Dedication

To my only brother, whose love for education, and confidence in me, encouraged me to enrol for the MBA Programme.

Declaration

I, do hereby declare that this dissertation is the result of my own investigation and research, except to the extent indicated in the acknowledgements and references and by comments included in the body of the report, and that it has not been submitted in part or full for any other degree to any other university.

__________________ Students Signature

______________ Date

----------------------------Supervisors Signature

----------------Date

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Abstract Banks are at the epicentre of countries financial needs. Regulators like the Reserve Bank of Zimbabwe feel the need for an indirect regulatory and monitoring system. The Reserve Bank of Zimbabwe has taken a position to implement Basel II Accord recommendations in the countrys banking industry, using a phased approach. The Basel II accord was developed by the developed countries (mainly the G10 countries) to address the needs of their financial markets with regards to credit risks, market risks and operational risks. A number of developing countries like Zimbabwe have adopted the Basel II accord as a regulatory tool in their less advanced financial markets. Since the Basel II accord was developed to meet the requirements of developed markets, this research sought to determine if it is suitable and applicable to Zimbabwes developing market, as well as establish its implementation feasibility in Zimbabwe. The main tool of data collection used was the self administered questionnaire which was sent to selected professionals deemed to be knowledgeable about the subject area, mainly in the banking sector. Face-to-face interviews based on the questions in the questionnaire were also conducted in-order to enhance data collection. This study brought to light that Basel II is of immense benefit to the risk management of banks in Zimbabwe. An opportunity to improve Zimbabwean banks risk management systems to international standards has been presented by implementation of Basel II. However, implementation challenges have been brought to the fore. These include mainly skills shortages to ensure smooth implementation, inadequate funding and the indigenisation laws enacted by the government. Recommendations such as increased awareness and training, offering incentives to banks were made. In addition faster implementation was identified as an important aspect, as it will help turn around the fortunes of Zimbabwes commercial banks and improve stability in the market.

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Acknowledgements I would like to take this opportunity to thank all the people who contributed to the successful completion of my dissertation. First of all, my supervisor, Mr. Rashid Mudala who was a source of constant guidance and encouragement right from the beginning. His advice, inspirations, enthusiasm and suggestions have been invaluable in shaping this dissertation and in providing me with all the support required in completing this task. I am highly obliged to my MBA class mates (2008 2010) for the support and assistance provided during my MBA journey. Their diverse wisdom and knowledge made the effort a pleasure. My great appreciation goes to all the participants for their valuable time for filling the questionnaires. I am grateful for my mother, whose encouragement inspired me to pull through my studies, under the most difficult circumstances of my life. Many thanks go to my wife and my children for their support and understanding of my busy schedule during my MBA journey at the University of Zimbabwe. Finally, I thank God, from whom all wisdom and knowledge flows.

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Table of Contents Contents Page

Dedication.................................................................................................................................i Declaration...............................................................................................................................ii Abstract...................................................................................................................................iii Acknowledgements.................................................................................................................iv Table of Contents.....................................................................................................................v List of Abbreviations ...........................................................................................................viii List of Figures.........................................................................................................................ix List of Tables............................................................................................................................x Chapter 1..................................................................................................................................1 Introduction..........................................................................................................................1 Introduction......................................................................................................................1 1.1 Background to the Study............................................................................................2 1.2 Statement of the Problem...........................................................................................7 1.3 Research Objectives...................................................................................................8 1.4 Research Questions....................................................................................................8 1.5 Proposition of the study.............................................................................................9 1.6 Justification / Significance of the Study....................................................................9 1.7 Scope of Research......................................................................................................9 1.8 Assumptions of the Study........................................................................................10 1.9 Limitations / Challenges..........................................................................................10 1.10 Chapter Summary..................................................................................................11 Chapter 2................................................................................................................................11 Literature Review...............................................................................................................11 2.0 Introduction..............................................................................................................11 2.1 What is Basel II........................................................................................................12 2.1.1 Intentions...........................................................................................................13 2.1.2 Pillars of Basel II Accord.................................................................................13 2.1.3 Effects of Basel II.............................................................................................23 2.1.4 Critique of Basel II...........................................................................................24 2.2 Benefits / Opportunities of Adopting Basel II Capital Accord ..............................24 2.3 Key challenges for Banks which adopt the Basel II Capital Accord......................29 2.4 Approaches to successfully implement the Basel II Capital Accord......................30 2.4.1 Evaluation of the Basel II Capital Accord........................................................32 v

2.5 Empirical Literature Review....................................................................................34 2.5.1 The Development of Basel II Accord in Australia ..........................................35 2.5.2 The Development of Basel II Accord in the United States of America..........37 2.5.3 The Development of Basel II Accord in Japan................................................37 2.5.4 The Development of Basel II Accord in India ................................................38 2.5.5 The Development of Basel II Capital Accord in Emerging Economies..........39 2.5.6 Basel II implementation in Zimbabwe.............................................................40 2.5.7 Basel II and the global financial crisis.............................................................43 2.6 Chapter Summary....................................................................................................48 Chapter 3................................................................................................................................49 Research Methodology.......................................................................................................49 3.0 Introduction..............................................................................................................49 3.1 Research Design.......................................................................................................49 Study Population............................................................................................................50 Sampling Technique and Data Collection.....................................................................50 3.3.1 Probability Sampling........................................................................................51 3.3.1.1 Simple Random Sampling.........................................................................51 3.3.1.2 Systematic Sampling.................................................................................51 3.3.1.3 Stratified Sampling....................................................................................51 3.3.1.4 Cluster Sampling.......................................................................................52 3.3.2 Non Probability Sampling................................................................................52 3.3.2.1 Quota sampling..........................................................................................52 3.3.2.2 Convenience sampling...............................................................................52 3.3.2.3 Judgemental sampling...............................................................................52 3.4 Sample Selection......................................................................................................53 3.5 Development of Research Instruments ...................................................................53 3.5.1 Questionnaires .................................................................................................54 3.5.1.1 Open Ended Questions..............................................................................54 3.5.1.2 Closed Questions.......................................................................................54 3.5.2 Face to Face Interviews....................................................................................54 3.6 Data collection Procedure .......................................................................................55 3.7 Data validity and reliability.....................................................................................55 3.8 Pilot Study................................................................................................................56 3.9 Ethical Considerations.............................................................................................56 3.10 Data Processing, Analysis and Presentation..........................................................56 3.11 Chapter Summary..................................................................................................57 Chapter Four...........................................................................................................................58 Data Presentation and Analysis.........................................................................................58 4.0 Introduction..............................................................................................................58 4.1 Banking Experience.................................................................................................58 vi

4.2 Bank Ownership.......................................................................................................60 4.3 Progress with Basel II Capital Accord....................................................................60 4.4 Gap Analysis............................................................................................................62 4.5 Readiness for the Basel Requirements....................................................................63 4.6 Basel II and Value Addition....................................................................................64 4.7 Level of Basel II Capital Accord Awareness..........................................................65 4.8 Degree of Priority for Basel II.................................................................................66 4.9 Challenges of Basel II Implementation...................................................................67 4.10 Opportunities from Basel II Implementation........................................................69 4.11 Advantages of Implementation of Basel II............................................................70 4.12 Appropriateness of Basel II Accord to Zimbabwe................................................71 4.13 Categories of Banks that have Benefited from Basel II in Zimbabwe.................72 4.14 Level of RBZ Contribution ...................................................................................74 4.15 Chapter Conclusion................................................................................................75 Chapter 5................................................................................................................................76 Conclusions and Recommendations..................................................................................76 5.0 Introduction..............................................................................................................76 5.1 Conclusions of the Study.........................................................................................77 5.2 Recommendations of the Study...............................................................................80 5.3 Suggestions for Further Studies...............................................................................82 References..............................................................................................................................82 Appendices.............................................................................................................................92

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ADI AMA APRA BCBS BIA BIS CAR CFA CRAR DEM EAD EL ERMF FRM GFC GNU IBNR IMF IRB LGD MBS PD PRM RaRoc RBS SME SPSS UL VaR

List of Abbreviations Australian Authorised Deposit Taking Institution Advanced Measurement Approaches Australian Regulation Authority Basel Committee on Banking Supervision Basic Indicator Approach Bank of International Settlements Capital Adequacy Ratio Chartered Financial Analyst Capital to Risk Assets Ratio Deutsche Mark Exposure of Default Expected Loss Enterprise Wide Risk Framework Financial Risk Manager Global Financial Crisis Government of National Unity Incurred but-not-Realised International Monetary Fund Internal Rating Method Loss Given Default Mortgage Based Securities Probability of Default Professional Risk Manager Risk Adjusted Return on Capital Risk-Based Supervision Small to Medium Enterprises Statistical Package for Social Sciences Expected Losses Value at Risk viii

List of Figures Figure Page 2.1 Pillars of the Basel II Capital Accord...................................................................14 2.2 Basel II implementation, a phased approach.........................................................32 2.3 Basel II Capital Accord, progress on adoption.....................................................35 4.1 Banking experience...............................................................................................58 4.3 Bank Ownership....................................................................................................59 4.4 Progress on implementation...................................................................................60 4.5 Gap analysis...........................................................................................................61 4.6 Readiness for Basel II requirements......................................................................62 4.7 Basel II value addition...........................................................................................63 4.8 Level of Basel II awareness...................................................................................64 4.9 Degree of priority...................................................................................................65 4.10 Appropriateness of Basel II Accord in Zimbabwe................................................71 4.11 Illustration of the impact of Basel II a banks financial performance...................72 4.12 Level of RBZ contribution....................................................................................73

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List of Tables Table Page 1.1 List of registered commercial banks in Zimbabwe................................... 6 2.1 Calculation of capital requirement within Pillar I: Credit risk..................18 2.2 Financial institutions minimum capital requirements................................34 4.1 Challenges of Basel II implementation......................................................66 4.2 Opportunities from Basel II implementation.............................................68 4.3 Advantages of implementation of Basel II................................................69 4.4 Categories of banks that have benefited from Basel II in Zimbabwe........71

Chapter 1 Introduction Introduction As at 31 December 2009, there were 27 registered banking Institutions in Zimbabwe under the supervision of the Reserve Bank of Zimbabwe (RBZ), consisting of 18 commercial banks, 4 merchant banks, 1 discount house and 4 building societies (RBZ, 2010). The financial sector is dominated by commercial banks, following the conversion of several lower level licences in recent years. On the back of dollarization, the RBZ introduced a phased implementation plan for new capital requirements. Commercial banks were expected to be capitalised to the tune of US$12.5m by 31 March 2010, 50% of which had to be met by 30 September 2009. Notwithstanding the macroeconomic stability brought about by the Government of National Unity (GNU), the supply of money in the economy remains very low, and banks capacity to lend is constrained. As such, bank balance sheets are relatively small and maintaining adequate capitalisation remains a major theme. Deposit levels remain low and short-dated, and in the absence of a lender of last resort facility, coupled with non-functioning interbank market, banks are not prepared to over-expose themselves through increased lending. In an effort to improve liquidity in the market, RBZ reduced statutory reserves from 10% to 5% with effect from 1 February 2010 (RBZ Annual Report, 2010). Banks are a critical component of the countrys economy. They rely on taking-in deposits from clients to fund the lending they then provide across all sectors of the economy. The safety and soundness of the banking system is of paramount importance. The collapse of one bank could result in diminishing confidence in the whole banking system and dire consequences for the entire country, as evidenced by Zimbabwes banking crisis of 2004/2005.

