2.1. Financial/Liquidity Crisis 2008
The recent financial crisis was a result of a liquidity crisis that emerged from a credit crisis. It is apparent that the crisis developed from a worldwide financial fiasco involving the collateralized debt obligations (CDOs), credit default swaps (CDSs), sub-prime mortgages, and frozen credit markets. The credit crisis involves two groups of people, which are homeowners (mortgages) and investors (large institutions, i.e., mutual funds, insurance companies, pension funds, and sovereign funds) brought together via the Wall Street financial system. In the early 2000s, the credit throughout the financial system was extended due to the low level of interest rates (
Grosse 2012). To fulfill the “American dream” of owning a house for all borrowers regardless of their credit standing, the institutions, i.e., mortgage companies, commercial banks, and savings and loans (S&Ls) offered a vast range of mortgage-related financing. The loan repackaging institutions, for example, Fannie Mae and Freddie Mac, quasi-government agencies, acquired these mortgages from lenders and resold the mortgage-backed securities (MBSs) into the capital market upon obtaining high credit ratings from the credit agencies. In addition, the credit rating agencies failed to appreciate the risk of certain innovative financial assets such as mortgage-backed securities (MBSs), CDOs, and CDSs. During this time, the highest credit rating, AAA, was passed out like candy (
Atik 2011). These securities started trading globally. Against this background, loan officers started making risky home loans. When they were running out of prime mortgages, they went on to low-credit, sub-prime mortgages, where there was a push by the government to extend more credits to lesser-earning Americans. The magnitude of this force resulted in growing of risky activities (
Schwerter 2011). The sub-prime owners were barely able to make their monthly installment at low interest rate levels, and when the interest rates shot up, they were unable to meet their monthly installments. This led to a massive sell out in properties, which drove the property prices down, and in turn, many loans ended up as non-performing loans. The property markets crashed and impacted the MBSs, where the lenders were unable to meet their obligations. On top of that, the insurers had insured the top investments bankers, i.e., the lenders who had issued these securities and that ended up bankrupting them as they could not meet the liquidity obligations related to the CDSs.
Apart from a credit crisis, the lack of funding strategies and assets management from the banks also surfaced during the financial crisis. The banks’ vulnerability to liquidity-solvency feedbacks was intensified due to the extreme dependence on short-term wholesale markets to finance greater leverage, which had worsened the banks’ maturity mismatch. This subsequently affected the banks’ financing capability, resulting in an inability to trim their balance sheet, which had further exposed institutions to insolvency. As a result, capital and interbank markets were squeezed, whereby the financial losses of the banks started to mount (
Giustiniani and Thornton 2011).
In the case of Malaysia, one could learn from the past 2009 financial crisis. Despite being exposed to the adversity of the global financial crisis, the domestic monetary and financial conditions to support economic activity remained positive. The financial intermediation process functioned commendably and smoothly due to the elasticity of the capital markets and banking sector, as well as the swift policy response. Domestic conditions were developed evidently towards year-end with positive signs of recovery. In early 2009, the Malaysian ringgit was volatile in the global financial markets; the Malaysian ringgit and regional currencies faced intense depreciation pressure due to a worldwide financial and economic crisis. However, with initial signs of stabilization in the global financial markets and economic activity, the sale of financial assets reduced globally by March 2009 (
Bank Negara Malaysia 2009).
Malaysia’s experience and performance during the financial crisis period can be viewed from the exchange rate, interest rates, and equity markets. Investor inclination had moved toward holding cash to preserve capital during this stressed financial situation. The reversal of portfolio investments and the outpouring demand for US dollars resulted in the remittance of funds to the US, which spawned substantial depreciation of currencies in the regional economies. On 2 March 2009, the Malaysian ringgit depreciated to its lowest of RM3.7255 against the US dollar since February 2006. The continuous net trade surplus had provided fundamental sustenance for the demand for the Malaysian ringgit, which had partly mitigated the depreciation effect. The interest rate was lowered substantially to support monetary policy to alleviate the impact of the domestic economic and financial crisis. In November 2008, there was a 25-basis-point reduction in the overnight policy rate (OPR), which subsequently reduced further in January 2009, by 75 basis points. However, an addition of 50 basis points was observed in February 2009, as presented in
Figure 1. To accelerate the transmission of the policy rate to retail rates, the statutory reserve requirement (SRR) was reviewed from 4% to 1%. Bank Negara Malaysia managed to preserve a stable market environment even with the unpredictable global environment.
