
level acceptable and capital forms. Major changes have either been effected or proposed on the
prevailing capital regulations. The capital adequacy has been an area of focused to help banks
withstand loses without being insolvent thereby managing the risks effectively. Thus, the capital
adequacy is being implemented to promote banks’ resilience and hence the regulations are
channeled towards ensuring that adequate capital is available in terms of both capital form and
amount that has to be held.

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Through the Australian Prudential Regulation Authority (APRA), the requirement of
capital adequacy has been made much stringent based on Basel II. The banks must quantify their
credit, operational and market risk with the credit risk given the most focused as it indicates that
Australian banks have focused on traditional lending tasks. Therefore, APRA puts it a mandatory
for each locally incorporated bank in Australia to hold a minimum capital of 8% of its risk-
weighted assets. The bank must have at least 50% of its total capital being better-quality Tier
one. This means that a minimum Tier one ratio of 4%. These minima can be increased by APRA
for individual bank in case it considers it essential based on the bank’s risk profile.

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References
Beltratti, A. and Paladino, G., 2016. Basel II and regulatory arbitrage. Evidence from financial
crises. Journal of Empirical Finance, 39, pp.180-196.
Cummings, J.R. and Durrani, K.J., 2016. Effect of the Basel Accord capital requirements on the
loan-loss provisioning practices of Australian banks. Journal of Banking & Finance, 67, pp.23-
36.
de Jesus Santos, L., da Silva Macedo, M.A. and Rodrigues, A., 2014. Determinants of the
disclosure level of the Pillar 3 recommendations of the Basel II Accord in the financial
statements of Brazilian financial institutions. Brazilian Business Review, 11(1), p.25.
Kinateder, H., 2016. Basel II versus III–A Comparative Assessment of Minimum Capital
Requirements for Internal Model Approaches.
Mascia, D.V., Keasey, K. and Vallascas, F., 2016. Did Basel II Affect Credit Growth to
Corporate Borrowers During the Crisis?. In Financial Crisis, Bank Behaviour and Credit
Crunch(pp. 83-94). Springer, Cham.
Rad, A., 2016. Basel II and the associated uncertainties for banking practices. Qualitative
Research in Financial Markets, 8(3), pp.229-245.
Roy, A., 2016. Low RWA but high GNPA? Risk performance of some Indian banks under Basel
II-SA. Journal of Risk Management in Financial Institutions, 9(1), pp.85-98.
Targino, R.S., Peters, G.W. and Shevchenko, P.V., 2015. Sequential Monte Carlo Samplers for
capital allocation under copula-dependent risk models. Insurance: Mathematics and
Economics, 61, pp.206-226.