It is for this reason that banks are highly regulated, (in our case by the Reserve Bank of Zimbabwe) and that the Bank of International Settlements (BIS) first issued in 1988 a comprehensive set of principles and practices (Basel I), to help minimise this risk (Jackson, 2001). These mostly involve risk management, capital management and corporate governance and they are adopted by over 100 countries worldwide. BIS is based in the city of Basel, Switzerland and it is where banking regulators and industry practitioners from around the world gather to discuss and develop, amongst other things, banking supervision principles and practices and ultimately banking regulation. This is the origin of the term Basel. Basel I is now more than twenty years old and is out of date. Our primary regulator, RBZ, has confirmed the phased implementation of Basel II in Zimbabwe since 2004. 1.1 Background to the Study According to Gup (2004), the Basel committee, whose history can be traced back to 1974, has played a pivotal role in the standardisation of bank regulations across jurisdictions in the world at large. June 26, 1974, saw troubled Bank Herstatt being forced into liquidation by German regulators. On that day, several banks had entered into some transactions with this bank, where they had released DEM payments to Bank Herstatt, Frankfurt in exchange for USD that were to be delivered in New York. As a result of the time-zone differences, Bank Herstatt ceased operations before all its counterparty banks could receive payments due to them. In response to the crossjurisdictional implications of the Herstatt debacle, the G10 Countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States) and Luxembourg as well as Spain formed a standing committee called the Basel committee on banking supervision under the auspices of The Bank for International Settlement (BIS). This committee comprises representatives from central banks and regulatory authorities from the member Countries. According to Gup (2004), the committees focus has evolved over time to embrace initiatives to: (i) (ii) Define the roles of regulators in cross-jurisdictional situations. Ensure that international banks do not escape comprehensive supervision by their home regulatory authorities.

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Promote uniform capital requirements so as to encourage fair competition among different banks from different countries.

The committee, which has no formal authority, meets in Basel, Switzerland where it has its secretariat at the Bank for International Settlements, four times a year (Federal Reserve Bulletin, 2003). It works to develop broad supervisory standards and promote best practices in the expectation that each country will implement the standards in ways most appropriate to its circumstances. In 1988, the Basel Committee on Banking Supervision (BCBS), of the Bank for International Settlements (BIS), introduced an international standard for regulating banking institutions founded on a common measure of capital provisions for credit risk and credit risk categories. The international standard has widely become known as the Basel I Capital Accord. The main objective of the BCBS was to encourage international banks to boost capital positions and to reduce competitive inequalities. Basel I introduced the system of risk based capital requirements. It initially explicitly covered credit risk and it set a minimum level of capital expressed as a ratio of the total risk-weighted assets. According to the BCBS (1999), banks are required to maintain a minimum capital adequacy ratio of 8% measured as net capital divided by total risk weighted assets. The Basel I Capital Accord has been implemented by all the G-10 countries and over 100 other countries outside the G-10 have since embraced the principles prescribed under the Basel Accord. Zimbabwe adopted the Basel I Capital Accord when it enacted a new Banking Act and Regulation in 1999 and has since then pegged the minimum capital adequacy ratio at 10%. In addition to the BCBS capital requirements, banking institutions in Zimbabwe are also required to maintain a minimum level of core capital in accordance with the requirements of the Government of Zimbabwe (1999), Banking Act [Chapter 20:24]. The adoption of Basel I has to a larger extent induced relatively weak capitalised banks to maintain higher levels of capital. However, some banks have, over the years learnt how to exploit the broad nature of the Basel I Capital Accord by exploiting the limited relationship between actual risk and 3

the regulatory capital charges, thus undermining the meaningfulness of the requirements. According to the BIS (1999), this prompted the BCBS to make some revisions to the Basel I Capital Accord. In January 2001, the Basel Committee issued a comprehensive revision to the Basel I Accord with its roll out set for 2004. This became known as the Basel II Capital Accord (Griffith-Jones, 2003). The move was made necessary due to the short comings discovered under the Basel I Accord. According to Boardman, (2006) cited in Mandevco Business Solutions (2007), Basel II is the biggest single change in banking for decades. It is not merely a change in the method of calculating capital requirements but a fundamental shift in the philosophy, understanding and measurement of risk. The Reserve Bank of Zimbabwe (RBZ) has adopted a gradual approach to the Basel II implementation in order to allow for a smooth transition from the current system to the new approaches. Beginning January 2004, Zimbabwean banking institutions were required to allocate capital for market and operational risk as per the Basel II standardised approaches. In the last quarter of 2005 the RBZ enhanced its Risk - Based Supervision (RBS) process which was initially adopted in 2002. A comprehensive RBS Policy Framework Guideline No. 02-2006/BSD was also produced and circulated to the market in July 2006. The RBS framework plays an important role in setting out the foundation and ground work for Basel II - Pillar II (Supervisory Review Process). Further, the RBZ issued a Risk Management Guideline No. 01-2006/BSD as a step towards creating the right environment and a necessary background for the introduction of solid risk management principles prior to implementation of Basel II Accord. The RBZ has also issued guidance to the market that include a roadmap on the internal audit function in banks, as well as a framework for cooperation between the supervisors and banks external auditors. The roles of these stakeholders complement the supervisory function under Basel II - Pillar II and are important facets of the risk-focused supervision approach. In order to promote market discipline under Basel II - Pillar III (Market discipline and disclosure) the RBZ issued to the market a Corporate Governance Guideline No. 01-2004/BSD and is finalising an enhanced Financial Disclosure Guideline. In addition, the RBZ is also working 4

towards establishment of a Credit Reference Bureau. The Bureau is going to act as a central repository of credit information for counterparties of banking institutions. The RBZ already requires banking institutions to allocate capital for market and operational risks with effect from March 2005 in line with Basel II Pillar I (minimum capital requirements). Capital allocation for these risks is done using the standardized approach. In order to reduce operational risk associated with failed systems, the RBZ also insists on banks having comprehensive disaster recovery and business continuity plans to ensure that there are alternative arrangements if the core-banking and settlement functions of a bank are to fail. In his January 2009 monetary policy statement, the RBZ Governor Dr. Gideon Gono implored upon banks to ensure that they fully adopt the Basel II Capital Accord standardised approach for allocation of credit risk, market risk and operational risk with effect from February 2009. The Basel II Accord sets the requirements for each of the main risks that can cause bank major financial losses. Commercial banking system needs stable and internationally accepted rules and regulations and for this reason a common capital measurement system and a credit risk measurement framework Basel II Capital Accord is in the process of being rolled out in Zimbabwe and financial intermediaries worldwide (KPMG, 2004). The Basel II Capital Accord is expected to affect the entire Zimbabwean financial services sector which was made up of 28 banking institutions as at 31 December 2009 (see Table 1.1 below). It seems as though a dichotomy between foreign owned commercial banks and locally owned banks exists in terms of the pace of regulatory adaptation to the Basel II Capital Accord. International banks which are controlled from holding companies in developed worlds are almost Basel II compliant or are working towards being compliant noting that regulations in developed jurisdictions would require all subsidiaries to be compliant if a holding company is to be certified Basel II compliant. In the July 2009 monetary policy statement the RBZ released Guideline No. 12009 / BSD: Technical Guidance on Basel II Implementation in Zimbabwe which spells out measures to be undertaken by banks in working towards harmonising bank capital regulation requirements. The Guideline specifies that in order for commercial banks in Zimbabwe to increase their global ratings for accessing international capital under the current multi currency regime in Zimbabwe, being Basel II certified is an added competitive advantage. Basel II compliance also 5

reduces high cost of borrowing from the international capital markets and reduces counterparty limits which can be imposed on non compliant banks. It has now become inevitable that the Zimbabwean commercial banking sector should move with pace in implementing the Basel II Capital Accord in line with globally acceptable capital management techniques. Table 1.1: List of 18 Registered Commercial Banks in Zimbabwe Foreign Owned Banks 1.Barclays Bank of Zimbabwe Limited 2.MBCA Bank Limited 3.Stanbic Bank Zimbabwe Limited 4.Standard Chartered Bank of Zimbabwe Foreign Owned Banks Locally Owned Banks 1. Agricultural Development Bank of Zimbabwe 2. African Banking Corporation Limited 3. CBZ Bank Limited 4. CFX Bank Limited Locally Owned Banks 5. FBC Bank Limited 6. IBC Bank Limited 7. Inter-market Banking Corporation 8. Kingdom Bank Limited 9. Metropolitan Bank of Zimbabwe Limited 10. Premier Banking Corporation 11. NMB Bank Limited 12. TN Bank Limited 13. Zimbabwe Allied Banking Group 14. ZB Bank Limited

Source: RBZ: Commercial Banks: Assets and Liabilities positions (2009). Against this background, an investigation on the likely challenges and implications of adopting the Basel II Capital Accord is carried out. The study also focuses on the level of awareness and readiness of Zimbabwean commercial banks in the process of rolling out Basel II, taking a critical insight into implementation challenges and opportunities. In addition, it addresses whether adoption of Basel II is going to be successful in limiting risk-taking relative to capital as intended and recommends solutions on the way forward on measures to be undertaken by the supervisory authorities and commercial banking institutions in Zimbabwe. 1.2 Statement of the Problem Following the Zimbabwe banking crisis of 2004, the research seeks to analyse the effectiveness of the Basel II Accord in minimising bank failures in relation to Zimbabwes market. The Reserve Bank of Zimbabwe made it mandatory for all commercial banks to start adopting the Basel II 7

Capital Accord from June 2004. Given that the accord was crafted by the developed countries, mainly focusing on the needs of their advanced markets, this research is intended to determine if this accord can be successfully applied to Zimbabwes financial market, which is still developing, and is still way behind the developed markets, for which the accord was initially intended. In addition, the research seeks to determine if implementation of the Basel II Capital Accord is beneficial to Zimbabwes commercial banks, in terms of stability and financial soundness. 1.3 Research Objectives In order to adequately attend to the demands of the research problem, this research study is based on the following objectives: a) To ascertain whether the introduction of the Basel II Capital Accord protects the investors capital in commercial banks. b) To ascertain the level of compliance with the Basel II Capital Accord requirements in Zimbabwean commercial banks. c) To establish the impact and benchmark applicability of the Basel II Capital Accord in strategic capital risk management for both indigenous and international commercial banks in Zimbabwe. d) To make policy recommendations on challenges and opportunities created by the Basel II Capital Accord implementation in Zimbabwe.

