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Financial Markets Liquidity Basel Sample

Introduction

The uncertainties that characterize the current economic environment, in which financial institutions develop their activity, make the study of financial risks an essential element that must be analyzed and valued properly. It is important to analyze the financial risks from its manifestations, especially those presented in recent years such as the current crisis, the Mexican Peso crisis, the Brazilian Real crisis, the Asian crisis, the Russian moratorium, among others, to understand its effects and the lessons learned.

We understand risk as the vulnerability or exposure that is taken into an unknown situation, which is the probability of an adverse event. This unknown factor is better known as uncertainty (Holton, 2004). You can find different types of risk that are divided into 7 categories of economic risk. These are financial risk, market risk, credit risk, liquidity risk, operational risk, technology risk and legal risk. Therefore, international organisms have made agreements and regulations in a global context, adjusting locally through Basel Accord, Basel II and Basel III.
The consensus that support and design Basel III in short period of just two years is considered as an achievement. The new requirements represent such a deep transformation of global banking regulation that it must be approached with restraint and applied gradually, taking into account the possible negative effect on credit and the recovery of the global economy. The regulation should establish a system of free competition in which there is no discrimination between different banking models.

As far as the liquidity of financial institutions is concern, we found a big problem in accumulating large amount of permanent and static capital. But, the banks have a fragile capital structure, subject to bank runs, in order to perform these functions. Funding illiquid loans by a bank with volatile demand deposits is rationalized in the context of the functions it performs. This model can be used to investigate important issues such as narrow-banking and bank capital requirements.

Issues

The main problem is that having a fragile bank capital structure, the capital requirements are not correct, flexible or adaptive at different circumstances. The banks are not adapting the risk incurring at each institution. They just accumulate capital and make pro-cyclical adjustments.
The requirements of Basel are adapted in different ways all across the world. The application on each country that had implemented these regulations is based on the process and the structure of their capital.
Even though the basic problem with Basel is that the capital requirements are based on pro-cyclical movements. Banks accumulate large quantities of capital in economy peaks because in order to increase their business and when the economy is down, banks could decrease its capital because they are not granting credits.

Importance of Paper

This dissertation will design helpful tools for the financial risk valuation and the financial authorities. The main contribution is a method of counter-cyclical adjustments to capital requirements. From this methodology, variables and procedures shall be established to determine which countries are those that could have a working capital adjustment for or against cycles, and/or where parts of the economy could change. This will help the various financial institutions to make decisions and help the regulators to legislate the local version of Basel III in each country.
It will apply real data to compare the proposed methodology against different studies in literature and the potential impacts of adopting the proposed methodology will be simulated with a historical basis. Also as a result of this study, without taking a secondary role, you will see the impacts of Basel III in different countries.

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I believe this research can be very useful in various aspects, both theoretical and practical. Always trying to innovate into new methods will help us in making decisions and will promote change and innovation in the financial system.

Theoretical Framework

Liquidity is a concept that has existed since the beginning of barters and exchange activities, when people start using currency as payment and has given rise to different theories of money. Karl Menger (1892) begins to approximate the concept of liquidity in his work “On the Origins of money” such as, the ability of man to exchange a quantity of goods, where interaction of supply and demand gets the desired and necessary amount rather the need and the difficulties in obtaining these, associating with the theory of money with the degree of liquidity of assets.

From the point of view of financial institutions liquidity can be defined as "the ability of the institution to fund and increase in the assets and meet its obligations as they are expiring (Delfiner et al, 2006).

The notion of liquidity refers to the ability of an investor to liquidate a position at the lowest cost or no cost and without risk. Liquidity is a function of the market and depends on factors like, the number of participants, the frequency and size of trading volume and transaction costs, this depends on the type of market or instrument that wants to be traded, more standardized instruments (actions) are usually more liquid than those instruments are not standardized or tailored, and are generally held to maturity. However, more standardized markets are not perfectly liquid; volatility fluctuates all the time and can easily fall in a crisis that is why liquidity is not guaranteed.

Liquidity risk is closely related to market risk, interest rate risk, profitability, solvency and the risk that interest rate mismatch the horizon of maturity of assets and liabilities. When the balance is exposed to this risk, we need a reorganization of assets and liabilities, which reduces the liquidity risk, but it affects the profitability and solvency of the financial institution. If the financial institution improves the mismatch between assets and liabilities they may not receive the expected return and assume time delay in their payment flows.

Basel III is an opportunity as well as a challenge for banks. It can provide a solid foundation for the next developments in the banking sector and it can ensure that the past mistakes are avoided. Basel III is changing the way management of banks addresses risk and financing. The new regime seeks greater integration of the finance and risk management functions. This will drive the convergence of Probably the CFOs and CROs of Responsibilities in delivering the strategic objectives of the business.

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Hypothesis

The liquidity of financial institutions should not rely as provided for Basel III, in the accumulation of a large amount of permanent capital and static, but counter-cyclical adjustments tailored to the risk in which each entity incurs. 

Objectives

  •  Find the main factors that will define stable Financial Systems.
  •  How and why liquidity is an important variable of stability of the financial systems?
  •  Analyze the main problems of Basel III.
  •  Make recommendations for methodologies, regulation and supervision.
  •  Analyze the impacts of Basel III in the financial systems
  •  Study of different Methodologies to calculate liquidity Risk.
  •  Study different cases of liquidity problems (European Union, America, Asia).
  •  Propose countercyclical adjustments of methodology for the requirement of capital.
  •  Demonstrate the benefits of a countercyclical vs. pro-cyclical adjustments.
  •  Create a table of which country clubs can use to counter cyclical adjustments and which can use pro-cyclical adjustments.
  •  Scenarios of the possible effect of each methodology of the different cases.

Methodology

Econometric, statistical and complexity methods will be required for the analysis of information. The choice of any of these methods will be used according to the characteristics of the data, the number of variables, also checking the accuracy and integrity of the information. Index Themes1 Año2 Año3 AñoI.IntroductionII. Financial SystemsIII.Basel II and III AnalysisIV.LiquidityV. Liquidity and the Financial SystemsVI.Conclusions

Schedule

This is a proposed timetable for the study and development of topics mentioned above. The activities considered for the development of this PHD thesis are: attending various seminars and summer schools, only if they are relevant and provide an added value to the research. If it is necessary country-specific information, I have contacts in the United States, University of Texas "Thunderbird", National Taiwan University and the Autonomous University of Mexico, where I can obtain the required data and / or work together with the university to obtain the necessary data.

Bibliography:

  • Atkinson, A. and F. Messy (2012), “Measuring Financial Literacy: Results of the OECD / International Network on Financial Education (INFE) Pilot Study”, OECD Working Papers on Finance, Insurance and Private Pensions, No. 15, OECD Publishing.
  • Arestis P., Demetriades P. and Luintel K. (1997), “Financial Development and Economic Growth: the Role of Stock Markets” Keele Department of Economics Discussion Papers (1995-2001) 97/05, Department of Economics, Keele University.
  • Bank for International Settlements – Basel Committee on Banking Supervision (July 2010), ConsultativeDocument “Countercyclical Capital Buffer Proposal”.
  • Bank for International Settlements (February 2011) “Basel III: Long-term impact on economic performance and fluctuations”, BIS Working Papers No 338.
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