Within such a moment of the period, banks lowered their retail offer rates to businesses and households in response to the OPR reduction. On December 2009, the commercial bank’s benchmark rate or base lending rate (BLR) was reduced from 6.72% to 5.51%, equivalent to 121 basis points. As a result, the interest cost on rate loans attached to the BLR was reduced. Thus, the disposable income of debtors was increased. In the same way, this had subsequently lowered the installment amounts for retail borrowers’ loans. The change in the BLR was transferred swiftly, and banks reduced their respective BLRs within two weeks of the OPR changes. Another essential point is that the interest rate reduction benefited the new mortgagors, as households’ and businesses’ lending rates were reduced. In December 2009, the average lending rate (ALR) was reduced by 127 basis points as compared to October 2008, i.e., from 6.17% in October 2008 to 4.90% in December 2009. Upon revision of the OPR, entire sectors of the economy recorded lower interest rates. By the end of 2009, the ALR on loans outstanding was reduced to 4.83% through a re-pricing of new and existing loans. The financing activity was sustained by the reduced interest rate atmosphere, which in turn adjusted the deposit rates downwards. While this is the case, BNM imposed a floor on fixed deposit (FD) rates ranging between 2.00% and 2.50% for the FDs with tenures between 1 and 12 months.
In early 2009, the local equity market had faced volatility due to the domestic and global market challenges. Later, in the second quarter of 2009, Malaysia and global equity markets showed positive recovery as investors became opportunistic in the highly stabilized financial markets and accommodative monetary environment. On 12 March 2009, the benchmark “FTSE Bursa Malaysia Kuala Lumpur Composite Index” (FBM KLCI) reached 838.4 points and later on climbed modestly, as presented in
Figure 2.
The Islamic financial system requires all financial transactions to be associated with an asset-linked or trade contract. The Islamic financial system has been seen as a more resilient and viable alternative to financial shocks. In addition, riba or interest-based contracts are forbidden as Islam promotes trade activities and business to produce a fair and reasonable profit. Moreover, there is a close association between financial flow and output in Islamic finance. This vital ownership or real sale value of Islamic finance protects possible risks from leverage and speculative financial activities. Furthermore, Islamic finance is based on risk and profit-sharing bit (for example, Mudarabah contracts). In an Islamic finance structure, businesses are required to maintain a high level of disclosure and clearness in profit and risk sharing. These disclosures allow the market to allocate suitable risk premiums to companies, thus improving the likelihood of market discipline. The Islamic finance structure is guided by Shariah (Islamic law), which provides financial stability through an integral check and balance system (
Ahmed 2010). Another key benefit of the Islamic financial institution is to protect society and individuals from financial and economic crises. There is no doubt that riba (usury and interest) and maysir (speculative activities, e.g., gambling) led to the present financial crisis. The world financial crisis could be avoided by adhering to Islamic ethics and principles through the ban of riba and maysir practices and distinguishing others’ interest in one’s economic prosperities (
Ahmed 2010). The Islamic financial system deals with real assets, which prohibits speculative activities and prevents asset bubble creation. On the contrary, the empirical results suggest that the conventional system in Malaysia was able to absorb the shocks better than that of the Islamic banks (
Kassim and Shabri Abd. Majid 2010).
Previously, asset markets were flexible, and funding opportunities were available at low cost. Market fluctuations rapidly disperse liquidity and could also create illiquidity that can last for a lengthy period. The banking system faced difficulties and required central bank support (
Basel III 2013). The Bank for International Settlements (BIS) has resolved that a lack of liquidity was an important substance for the crisis. Therefore, in responding to the speed at which much of the world’s financial sector ran out of surplus, and especially overnight cash, in October 2008, Basel III set much higher standards for liquidity (
World News Media 2013).
In addition, numerous problems have been identified among empirically oriented studies, including the contradictory features of the LCR and the NSFR among two central standards (
Dermine 2013); the complexity of the liquidity regulations (
Chorafas 2011;
Haldane and Madouros 2012;
Hoenig 2012); and the fact that even though the LCR constraint tends to increase the intertemporal persistence of the banks’ deposits (i.e., the relationship between deposits in the previous and current period), it also increases the responsiveness of deposits to interest rate variations/shocks (
Balasubramanyan and VanHoose 2013).