1.4 Research Questions Questions related to the foregoing, which need to be answered are: a) Does the introduction of the Basel II Capital Accord protect investors capital in commercial banks in Zimbabwe? b) Are concepts and requirements of the Basel II Capital Accord understood and embraced by commercial banks in Zimbabwe? c) What benefits or costs have accrued to Zimbabwes commercial banks in regard to strategic capital risk management since the beginning of Basel II Capital Accord gradual implementation in 2004 to date? 8

d) What policy recommendations with regards to implementation challenges and opportunities of the Basel II Capital Accord can assist stakeholders in the implementation process? 1.5 Proposition of the study The study proposes that the Basel II recommendations are suitable and helpful in improving the stability and financial soundness of Zimbabwes commercial banks. 1.6 Justification / Significance of the Study The study seeks to establish the likely effect of fully adopting the Basel II capital requirements on Zimbabwean commercial banks. Delays in the transition to full implementation of the Basel II Accord can be very costly for Zimbabwean commercial banks in the medium to long term . This study further seeks to establish the levels of comprehension and applicability of the Basel II Accord by banks in Zimbabwe, and work as a stocktaking exercise in mapping a way forward. Interested stakeholders such as business, bankers and policy makers in the financial services sector will find the study useful as a reference and policy crafting material. The multi-currency regime ushered in new opportunities and challenges since its introduction in February 2009. This study advocates for realignment of Zimbabwean banks capital to the International Convergence of Capital Measurement and Capital Standards (BCBS, 2005) in response to the new economic environment. Zimbabwean commercial banks are on a Basel II journey which started in 2004, in a quest to attain world class standards in risk and capital management. This study carried out a diagnosis of the progress made to date and tried as much as possible to fill in the technical knowledge gap that exists in the market. 1.7 Scope of Research The scope of the research was limited to the challenges and opportunities that the Basel II Capital Accord has had to Zimbabwes commercial banking sector. The research focused on both locally and foreign owned commercial banking institutions in Zimbabwe. The target population consisted

of staff conveniently chary picked from the 18 registered commercial banks in Zimbabwe in line with limitations alluded to under section 1.9 below. 1.8 Assumptions of the Study The following assumptions were made: a) Only professional people who are knowledgeable about the Basel II Capital Accord and are also aware that the new accord is being gradually introduced by the RBZ were targeted as participants. Professionals who are deemed knowledgeable about the Accord include bankers, economic commentators, market analysts, asset managers, RBZ bank supervision staff, economists, Risk and Compliance champions in the commercial banking sector. b) It was assumed that all respondents in the study had an appreciation of the challenges and opportunities that the Basel II Accord is to have on Zimbabwes economy. The respondents were assumed to have at least some basic understanding of the Basel II Accord. c) All respondents to the questionnaire had sufficient background information on the financial system in Zimbabwe and were up-to-date with recent developments in the commercial banking sector in particular. d) Respondents had the same understanding of the financial health assets and liabilities positions of institutions operating in the Zimbabwean financial sector. e) It was assumed that the current policy of gradual introduction of the Basel II Accord into the local financial sector remained unchanged during the period of the study as turbulence in the sector may have affected the views of the respondents and therefore the findings of the study.

1.9 Limitations / Challenges The researcher noted that it would be a mammoth task to try and analyse opportunities and challenges being faced by all players in the financial services sector in Zimbabwe. Since all commercial banks in Zimbabwe have taken on the functions of merchant banks in addition to their traditional retail banking products, the researcher chose to focus on commercial banks only, as they 10

now have a full range of banking products on offer. This study is restricted to Basel II Accords implementation challenges and opportunities covering Zimbabwes commercial banking sector for the period 2004 to 2010. The period was chosen on the basis that this is the time frame covering the Accords implementation since inception, following the publication of the revised version of the Accord by the BCBS (2004a). The financial services sector is made up of 28 banking institutions (commercial banks, merchant banks, building societies, finance houses and discount houses) and 17 asset management companies as of July 2010 require a considerable amount of time and funding resources to ensure feasibility in undertaking the study within 6 months.

1.10 Chapter Summary Chapter 1 provides the introduction and background information to the study. Chapter 2 presents the literature review which will contain a discussion of major issues on the Basel II. Chapter 3, methodology introduces the dissertations research design and all its components, data sources and data collection and analysis. Chapter 4 provides the research findings and analysis. Chapter 5 covers conclusions and recommendations derived from the analysis of research findings. Insights are also offered alongside the recommendations, directly addressing the problem statement. However due to the relative complexity and extensiveness of this research area, certain issues of interest may not be sufficiently covered herein. These aspects are highlighted in this chapter for possible further research.

Chapter 2

Literature Review 2.0 Introduction The purpose of this chapter on literature review is to remove the need to rediscover knowledge that has already been reported on. This helps in the development of a conceptual frame work for the whole research. The literature review helps to build upon the work that has already been done in the field being researched as supported by Saunders, Lewis and Thornhill (1997:43) quoted verbatim below: 11

Knowledge does not exist in a vacuum, and your work only has value in relation to other peoples work. Your findings will be significant only to the extent that they are the same or different from, other peoples work and findings However, this chapter reviewed literature on the Basel II, the pillars of Basel II, effects of Basel II, challenges and opportunities of the accord. The chapter formed the basis on which the study findings will be discussed on.

2.1 What is Basel II Basel II are guidelines for supervision of banks that have been developed by the Basel Committee, an organization with the aim to create stability on the financial markets, which was founded in 1974 as a result of disturbances on the financial markets. The committee does not possess any supranational- or legal authority, it does, however, establish guidelines for the individual authorities to implement (Basel Committee, 2007). The first guidelines, Basel I, were created when the Basel Committee became concerned about the capital ratios in banks and the lack of international convergence of regulations. A consultative paper was circulated and the Group of Ten countries decided to implement the new standards in 1988. The main aims of the standard were to promote soundness and stability, and moreover, to ensure a high degree of consistency and fairness in its application. It aimed at a capital ratio, based on five different weightings, with a focus on counterparty risk. Basel I stated that the ratio should be at a minimum of 8 %, although national authorities can decide that there is need for higher capital coverage (The Basel Capital Accord, 1988). It did, however, turned out that the capital ratios declared in Basel I were not adequate to create stability in the financial markets. Banks established ways to avoid the regulations and Basel I was no longer able to reflect the capital ratio and the risk profile of banks. Several attempts followed as to improve the framework. These gradually build up the new regulations called Basel II (Karling et al., 2002). The new framework was the result of a process to create regulatory guidelines for internationally active banks that should govern their capital adequacy. Through the new revised framework the Basel Committee aims to promote a stronger risk management. It is stated that there has been a positive reaction from banks and other interested parties, concerning the new regulations (Basel Committee, 2006).

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2.1.1 Intentions
The aims of the new rules for capital requirements were to contribute to the stability in the financial system, to create an increased level of fairness in competitive market of banks, and to increase the risk sensitivity of the system. The regulations were formed primarily with focus on banks that are internationally active, but could, however, be applied on other banks as well (Finansinspektionen, 2001). A significant change from the previous standard is the opportunity of banks to use internal measurements (Basel Committee, 2006). Further, the new regulation aims to create incentives for an effective way to handle risks and control (Forsell and Lnnqvist, 2004). It aims to provide a better risk sensitivity measurement, with a greater coverage of risks that appear in the financial system. The new regulations aim to survey the processes of risk control to a greater extent and increase transparency (Finansinspektionen, 2001). The bank should be given incentives for using methods that are more risk sensitive and thereby measure the capital need with more precision (Finansinspektionen, 2001).

2.1.2 Pillars of Basel II Accord

Furfine (2002) put forward that the Basel II Accord relies on three pillars: capital adequacy requirements, supervisory review and market discipline. Yet, the articulation between these three instruments is far from being clear. On the one hand, the recourse to market discipline is rightly justified by common sense arguments about the increasing complexity of banking activities, and the impossibility for banking supervisors to monitor in detail these activities. It is therefore legitimate to encourage monitoring of banks by professional investors and financial analysts as a complement to banking supervision.

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PILLAR I: Sets minimum capital requirements for... (a) Credit Risk: (Standardised, Foundation IBR and Advanced IBR approaches); (b) Market Risk framework (Standardised and Internal Value at Risk Model); (c) BIA, Standardised and AMA.

PILLAR II: Sets supervisory review processes for (a) Regulatory Framework for banks (Internal Capital Adequacy Assessment Process (ICAAP) and Risk Management. (b) Supervisory Framework (Evaluation of internal systems of banks; Assessment of risk profile; Review of compliance with all regulation and Supervisory Measures)

PILLAR III: Sets market discipline and (a) Disclosure requirements of banks (Enhanced comparability of banks; (b) Transparency for market participants concerning the bank's risk position)

Figure 2.1: Pillars of the Basel II Capital Accord Source: Adopted from Mandevco Business Solutions (2007) Pillar 1 Minimum Capital Requirements This pillar consists of three different parts: credit risk, operational risk and market risk (Basel Committee, 2006). It states how much capital the bank must hold to cover its credit exposure, which is the part that can be found in previous regulation as well. The capital ratio stating a minimum of 8% remains, though there are some changes made in the measurements (Finansinspektionen, 2001). The capital base, which you use to calculate capital ratio should be

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based primarily on equity capital and disclosed reserves, as it is the only element that is equal in all banking countries. There may, however, be other constitute of capital that could be included. Credit Risk The capital requirements for credit risks can be calculated either through a standardized approach, which is similar to the method for calculation in Basel I, or through a method based on internal rating (Basel Committee, 2006). The standardized method differentiates from Basel I by using different frameworks for risk weighting. These are based on an external credit assessment by an institution which is recognized by national supervisors. It is necessary that the external credit assessor meet five different criteria given in the regulatory framework. By using the ratings of the credit assessor a risk weight of a certain exposure will be given, depending on the type of the exposure. Claims on sovereigns and central banks with a very high rating should be weighted lower than claims on corporate with the same rating. Credits that do not have guiding ratings have risk weights specified in the regulatory framework (Basel Committee, 2006). The Internal Rating Method (IRB) approach allows banks, approved by the supervisory authority, to use internal ratings when measuring credit risk (ibid). The purpose of this model is for the bank to be able to use existing internal models for measuring counterparty risks, as these are made as a part of their core business, and thus are seen to be relatively reliable (Karling et al., 2002). When applying the IRB method banks calculate Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and Maturity (M). Banks may, however, be obliged to use a standardized value provided by the supervisory authority for some of the components (Basel Committee, 2006). A minimum requirement for applying the IRB approach is that they can provide an estimate of PD, which makes them eligible for the foundation IRB approach. The advanced IRB approach involves internal assessment of the other parameters as well, meaning that the demands are higher to be approved by the national supervisor for applying it (Finansinspektionen, 2001). The risk weights given through the IRB approach should express the probability that the losses during a specific period will be extra high, while the normally expected credit losses should be covered by incomes. Hence, the risk functions are based on calculation of unexpected losses (UL) 15

and expected losses are treated separately (Basel Committee, 2006). For the calculation of risk, the portfolio of the bank is divided in to five different types of exposures: (a) corporate (b) sovereign (c) bank (d) retail and (e) equity. In this essay the focus lies on corporate and retail exposures. Corporate exposures are, according to the Basel Committee (2006), defined as: a debt obligation of a corporation, partnership, or proprietorship. The borrower is typically an entity, which needs finance to operate physical assets. The exposure gives the lender substantial control over the assets/income generated by the assets (FSF, 2008). The borrower generally does not have capacity to repay the credit, in any other way than paying part of the generated income. The primary source of repayment is as a result the income generated by the assets. When calculating capital requirement for credit exposure to corporations the banks need to calculate PD within the foundation IRB approach and whilst under the advanced approach they need to provide estimated of all factors (PD, LGD, EAD and M) (Basel Committee, 2006). A retail exposure consists of exposures to individuals such as revolving credits or lines of credits, mortgages, and loans given to small businesses, where the credit is smaller than $ 1 million or where there is an individual that is personally liable. Within the retail exposure there is no distinction between foundation and advanced IRB approach and the bank need to estimate PD, LGD and EAD (BIS, 2009). There are several risk-weight functions for all these different exposures, given in the regulatory framework. As within the standardized method, a function for e.g. retail credit is different from that of a credit to a corporate (BCBS, 2006). Estimates of risk, leading to risk component factors are done by the bank or given by the supervisory authority (risk components). These are transformed into risk weighted assets and capital requirement through risk functions. The usage of these functions to arrive at capital requirements is mandatory within the foundations well as the advanced IRB approach (Basel Committee, 2006). It is expected that once banks use parts of the IRB approach, they should apply IRB for the entire bank group. It is, however, expected that it will be a gradual process and national supervisors may allow banks to apply a gradual adaption. When the banks use the IRB approach for a specific asset class, however, they need to use it for that asset class within all business units. The bank further 16

needs to provide an implementation plan, describing how they intend to build up the process of applying the IRB approach. One of the main features of the Basel II accord is that it allows banks a wide choice of regulatory regimes for the assessment of both credit and operational risk, the most advanced of which rely on banks internal risk models to calculate appropriate risk charges. This is particularly the case for the foundation and advanced internal ratings based (IRB) approach to credit risk and one of the stated intentions of the Basel II is to thus allow capital charges to reflect more sensitively banks assessments of their portfolio risk. While this devolution of risk assessment is, in principle, beneficial it may induce perverse behaviour in times of crisis if unchecked by an appreciation of the endogenous nature of risk and liquidity at the systemic level. Market participants generally view risk as an exogenous variable. Certainly, the risk-forecasting models based on value-at-risk (VaR) that are currently employed, and whose use is actively encouraged by the proposal, are based on the assumption that forecasting credit risk is an activity not unlike that of forecasting weather. Importantly, it is assumed that ones own action, based on a volatility forecast, does not affect future volatility itself just like forecasting weather does not (yet) influence future weather. However, this reasoning is faulty. Volatility is determined in the market, in large part by the behaviour of all individual market participants - in other words, risk is endogenous by definition. The failure to recognise this endogeneity is relatively innocuous during times of calm in which the actions of many heterogeneous market participants (in terms of risk-aversion, portfolio positions etc.) more or less cancel each other out. In times of crisis, in contrast, this endogeneity may matter enormously if agents become more homogeneous as a result. Using similar risk models, they may pursue similar strategies to mitigate the adverse effects of the on-setting crisis. In such a case, individual actions do not more or less cancel each other out but may in fact reinforce each other. Consider, for example, a fall in prices. A market participant may then have an incentive to sell her asset which, in turn, is reinforced if someone else also sells this asset, thus reducing the price even further. This effect is a pure externality individual banks do not take it into account when making decisions, yet it affects the stability of the banking system as a whole. This 17

externality is not acknowledged by existing forecasting models nor, in fact, by the regulations in the proposal, yet, bank regulations are intended exactly for these moments of crisis. Hence, the proposal should acknowledge the endogeneity of risk and liquidity at the systemic level and provide safeguards to deal with it. Note that the above argument is not one against regulation per se, but rather against the use of VaR or of similar approaches to measuring risk for regulatory purposes. Employing such methodologies is problematic in two senses. First, by failing to acknowledge the endogeneity of risk and liquidity at the systemic level they produce inaccurate volatility estimates. Second, by encouraging all market participants to employ similar risk modelling techniques regulation renders them more homogenous in risk aversion and trading strategies, thus rendering the financial system less stable. Table 2.1 Calculation of Capital requirement within Pillar 1: Credit Risk Credit Requirements Corporate Standard Method Calculation through external ratings and Retail given risk weights Weighted at 75% Foundation IRB Estimation of PD, given values of EAD,LGD and M Only one method for IRB Source: Finansinspektionen, (2001) Operational Risk According to the Basel Committee (2006), operational risk is defined as: the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. It involves the risks that result from mistakes, errors, accidents or crimes that can cause losses (Finansinspektionen, 2001). The operational risk will be calculated through different models (i) the Basic Indicator Approach, (ii) the Standardized Approach and (iii) Advanced Measurement Approaches (Basel Committee, 2006). The Basic Indicator Approach means that the bank must hold a percentage of gross annual income over the last three years to cover for operational risk. Internationally active banks with significant exposures to operational risks should, however, use a more sophisticated approach than the Basic 18 Advanced IRB Estimation of PD, EAD, LGD and M Estimation of PD, EAD and LGD

Indicator Approach. In the Standardized Approach the banks activities are divided into different business areas where the need for capital to cover operational risk is calculated on the gross income of that business area and multiplied with a factor, assigned to the business line (Basel Committee, 2006). Under the most advanced model, AMA, the banks will use an own method to calculate their operational risk (Basel Committee, 2006). The committee has, based on historical information from the large banks, decided that the approximately 20% of the demanded capital should be derived from operational risk. This could mean that the capital derived from credit risk decreases, as the committee does not aim the total capital demand to increase, even though operational capital increases (Finansinspektionen, 2001). In light of the above, the Basel II is vague about the definition of the features of operational risk. What types of losses are to be considered? Some losses can be settled (i.e. estimated) immediately because their value is known. Other losses are by definition unpredictable, such as payments arising out of litigation incurred-but-not-realised (IBNR) in insurance terms (Danielsson, 2000). How are operational risks to be subdivided or rather with which types of operational risk should regulation be concerned? If one wants to add an operational risk charge to pillar I, then careful thought has to be given to its definition and the diverse statistical properties of its components (Leeladhar, 2007b). On these issues, some lessons may be gleaned from actuarial reserving techniques that include loss development models, IBNR claims and related methodologies. While the Basel II acknowledges the need for a more careful study of the nature of operational risk its inclusion of operational risk in pillar I certainly seems premature from a methodological point of view (BIS, 2009). On a more fundamental note, the reason for including operational risk in the calculation of regulatory capital charges is, to say the least, not obvious. Why should operational risk be subject to regulation at all? Presumably, capital adequacy regulations exist to rule out systemic failures through contagious bank failures (Reddy, 2008b). Market and credit risks, for example, are risks shared by all market participants with many common exposures. Hence, bank failures that are due to market or credit risk can spread because they arise out of shocks that are common to many 19

participants (BIS, 2009). Operational risk is fundamentally different, however - it is, in most cases, purely idiosyncratic. Any losses created by operational mishaps accrue directly to the equity holders, management and bondholders of a particular institution but do not spread to other institutions (FSI, 2004). Finally, it should be noted that, if imposed, an operational risk charge may well act as an anticompetitive tax on banks to the benefit of other non-regulated financial intermediaries (Symous and White, 2007). Consider, for example, a bank that runs a virtually risk-free tracker fund through a fund management subsidiary. It would have to incur an operational risk charge, although its competitors in the non-bank sector would not have to do so and would not do so because the operational risk involved in running such a fund is very small (Tucker, 2009). Such a levy would distort the level playing field of banks vs. other non-regulated financial institutions and create incentives for consolidation in the banking sector as well as non-bank spinoffs of many bank activities (BIS, 2009). Presumably, the new proposal is not intended to affect the competitive structure of the banking sector or lead to disintermediation. Market Risk The third and final part of the first pillar is market risk. It is the risks of losses as a result of changes in market prices: the risk related to interest rate instruments and other equities in the trading book, foreign exchange risk and commodities risk. As for the other risks under this pillar there is one standardized alternative and one alternative based on an internal model, which requires supervisory recognition to be applied (Basel Committee, 2006)