2.3. Origins of the Basel Committee and Revisions Made to the LCR by Basel Since Its Introduction in 2010
The origins of the “Basel Committee on Banking Supervision” (BCBS) came about in 1973 from the breakdown of the Bretton Woods system of managed exchange rates, which then led to the financial market turmoil. The central bank governors of the G10 countries established a Committee on Banking Regulations and Supervisory Practices at the end of 1974 in reaction to disruptions in the international financial markets, which was later renamed the “Basel Committee on Banking Supervision”. Formed as a forum for regular collaboration between its member countries on banking supervisory matters, the committee aims to improve financial stability by enhancing the supervisory knowhow and the quality of banking supervision globally (
Tonveronachi 2007).
The banks are forced to hold more of their capital because shareholders’ equity is always the last to be reimbursed in a scenario of bank liquidation. Thus, the idea of holding higher capital is that it will be available to absorb unanticipated losses without causing the bankruptcy of the bank. The Basel structure bases the computation of capital requirement on risk-weighted assets in order to discourage banks from taking excessive risks, in which it includes the riskiness of specific classes of borrowers. The
Basel I (
1994) was focused on shielding banks against credit risk, whereby the minimum “capital adequacy ratio” (CAR) was set at 8%. An explicit capital cushion for market risks was introduced in the 1996 Market Risk Amendment due to banks’ activities of trading. A proposal for a new capital adequacy framework in June 1999 was introduced by the committee to substitute the 1988 accord. This led to the issuance of the Revised Capital Framework in June 2004, branded as Basel II. The new framework was intended to enhance the method of regulatory capital requirements, addressing the underlying risks and the financial innovation that had occurred in recent years (
Committee on Banking Supervision 2015a). The completely revised Basel II framework offered a more sophisticated and thorough structure than Basel I in numerous aspects and came into force at the end of 2006. The changes were intended to reward and encourage continued enhancements in risk measurement and control.
Three pillars were introduced under Basel II. Pillar 1 comprises the minimum capital standards for operational risk apart from credit risk, and market risk was subsequently added. Pillar 2 places the supervisory review process under the purview of national regulators. Internal controls and supervisory review form the second axis of the regulatory framework. Banks are required to have an internal system and models to assess their capital requirements given the regulatory framework and incorporating each bank’s specific risk profile. The integration of the nature of risks not fully covered by the accord, such as reputation risk, strategic risk, concentration credit risk, and interest rate risk in the banking book is required of all banks (IRBBB) (
Balthazar 2006), and Pillar 3 entails the incorporation of disclosure standards directed at “market discipline” via the regulatory disclosure requirements. The market participants can access vital information relating to a bank’s regulatory capital and risk exposures, which increases transparency and assurance about a bank’s exposure to risk and the overall capability of its regulatory capital (
Committee on Banking Supervision 2015a). This information is required to be publicly disclosed to the market at least twice a year via the bank’s financial reports. The forms of risk and the choice of asset classes included for calculating capital requirements, as well as the techniques used for risk weighting—the standardized approach (SA) and internal ratings-based (IRB) approaches involve greater complexity under Pillar 1.
The amendments to the LCR include revisions to the characterization of HQLAs and net cash outflows. Among the changes made were expanding the description of HQLAs by including level 2B assets, which have been given higher haircuts and limits. The corporate debt securities that are rated A+ to BBB are given a discount of 50%. In addition, some unencumbered equities are exposed to a 50% cut, and certain residential mortgage-backed securities rated AA or higher are subjected to a 25% cut. The combined level 2B, after discounts, is subject to a boundary of 15% of total HQLAs (
Committee on Banking Supervision 2013). Furthermore, banks must obey the local regulator’s requirements for the following rating requirements for the qualifying level 2 assets, usability of the liquidity pool, operational requirements, operations of the cap on level 2 HQLAs, alternative liquid asset (ALA) framework, and central bank reserves details.