Pillar 2 Supervisory Review Process The second pillar forms four founding demands that cover the tasks of the supervisory authority and of the bank (Finansinspektionen, 2001). Firstly, banks should have a process for determining their overall capital adequacy and a strategy for maintaining capital levels. Secondly, supervisors should review the methods the banks use for capital assessment and make sure they comply with regulatory capital ratios. Further, they can take supervisory actions if they are not satisfied with 20

those methods. Thirdly, supervisors should expect the banks to have a higher capital ratio than the one set by regulatory standards. They are allowed to require banks to hold more capital than the minimum demand. Fourthly, the supervisory authority should seek to intervene at an early state to avoid capital to fall below the required, and should require immediate action if capital is not maintained or restored (Basel Committee, 2006). Although a minimum level of capital is stated through the first pillar the bank need to keep greater capital reserves to have a buffer for unexpected events. Especially as the means of measurements are more risk sensitive and the capital reserves demanded may increase drastically if the economy goes in to a recession. This does further increase the demands on the supervisory authority (Finansinspektionen, 2001). In light of the above Pillar II forms an integral part of the capital adequacy accord. It obliges regulators to assess the quality of individual banks risk modelling, allows them to be more flexible with respect to a banks particular circumstance in her setting of capital charges and encourages closer co-operation between supervisor and bank (BIS, 2009). As such, pillar II makes possible a more adequate enforcement of prudential regulation and must be welcomed. However, a more careful argument for the necessity of such flexibility that takes into account some of the less obvious implications of allowing regulators such flexibility (Dale, 2007). For example, a high degree of flexibility risks counteracting the second of the main objectives of the existing and proposed accords, namely that of generating a level playing field. In particular, flexibility creates the inherent danger that a regulator may use her discretion to lower capital ratios for banks under her control in order to afford them a competitive edge (Cornford, 2005). Alternatively, she may choose to stick to the minimum ratios prescribed under pillar I when prudence would suggest higher capital charges. These possibilities take on real significance in the light of existing differentials in enforcement of the current accord within Europe, with the UK taking a markedly more flexible approach than some continental regulators (Cornford, 2009a). In the US, in contrast, relaxing capital adequacy ratios is ruled out by legislation according to Morris and Shin (2001). Consequently, there is a need for a mechanism that ensures that pillar II is

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implemented uniformly across countries and that such quality assessments as are undertaken under its auspices are consistent across regulators. On the other hand, a strong pillar II is necessary to counteract what amounts to a design flaw in regulation through capital adequacy ratios (Jayamaha, 2006). As already mentioned above, in times of crisis, minimum capital adequacy ratios require a firm either to take on more capital or to dispose of risky assets. In the short run, the former may be impossible or very costly. Disposing of risky assets, in contrast, will only deepen the crisis by accelerating the downturn. The flexibility afforded to regulators under pillar II enables them to react to such a situation by injecting liquidity into the system (FSF, 2008). When such flexibility is absent, as for example in the United States, where strict adherence to target capital ratios is written into law, regulation creates a knee-jerk reaction that may aggravate any crisis (BIS, 2009). As a result, a strong pillar II is welcomed as a means of averting such damaging endogenous responses. As a final point, a worrying aspect of the Committees proposal to enable banks to progressively use their internal systems is the substantial imbalance in resources (both financial and human) between banks and their regulators. Banks have hired teams of very well trained statisticians and risk specialists to design ever more sophisticated risk assessment and management tools. The complexity of credit risk models is an order of magnitude higher than that of market risk tools. While regulators in large developed countries may be able to train teams with enough technical capacity to understand and evaluate banks credit risk systems it is unlikely that poorer countries like Zimbabwe will be able to do so. Pillar 3 Market Discipline The third pillar aims to use market powers to create stability by increasing the information demanded from banks. It is important that customers, investors and other stakeholders have information about the banks, to be able to judge their financial strength and risk profile. Providing this information will further create incentives for the banks to behave in a way that reduces risk. It is of great importance, however, that the information demanded is not too high, as it could display confidential information, at the same time, as it is important that the information is comprehensive

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enough. It is included in the responsibility of the supervisory authority to control how the banks apply the information requirements (Finansinspektionen, 2001).

2.1.3 Effects of Basel II

The aims of Basel II are, according to Finansinspektionen (2001), to increase the resistance of the financial system against economic disturbances and to contribute to an increased economic efficiency. This should be achieved by having large capital requirements for banks with higher risk level, at the same time as the capital requirements for banks that are only exposed to low risk should not be as high. If the capital requirement is very standardized, as with Basel I, there is a risk that the banks need to keep a capital buffer that is excessively high and thereby transfer too large cost for loans to their customers. If, on the other hand, the capital requirement is too low the loans will be overly cheap and the stability in the system will decrease (Finansinspektionen, 2001). The change in cost structure as a result of the regulations means that the structure of the financial sector changes. This change in structure leads to the fact that it could be favourable for customers that want credit for projects with low risk, as opposed to those that want credit for high risk projects. It could be suspected that the prices to customer (interest rates) will be affected by the new regulations, as the capital requirements are lower to customers that run lower risk (Leeladhar, 2007a). It should, however, not be expected that the changes in prices will be significant, as the primary aim is not to increase the cumulated capital requirement in the banks. According to Finansinspektionen (2006), the capital requirements for the four Swedish banks will decrease by 1.2 percent, according to the standardized method, and 25.8 percent, according to the foundation IRB method. The calculations within the other pillars can, however, mean an increased capital requirement. Part of the reason for the large decrease in capital requirement could be that the framework allows the capital requirement for retail credit to decrease. Retail credits contribute to relatively large part of the credit portfolio in Swedish banks, in comparison to in banks from other countries. Thus, Basel II means great changes, demands and consequences for the financial sector through giving the banks opportunities to have lower capital buffers, and further give them a greater ability for management control, if able to use the regulations in the right way. It gives the

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banks an opportunity for more efficient risk control, and further provides an instrument for control of the business (Forsell and Lnnqvist, 2004).

2.1.4 Critique of Basel II

The criticism of Basel II has its roots in the general problems of measurement models. Within the traditional risk modelling methods forecasting requires historical information, which may not be fully comparable with current conditions and with what will happen in the future (Ceccheti et al, 2009). Many historical examples show that it is not possible to predict the future with models based on historical information. Further, when estimating risk there is always a problem when using methods bases on mean and standard deviation measures, as given by the law of large numbers (Butler, 2009). Finally, the problem of logical reasoning by investors always leads to concerns about risk models. To be able to use risk models at an operational level for management control it is important that the models actually provide a realistic view. If not, it will neither be helpful for management and control, nor for improved decision-making (Wahlstrm, 2009). It has furthermore been shown, according to Blum (1999), that capital requirement can actually increase riskiness of banks. If a regulation reduces future profits, capital regulations further increase the incentive for equity in the future and therefore higher risk today. Kirsten (2002) shows that external ratings are better to estimate risk than internal ratings, although banks have better diagnostic skills than external assessors. Wahlstrm (2009) does in his research, furthermore, show that negative views of Basel II have been stated within the organizations applying it, concerning the resource intensive nature of the new regulations. The fact that there is a knowledge gap between banking staff members concerning the regulation, lack of applicability at operational levels, and opportunities for different interpretations are other negative statements. The negative opinions stated were, however, larger in banks with a decentralized organizational structure. 2.2 Benefits / Opportunities of Adopting Basel II Capital Accord The three pillars work in an integrated way to strengthen the stability of banking systems. The Basel Committee (2004), specifically labelled the New Accord (Base II) as a revised framework, which provides regulators room to determine the most effective way to apply the recommendations. According to Weder and Wedow (2006), the adoption of Basel II allocates 24

capital more effectively thereby enhancing risk management by requiring changes in an organisations technology and business processes. Other benefits to accrue to banks that embrace Basel II requirements are as follows: a) Basel II is intended to improve the safety and soundness of a financial system by placing increased emphasis on a banks internal control and risk management processes and models, the supervisory review process and market discipline (Weder and Wedow (2006). b) c) Basel II substantially changes the treatment of credit risk and also requires that banks have sufficient capital to cover operational risks. The 2004 revised capital Accord framework enforces implementation of an Enterprise-wide Risk Management Framework (ERMF) ties regulatory capital to economic capital by placing strong emphasis on accountability, responsibility, reporting, communication, interdependency and transparency both internally and with all key stakeholders (BIS, 2009). d) Calculating capital requirements under Basel II Accord requires a bank to implement a comprehensive risk management framework across the institution. The risk management initiations are rewarded by lower capital requirements (BIS, 2009). e) Basel II encourages ongoing improvements in risk measurement, assessment and mitigation. Hence overtime it presents an opportunity for a bank to gain strategic competitive advantage by allocating capital to processes and markets which give the highest risk / return ratio. Hence resulting in a better understanding of risk / reward trade off or capital results (Reddy, 2008b). f) Basel II compliance is a risk management challenge with positive strategic business implications as the Accord provides for better quality and timeliness of risk information. g) Basel II Accord provides incentives to banks to adopt the latest advances in the field of risk management. Banks which embrace best practices in the management of risk tend to be awarded with lower capital requirements thereby bolstering

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development of the banking industry by offering more sophisticated products to customers. h) The new accord enhances a banks ability to assess lendings to Small to Medium Sized (SMEs) and allows for better risk adjusted pricing models. According to Helbekkmo H, Elghnayan S, Samuels D and Johnson R (2005:3), top 10 business management benefits gained from Basel II investments concur with those already highlighted. These are as follows: (i) (ii) (iii) (iv) (v) systems; (vi) market; (vii) structuring; (viii) (ix) (x) i) Risk adjusting customer profitability analysis; Risk adjusting incentive compensation; Improved risk disclosure to stakeholders and rating agencies Barrell and Gottschalk (2006), agree with Helbekkmo et al. (2005), by emphasising benefits on better decision making at loan, portfolio and organisational levels. At loan level, differentiating between risky borrowers is made easier by effecting an Expected Loss (EL) assessment: Improved provisioning by combining the borrower (PD) and facility (LGD) risk ratings a bank can refine the way it provides for expected loss. Improved pricing accuracy in measuring risk in lending, factored in 26 Target underwriting process on the riskiest deals and improve deal Risk adjust transaction pricing and cherry picking the best deals in the Risk adjusting a business line profitability for strategic planning purposes by application of tool such as RaROC; Implementing Economic Capital based risk limit setting and concentration risk management; Optimising a firm wide capital management; Improve loss reserving and provisioning in line with market demands; Identifying top operational risks and setting up ERMF early warning

loan pricing is critical to a banks competitive success. Tett (2009) argues that at portfolio level, the power to diversification, understanding the impact of concentration, understanding the impact of concentration as well as extending limits and capital are all benefits to accrue on adopting Basel II Accord. At organisational level, justifying large investments and rewarding smart risk taking are enhanced. j) Other benefits to be reaped by being Basel II compliance are as highlighted by Ruiz (2004), cited in the Economist (2004:22), May article, are as highlighted below: (i) Reduction in Capital Requirements - noting that banks are allowed to develop sophisticated internal risk-measurement processes and can prove them to be sufficiently accurate, hence allowed to use these to calculate the capital they must hold against their exposures thereby reducing capital requirements. (ii) Competitive advantages - banks that become Basel II compliant early tend to gain benefits in terms of capital efficiency, data and risk management uniformity, enhanced credit ratings, reduced operational losses and an improved credit risk/return profile. (iii) (iv) Enhanced decision making - improvements in financial reporting capabilities facilitates more informed decision-making. Increased brand loyalty - by various stake holders. Improved credit rating systems and improved management of operational risk is enhanced. Resulting in significant improvements in customer service, risk management, decision-making, operational efficiency, cost reduction, client confidence and enhanced brand as well as reputation According to the Reserve Bank Annual Report (2005), benefits of adopting the revised Capital Accord (Basel II) in the Zimbabwean banking market include the following: (i) Creating a better link between minimum regulatory capital and the banks risk profile; 27

(ii) Promotes the stability of the banking sector by ensuring the safety and soundness of banks;

(iii) Supports a level playing field in an increasingly integrated global financial system; (iv) Strengthens the link between regulatory capital and risk management; (v) Gives banking organizations stronger incentives to improve risk measurement and Management; (vi) Provides a consistent framework for improving supervisory assessments of capital adequacy and risk management.

Further, Basel II provisions not only ensure that banks maintain levels of capital that are in line with their risk exposure, but also require banks to control risk adequately and to justify the risks they have taken. Thus, over and above the calculation of capital requirements, the revised framework creates new opportunities for financial institutions through transforming of an enhanced regulation into a tool for creating value. Basel II has to be regarded as an opportunity to put in place new risk management and regulatory reporting standards. The advanced approaches for operational and credit risk encourages banks to embrace best practices in this area. The banking industry benefits from adoption of these new measures, more so because correspondent banks usually request for confirmation that their counterparties are moving towards adoption of Basel II. Improved risk measurement also promises better informed investors and greater discipline. If good risk measurement can improve internal discipline, then disclosing internal risk measures helps the market to understand banks risk postures and to react rationally. Hence, a number of authors noted that over and above the calculation of capital requirements, Basel II create valuable strategic opportunities for commercial banks.

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2.3 Key challenges for Banks which adopt the Basel II Capital Accord Helbekkmo et al. (2005) noted the following Basel II adoption challenges explained below: a) Improvements to the credit process - re-engineering internal credit rating systems using both default probability and transaction structure without destroying underlying knowledge. b) Accurate credit risk factor estimation and calibration across many different portfolios - measuring risk factors such as PD, LGD and ED can be quite challenging. Finding the right data gathering and calibration strategy for different portfolios can also prove to be an impediment. An appropriate model customised scoring models must be applied. c) A sound approach to operational risk - the challenge revolves around finding the most suitable tools and processes for specific task of calculating risk capital and estimating the amount of capital for holding against operational risk. d) An efficient strategy for data gathering and management - working out which data is useful to solve a problem at hand and how efficiently gathering data are hurdles to be considered. Tarusenga (2007) concurred with the fact that data availability and its management to date is very often cited as one of the major problems to implementing the Basel II risk control framework. e) An overarching economic capital framework for enterprises risk management banks that do not as yet have in place robust economic capital framework find it hard for them to comply with Pillar I and Pillar II. f) g) Lack of Time: data capture, which enables operational risk factors to be identified and analyzed, requires at least a years data to be fully operational. Data management: requirements involve upgrading and aligning Information Technology systems to facilitate data handling by ensuring consistency and integrity across the organization. Lack of data for operational losses, and a shortage of Basel experts are proving to be real issues for Basel II compliance. Identifying correct data, integrating the data, carrying out sophisticated analysis and creating the required reports are also other challenges associated with being compliant.

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h)

Inflexibility of existing information technology systems: systems must be compatible to the existing information technology architecture, provide a suitable reporting facility and support internal credit risk ratings analysis.

i)

Cost: the cost of compliance is also proving to be the biggest barrier especially for some banks in emerging markets. Allocating a budgetary vote for carrying out Basel II projects proves to be a problem due to commitment of funds in areas in support of survival strategies activities.

j)

Considerable attention must be given on the corporate governance side of Basel II implementation. Senior management and board members are expected to have a much stronger oversight that before and to ensure that a sufficiently strong risk control framework is in place.

2.4 Approaches to successfully implement the Basel II Capital Accord According KPMG (2004), Basel II implementation presents a highly complex corporate governance / risk management project necessitating a structured and disciplined approach which can be considered in four phases as shown under Figure 3 below. Phase I: It encompasses a gap analysis comparison of the banks current state against Basel II requirements, simulation of the impact of capital burden under the possible approaches and management decisions on credit and operational risk approaches and credit risk mitigation techniques. Development of a Basel II implementation plan is important in developing a project scope, project risks and a step by step approach. Phase II: The bank would establish teams to address Basel II implementation master plan, including credit risk, operational risk, market and other risks, capital planning, disclosures and the supervisory review process. Focus is now on defining data needs, organisational structures, processes and systems required for Basel II implementation (KPMG, 2004). Phase III: Under this phase a bank implements reviews and use testing to assess its approaches to risk measurement and modelling, data collection, capital adequacy, its compliance with minimum standards and its control environment (KPMG, 2004). 30

Phase Phase I: Asses and Plan Phase II: Design and Implement III: Use test and approval Gap Basel II Basel II Impact Corporate Governance/Risk > > Mgt. Credit and Operational Risk > > Use Test and Approval

Phase IV: Monitor and Control Monitor and Control

Organisation Process > >

> >

31

Market and Methods > Data > Implementation Master Plan Analysis Analysis Implementation Approaches > > other risks / Economic Capital Basel Rollout Plan Supervisory Review Process > and Disclosures > > > > > >

Systems >

Basel II Project Management

Figure 2.2: Basel II Implementation, a Phased Approach Source: Adopted from KPMG International, (2004). A World Wide Challenge for Banking business achieving benefits of Basel II Phase IV: Ongoing monitoring is essential both internally and externally. Pillar II requires banks to monitor and report regularly to senior management regarding the banks risk profile and capital needs. It also requires that supervisors review and evaluate a banks ability to monitor and ensure compliance with regulatory capital ratios. 2.4.1 Evaluation of the Basel II Capital Accord It is at the moment difficult to evaluate fully the impact of Basel II which is still in its infancy implementation stages in most jurisdictions worldwide. However several criticisms on the challenges and opportunities (2004 2009) have surfaced in the implementation phases (Symous and White, 2007). These relate to the adverse impact the new capital requirements would have on SMEs, emerging markets, banking sector competition and business cycles. Basel II should not be viewed as the cornerstone for financial stability. Authors such as Stiglitz (2001), argue that a bank subject to higher regulatory capital requirements looks for higher returns to offset its higher costs, and in the process engage in increased risk-taking. There is also a consensus among policy analysts that creating effective regulatory institutions in developing

32

countries would have greater challenges on their financial stability than introducing capital adequacy requirements. Pro-cyclical nature of Basel II permutes all the aspects of its capital adequacy framework. The standardised approach is based on credit ratings, which are suspected to move in tandem with economic cycles. Amato and Furfine (2004), find evidence that the creditworthiness of firms tend to be downgraded than an upgrade during economic booms. Under Basel II, a downgrade implies an increase in risk weights of capital requirements. Noting that raising capital is costly, banks prefer to minimise their capital requirements. Basel II is also criticised by Goodhart and Segoviano (2004) for its oversight of portfolio diversification on calculation of capital adequacy requirements. A belief that capital requirements do not improve the stability of a domestic financial sector and may even deteriorate it is shared amongst researchers. de Juan (2006) remarks that most Latin American countries adopted Basel capital standards in the 1990s, some also experienced severe banking crisis during that period. In Zimbabwe empirical literature suggests that the Reserve Bank should continuously monitor compliance with minimum capital requirements in line with taking appropriate supervisory action on banks whose Capital Adequacy Ratios (CARs) fail to meet the minimum requirements (RBZ, 2009). Following the introduction of the multi-currency regime in February 2009, the Reserve Bank has introduced a phased plan for enforcement of the prescribed minimum equity capital requirements. According to the Monetary Policy Statement, (July 2009) the Basel II phased implementation plan requires all banking institutions to meet 50% of the prescribed capital levels by 30 September 2009 and 100% by 31 March 2010. Table 5 below shows the expected minimum capital requirements in terms of the phased plan of implementation. Table 2.2: Financial Institutions Minimum Capital Requirements Minimum Capital Requirement (USD) as at 30 Type of Institution Commercial Banks Merchant Banks 33 September 2009 6,25 million 5,0 million Minimum Capital Requirement (USD) as at 31 March 2010 12,5 million 10 million

Building Societies 5,0 million Finance Houses 3,75 million Discount Houses 3,75 million Source: Adopted from Mid year RBZ Monetary Policy Statement, July 2009

10 million 7,5 million 7,5 million

In Zimbabwe, 2009/10 banks recapitalization plans have revealed that most banking institutions are going to be recapitalized through fresh capital injections by the holding companies, private placements, rights issues and strategic partnerships with new investors (RBZ, 2009). The phased plan acknowledged the need to afford the banking sector adequate time to reconstruct their balance sheets as well as restore confidence in the banking sector. Zimbabwean banks may have induced relatively weak capitalised banks to maintain higher capital ratios (RBZ, 2009). There is also evidence that bank capital pressures during the current economic downturns may have limited bank lending and contributed to economic weaknesses in some macro economic sectors. These effects reflect both regulatory and market pressure on banks to maintain ratios that are at least as high as the minimum. Formal regulatory requirements application has enabled the Reserve Bank to exert greater market discipline in line with the Basel II - Pillar II requirements on under capitalised banks (Pricewaterhousecoopers, 2010).

2.5 Empirical Literature Review In this section we trace the historical development of Basel II Accord as a bank capital concept. In section 2.5.1, 2.5.2 and 2.5.3 we draw on the experiences of the developed worlds, that is Australia United States of America and Japan as cases. Section 2.8.4 and 2.8.5 focuses on the concept of Basel II in emerging markets experiences. In each sub section we evaluate the effectiveness of Basel II Accord in the particular countries reviewed. Find below Figure 4 showing the progress that was made towards Basel II implementation in different jurisdictions by the end of the year 2007. Regulators in most jurisdictions around the world are working on implementation programmes with varying timelines and use of varying methodologies being restricted.