The variations to the explanation of the LCR, established and agreed by the Basel Committee over the past two years, also comprises some modifications to the assumed inflow and outflow rates, to better imitate actual scenarios in times of stress. The outflows on certain sorts of fully insured retail deposits have been reduced from 5% to 3%, and outflows on fully insured non-operational deposits from non-financial corporates, sovereign, public sector entities (PSEs), and central banks was lowered from 40% to 20%. In addition, the outflow rate was reduced from 75% to 40% for “non-operational” deposits sourced from non-financial corporates, sovereigns, central banks, and PSEs. Other items listed were committed but unfunded: inter-financial liquidity and credit facilities, the committed liquidity facilities to non-financial corporates, trade finance, derivatives, equivalent central banks operations, and client servicing brokerage. The Basel Committee on Banking Supervision (BCBS) agreed to a revised schedule for phase-in of the standard and supplementary text to give effect to the committee’s aim for the stock of liquid assets to be used in times of stress. The internationally agreed phase-in of the LCR was 60% in 2015, followed by a subsequent increase by 10% annually to reach 100% in 2019 (
PwC 2013).
2.4. Why Is Basel III Different to Basel II?
In 2004, Basel I was replaced by a more risk-sensitive accord having three “mutually reinforcing pillars,” Basel II (
Kaur and Kapoor 2015). In mid-2003, the last Consultative Paper (CP3) was delivered, and the final proposal was circulated in June 2004 (
Balthazar 2006). Recommendations with more refined descriptions for capital adequacy, disclosure requirements, and risk management (market risk and operational risk) were put in place. The risk weights for the corporate, bank, and sovereign claims were specified in this consultative paper via the use of external rating agencies (
Mohammed Ahmed 2016). Market users can assess the capital adequacy of the banks via the disclosure requirements based on information on the scope of use, risk coverages, capital, and risk assessment procedures. The goal was to improve the comparability and consistency of disclosures through the revised Pillar 3 disclosures, as presented in
Figure 3 (
Committee on Banking Supervision 2015b).
The international financial crisis was a consequence of the failures of Basel II, where observers frequently mentioned that the dependency it caused on the rating agencies and regulatory capital requirements were determined based on the use of internal models (
Moosa 2010). Since the Basel II accord appeared to be one of the causes of the global crisis in 2008, on 12 September 2010, the oversight body of the BCBS, consisting of Heads of Supervision and the Group of Central Bank Governors gave a press release stating a significant strengthening of the capital requirements (
Allen et al. 2012). On 26 July 2010, the full endorsement of the agreement to the suggested reorganizations to the Basel II framework was achieved. These foundations aimed to formulate part of a package of transformations known as Basel III (
Morrison and Foerster 2010). The guiding principle aimed to encourage a more robust banking system by aiming towards the four vital banking considerations via capital, leverage, funding, and liquidity.
The common equity and tier 1 capital minimum requirements are 4.5% and 6%, while the minimum overall capital requirement are fixed at 8%. In addition, a 2.5% capital conservation buffer has been introduced. It is a requirement that the capital conservation buffer be met with common equity. As an institution starts to “use up” the conservation buffer, leading to the levels of common equity reaching the minimum required levels, it becomes subject to increasingly more stringent restraints on dividends and on discretionary executive compensation, leading to these payments being completely forbidden. Further to raising the capital requirements, the Basel III framework imposes stricter standards in order for instruments to be classified as common equity and be included as tier 1 capital (
Hendricks et al. 2016). From January 2013, financial tools that do not meet the requirements as common equity are excluded, while instruments that no longer qualify as other tier 1 capital, or tier 2 capital, are gradually excluded over ten years (
Morrison and Foerster 2010). Moreover, at the preference of the central banks of the countries, banks may be mandated to preserve a “countercyclical buffer” ranging from 0% to 2.5%, reliant on the economic environments.
The LCR necessitates banks to hold a cushion of HQLAs adequate to deal with the cash outflows faced in a severe short-term stress scenario, as indicated by supervisors. From 1 January 2019, the banks have been required to reach the minimum LCR requirement of 100%. The objective of the LCR is to ensure that banks will be able to withstand severe liquidity crises and prevent situations like a “bank run”. The leverage ratio commenced in January 2015 and was under an observation period by Bank Negara Malaysia (BNM), and the maintenance of a minimum level of 3% started from January 2018. The bank’s tier 1 capital divided by the average total combined assets of the bank is the computation for the leverage ratio. The NSFR was also introduced as a minimum requirement by 1 January 2018. For Malaysia, the leverage ratio and NSFR are currently being reported every quarter to BNM and are under an observation period (
KPMG International 2011).