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Figure 3: Basel II Capital Accord Progress on Adoption Source: Celent (2007) Risk Management and the Basel II Game: Market Updates at Halftime

2.5.1 The Development of Basel II Accord in Australia Egan (2007) noted that as the Basel II journey continues under the Australias regulatory authorities, Australian Prudential Regulation Authority (APRA), so are risk management practices continuing to improve for Australian Authorised Deposit Taking Institutions (ADIs) since implementation of the new framework on the1st of January 2008. The majority of ADIs have adopted the standardised approaches. APRA accredits ADIs wishing to adopt the advanced approaches (Carney, 2009). ADIs who adopted the standardised Basel II approaches did not undergo any accreditation processes, however, these had to have better risk management systems than that under the existing Capital Accord to be able to take advantage of the greater granularity provided by Basel II (BCBS, 2009a). As for the ADIs adopting the Basel II standardised approaches, provided the incentive to improve systems and to take advantage of a more risk sensitive capital regime. A number of ADIs 35

are working on taking advantage of some of the qualitative risk management techniques required of those banks adopting the advanced approaches and thereby improving the way they manage their risks (BCBS, 2009b). It is in the advanced Basel II approaches where both banks and their regulators are finding the Basel II requirements and processes most challenging. As a result of the need for comparability, the Basel Committee did not agree to ADIs imply using economic capital models for the purpose of calculating regulatory capital. It did, however, placed a number of processes around how banks were to estimate their risks for the purpose of calculating regulatory capital and, in the case of credit risk, how those risk estimates were to be modelled (BCBS, 2008). As the Basel II Accord implementation programme was being finalised, the Australian banks identified areas in which they had further work to undertake as part of the accreditation process. Egan (2007), noted that risk estimation was a rapidly evolving science that most banks noted, would have to revamp some of their models which were once leading-edge models. Documentation became an important element in ensuring that processes are robust and auditable and APRA requires appropriate documentation as part of its accreditation processes. Issues of governance permeate much of the Basel II Framework, but it is especially relevant in documentation (FSI, 2004). Information Technology systems have not always had the processes and robustness around them that APRA would expect nor have they always been subject to rigorous audit, or other independent, checking (Wellink, 2009). Sometimes APRA has formed the view that the systems and processes have more of a development look than of the robustness typically expected and seen in banks. In APRA's view, the Basel II accreditation process has led to the banks' risk measurement, management systems and processes being richer in data and more robust. A number of Australian banks have aspired to the advanced Basel II approaches without having had a history of using economic capital modelling in how they run their operations (BCBS, 2006). That has proved to be a particular challenge as those banks have had to grapple with the data and modelling issues. 36

Whilst implementation is ongoing in Australia, APRA noted that Basel II is primarily about a regulatory capital requirement that is more risk sensitive and through that encourages better risk management. On average amongst other merits, ADIs noted that there are modest reductions in regulatory capital associated with the implementation of Basel II.

2.5.2 The Development of Basel II Accord in the United States of America According to the KPMG (2003) all United States of America (USA) banking regulators have been supportive of Basel II. They have indicated that Basel II implementation required a small number of internationally active banks (about 8 major banks representing two thirds of USA banking assets and voluntary for a similar number of banks that may or may not be internationally active but wish to opt-in for the Basel II framework (BIS, 2009). The regulators stated intention is to allow only the Advanced IRB approach to credit risk for those banks; the Foundation IBR and Standardised approaches are not be permitted to be used in the USA (FSB, 2009b). Only Advanced Measurement Approaches to operational risk are permitted.

2.5.3 The Development of Basel II Accord in Japan Given the significant benefits of Basel II to the Japanese economy, the country has been one of the leading jurisdictions globally taking active steps to incorporate the requirements of the revised Basel Accord framework into their regulatory regimes (Weder and Wedow 2006). The revised framework under Basel II adoption of a three-pillar structure represents a major step forward in terms of the identification, quantification and management of risk and public disclosure. As an international financial centre that prides itself on adopting best practices that commands wide international acceptance, Japan has committed to adopting Basel II. Implementation of Basel II in Japan was done in phases starting on the 1st of January 2007 (Brunnermeier et al, 2009). This was done in accordance with the timetable recommended by the BCBS for its own members in line with other major international financial centres, such as London, Frankfurt and Tokyo, and also broadly similar to that of Australia and Singapore (BCBS, 2009d). Recognizing that banks in Japan vary widely in terms of business focus, size and complexity, as well as the nature and combination 37

of risks they face, the regulatory authorities in Japan adopted a menu-based approach in implementing Basel II. Banks were expected to choose options based on their risk profile and complexity of operations, and the results of their own detailed feasibility studies as well as costand-benefit analyses (BCBS, 2009b). Reddy (2008b) put forward that Basel II is providing incentives to banks that adopted the latest advances in the field of risk management. Japanese banks which adopt best practices in the management of risk are being awarded with lower capital requirements (Tucker, 2009). Enhanced risk management has improved the banks ability to offer more sophisticated products to customers, thereby helping bolster development of the banking industry (FSB, 2009b). The new accord has enhanced banks ability to assess lending to sectors such as SMEs and allow for better risk-adjusted pricing in Japan. On a macro perspective, the greater risk sensitivity of Basel II and the inclusion of a wider range of risks have further enhanced the safety and stability of the banking sector, strengthening the position of Japan as an international trade centre.

2.5.4 The Development of Basel II Accord in India The policy approach to financial sector in India is that the ultimate goal should be to conform to the best international standards and in the process, the emphasis is on gradual harmonisation with the international best practices (Sakoul, 2009). While considering implementation of the Basel II Capital Accord, special attention was given to the differences in degrees of sophistication and development of the banking system and it was decided that the financial sector initially adopts the Standardised Approach for credit risk and the Basic Indicator Approach (BIA) for operational risk (Tett, 2009). After adequate skills are developed, both by the banks and also by the supervisors, some of the banks may be allowed to migrate to the IRB and Advanced Measurements Approaches (AMA) (BCBS, 2009c). As per normal practice in regard to all changes in financial sector, and with a view to ensuring a particularly smooth migration to the Basel II Capital Accord, a consultative and participative approach has been adopted for designing and implementing Basel II Capital Accord in India (FSB, 2009b). Implementation of Basel II required more capital for banks in India due to the fact that operational 38

risk is not captured under Basel I, and the capital charge for market risk was not prescribed until recently (BIS, 2009). The cushion available in the system, which at present has a Capital to Risk Assets Ratio (CRAR) of over 12 per cent, provides for some comfort but the banks are exploring various avenues for meeting the capital requirements under Basel II (Jayamaha, 2008). In India, 85 commercial banks, account for about 78% (total assets) of the financial sector; over 3000 cooperative banks, which account for 9%; and 196 Regional Rural Banks, which account for 3% (Akhtar, 2006). Taking into account the size, complexity of operations, and relevance to the financial sector, need to ensure greater financial inclusion and the need for having an efficient delivery mechanism, the capital adequacy norms applicable to these entities have been maintained at varying levels of stringency (Akhtar, 2008). One might say that we are adopting a three-track approach with regard to capital adequacy rules. Given the differential risk appetite across banks and their business philosophies, it is likely that banks would self select their own approach, which in turn, is likely to engender a stabilising influence on the system as a whole (Carney, 2009). On the first track, the commercial banks are required to maintain capital for both credit and market risks as per Basel I framework; the cooperative banks, on the second track, are required to maintain capital for credit risk as per Basel I framework and through surrogates for market risk; the Regional Rural Banks, on the third track, have a minimum capital requirement which is, however, not on par with the Basel I framework (Matten and Trout, 2006). Consequently, we have a major segment of systemic importance on a full Basel I framework, a portion of the minor segment partly on Basel I framework, and a smaller segment on a non-Basel framework (CGFS, 2009).

2.5.5 The Development of Basel II Capital Accord in Emerging Economies A key debate on whether regulatory standards that work in industrialised countries are appropriate for emerging markets as solutions has been debated by a number of researchers as cited by Barrell and Gottschalk (2006). The Basel II Capital Accord was mainly aimed at internationally active banks, few of which are found in emerging economies. When talking of standards and appropriateness no single standard has proved to work in all economies or at all times. Even though it has been mentioned by the BCBS that over 100 countries had implemented Basel II, the assessments done in 71 countries by Barajas, Chami and Cosimano (2006), have revealed many deficiencies in the areas of risk management, consolidated supervision and corrective action for 39

undercapitalised institutions, which are considered to be crucial to sound supervision and proper Basel II implementation. According to further studies conducted on the challenges and impact of Basel II in developing countries, Griffith-Jones (2003), argued that Basel II could lead to an international credit crunch for developing countries due to a combination of reduced volumes of credit and interest on pricing of loans noting that regulatory capital requirements may flow through international lending rates. Key challenges as acknowledged by the IMF and World Bank (2002) are that most developing countries do not have adequate internal expertise to assess and assist Basel Accords implementation in various jurisdictions. According to FSF (2008) complexities of the Basel II framework entails that it has to be specifically tailored to suit the domestic economies and the domestic banking systems. Truman (2009) is for the view that regulators are right in insisting on the freedom and flexibility for adopting and implementing an appropriate roadmap without being constrained by any pressures. Jayamaha (2008) contends that the ideal solution for managing a complex task of this nature is through mutual cooperation and assistance amongst central banks throughout the world.

2.5.6 Basel II implementation in Zimbabwe Zimbabwe has lagged behind full implementation of the Accord although a lot of progress has been made in gradual implementation of components of the 3 pillars of Basel II (RBZ, 2009). Recently, the Reserve Bank of Zimbabwe published a Technical Guidance on Basel II implementation in Zimbabwe in April 2010 soliciting comments from market participants and other players such as auditing firms and analysts (RBZ, 2010). This guideline outlines the methodology and requirements for implementing Basel II in Zimbabwe. It deals with definition of capital, the calculation of the minimum capital requirements (Pillar I) for credit risk, operational risk, and market risk; supervisory review (Pillar II) and market discipline (Pillar III). Definition of capital is quite key with regulators setting caps for various components of capital. Challenges for the local financial sector in implementing Basel II Implementation of Basel II in various countries has been associated with a number of challenges associated with any large project implementation process. Fully aware of the practical aspects of 40

implementing a more modern, complete and risk sensitive prudential framework, the Basel Committee published, in July 2004, i.e. directly in the wake of the New Capital Accord, a document entitled Implementation of Basel II: practical considerations(Bank of France,2007). Already the Technical Guidance issued by the Reserve Bank of Zimbabwe requires that the core capital of a banking institution should exceed 50% of the capital base of the institution. Although this is meant to strengthen the capital base of an institution, it might be a challenge for local financial institutions to meet these requirements (RBZ, 2010). An analysis of countries across the world that have fully or partially implemented Basel II has revealed that compliance with Basel II is fraught with the following challenges (Pricewaterhouse coopers, 2010): Lack of resources and qualified personnel in modern risk modelling approaches: Banks are required to make relevant budgets for Basel II implementation and this should cover IT requirements and all the training requirements. In some instances banks have been hiring consultants to assist theme with Basel II (Bank of France, 2007). It is a fact that there are few professionals in Zimbabwe with qualifications such as CFA, PRM and FRM which are important risk qualifications laying the foundation for easier implementation. Most of those that have acquired such have left the country in search of greener pastures (KPMG, 2003). Executive ownership and change management: Implementing Basel II will require high level management commitment and may require changes to risk management in any institution. Typically a project management team reporting to the Managing Director and the Board will have to be in charge of the implementation process. Hard questions on internal impact, customer impact, business impact, regulatory impact and market impact will need to be asked throughout the implementation process and post implementation (KPMG, 2003). High operational and compliance costs which favour large banks which are able to bear such costs and benefits from economies of scale. Non-availability of high quality data is a challenge to the effective implementation of Basel II. Lack of sufficient data negatively impacts on calibration and benchmarking of models.

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The uncalculated, over-estimated/underestimated risks can nullify the whole efforts of Basel II implementation (Bank of France, 2007). Limited reliability of the ratings done by rating agencies defeats the purpose of enhancing market discipline. Credit rating agencies have come under fire in light of the recent subprime crisis with some jurisdictions such as the US mooting the idea of regulating such rating agencies (Pricewaterhouse coopers, 2010). Sector-specific implementation of Basel II: In many developing countries only banks are required to comply with Basel II, and not other financial services providers such as securities firms and the insurance sector. The Technical Guidance on Basel II implementation in Zimbabwe applies to both banking institutions on a solo as well banking group on a consolidated basis (RBZ, 2009). Regulatory arbitrage in banking operations across jurisdictions. These arise because of different implementation time tables, different approaches to implementation and different interpretation of Base II. In Zimbabwe, post implementation period will involve both regulators and banks monitoring the use of the new approaches with the objective of optimising their major objectives from their different points of view (RBZ, 2010). Implementing Basel II in the local sector offers various benefits and opportunities for the local financial services sector. Pillar 1 of the Basel II stipulates down specific calculation of regulatory capital to set against credit risk transfer transactions (such as securitisations and credit derivatives) (RBZ, 2009). This treatment set out in Basel II thus aims to ensure that securitisation transactions have their own economic reality, rather than seeking regulatory arbitrage as was sometimes the case under Basel 1. Secondly, by reinforcing the link between the capital base and the risks actually incurred, Basel II encourages banks to improve their systems for managing these risks as well as their due diligence procedures. Thirdly, Basel II gives banks and supervisors a vital tool, Pillar 2, with which to assess the risk profile of institutions and in particular to take account of certain risks that are sometimes difficult to quantify but whose impact can be great such as interest rate risk, refinancing risk and reputational risk (Bank of France, 2007). 42

Fourthly, Basel II sets out to promote stress tests as one of the tools for managing and assessing risks. Basel II stipulates that the stress tests conducted by banks must incorporate the effects of a large increase in credit and market risks as well as those of a rise in liquidity risk. The aim is to ensure that banks hold sufficient capital to absorb severe shocks (KPMG, 2003). Lastly, Basel II aims to substantially reinforce transparency and market discipline. Pillar 3 of the framework lays down numerous requirements regarding the disclosure of qualitative and quantitative information about capital and risk, including in respect of risk transfer transactions (Sakoul, 2009). Overally, Basel II, will assist banking institutions to better access and manage risks linked to securitisation transactions and to improve their financial reporting, two crucial areas in which the 2007-2009 global financial crisis have highlighted that significant progress needs to be made (Butler, 2009). With the rapidly changing developments in global financial markets and financial innovation, local financial institutions will need to continue investing in robust management of capital, improving risk management structures and practices commensurate with their risk appetite (RBZ, 2010). There are significant benefits for the local sector in implementing Basel II and to this end pen communication on implementation issues and challenges between the sector and the Reserve Bank of Zimbabwe will be important going forward. Banks with international presence will find it easier to implement Basel II in Zimbabwe by sharing information with their peers in other parts of the world therefore benefiting from economies of scale. According to the RBZ (2010) the local market and regulators will need to continue monitoring developments and amendments to Basel II issued by Bank of international settlements (BIS) to ensure timely adjustments are done to the local sector.

2.5.7 Basel II and the global financial crisis The Global Financial Crisis (GFC) began to take hold in 2007. Its origins can be traced to a boom in US housing prices between 2002 and 2005 and the rapid growth of sub-prime housing loans following a doubling of the amount of prime loans between 2001 and 2003 (FSB, 2009a). Consequently, the crisis largely preceded the introduction of Basel II, which in Australia was at the 43

start of 2008 whereas in the USA it was introduced over 2008 in parallel with the current requirements and applied only to the large internationally-active banks (Dale, 2007). According to Cornford (2009a) sub-prime loans are those made to borrowers with a weak capacity to make their loan payments (compared with prime loans) and thus an increase in such lending represents a decline in lending standards. Sub-prime loans though were encouraged in the US as a way of democratising lending by providing loans to those who were not eligible for prime loans, including minorities (Carney, 2009). Cecchetti et al (2009) contend that the loans business model, though, was flawed because it depended on continuously rising prices for the mortgaged properties. The assumed capital gain served to compensate the lender for losses from loan delinquencies or encouraged delinquent borrowers to refinance with the lender at a higher interest rate. The growth in lending for housing promoted an increase in the supply of housing that resulted in the stock of housing exceeding the demand. This led to a fall in housing prices that was exacerbated by the high (and rising) rate of mortgagee sales from the sub-prime loans (BIS, 2009). The crisis quickly spread to the securities markets because most of the sub-prime loans were securitised through asset-backed commercial paper (short-term securities that provided initial finance for the loans) and MBSs (long-term bonds that ultimately funded the loans). The value of the highest-rated (AAA) of these securities (surprisingly, most MBSs based on sub-prime loans were rated AAA) halved between July 2007 and March 2008, which created a major credit crisis for two reasons (FSI, 2008). First, new issuers could not borrow because they could not afford the resulting higher interest rate and, second, investors only wanted to sell the securities; and so liquidity in both the primary and secondary markets for MBSs dried up. The crisis spread to the related markets for structured securities such as collateralised-debt obligations (the collateral for which was sub-prime loans) and for credit-default swaps, drying up liquidity in these markets. A related feature of the credit crisis was the retreat by investors to US Treasury and other safe bonds, driving down their yields and further widening the credit spreads between them and those for structured and similar securities (BIS, 2009). The crisis spread to the large US investment banks (they were not subject to prudential supervision) as well as commercial banks when it became clear that they held large amounts of these (toxic) securities on their 44

balance sheets and this contracted the flow of funds by banks (and even more disturbingly) between banks (BCBS, 2009b). The global nature of the affected financial markets and a surprising lack of information about banks exposures (which spread fear) meant the credit crisis quickly became global in scope. The BCBS, along with other pan-national agencies (Knight 2008), has analysed the causes of the threat the GFC poses for global financial stability and the Committee announced (in March 2008) it was developing four amendments to Basel II in response: 1. In relation to Pillar 1 it was examining the adequacy of the capital charge for structured securities given their highly correlated risk exposure (being backed by assets of the same type) which led to their sudden downgrading (YV, 2009). The value-at-risk method of assessing the capital requirement for such securities during periods of low volatility did not adequately reflect their credit risk when volatility suddenly increased. Concern had been expressed when Basel II was being developed about the shortcomings of value-at-risk models in the context of financial system instability. (Goodhart, Hofmann and Segoviano 2004: 598) 2. The Committee was also developing a credit-default risk charge on assets held in banks trading books. This is in recognition of the credit risk posed by structured credit products that do not have a liquid secondary market. 3. In relation to Pillar 2 the BCBS is proposing that regulators widen their stress tests of banks risk-management systems to include contingent credit exposures such as those that arose when banks took back securitised (or collateralised) assets for reputation reasons. 4. The BCBS is also reviewing its disclosure requirements (under Pillar 3) in relation to securitisations, conduits and the sponsorship of off-balance sheet vehicles (Wellink 2008; BCBS 2008b). Prior to the crisis the BCBS had began a review of liquidity-risk management and supervision, but given that market and funding illiquidity are core aspects of the credit crisis, the work was given greater priority. The intention is to strengthen its standards for liquidity-risk management and supervision, especially in relation to liquidity stress testing that includes off-balance sheet 45

exposures and for funding capacity during periods of wholesale market funding illiquidity; as well as its reporting and disclosure standards relating to liquidity (BCBS 2008a). APRA has responded by intensifying its monitoring of bank liquidity and by strengthening its liquidity-management requirements on banks. The GFC provides a real-life stress test of the stability of the financial system and the regulatory framework that is intended to promote the financial systems stability (BCBS, 2009c). Basel II forms a fundamental part of the prudential supervision of individual banks that serves to strengthen their individual stability through their capital buffer; but it does not aim to ensure financial system stability. Consequently, despite its recognised flaws, which the BCBS has moved to remedy, Basel II did not contribute to the emergence of the GFC (BCBS, 2009d). As noted above, the origins of the crisis pre-dated the introduction of Basel II in the USA. The same cannot be said about the anti-regulation political culture in the USA. In the USA, sub-prime lenders included non-depository mono-line lenders (referred to in Australia as loan originators) and large banks, as well as community banks, consumer finance companies and thrifts, many of whom along with investment banks arranged the issue of MBSs (Ashcraft and Schuermann 2008). As noted above, Basel II has been applied in the US only to their internationally active commercial banks. The widespread use of originate-to-distribute lending in the US has been referred to as a shadow banking system that increasingly relied on a flawed originate-to-distribute model (Ashcraft and Schuermann 2008 detail the various flaws), which in the case of sub-prime loans was based on a business model that itself was seriously flawed (because of its reliance on ever-increasing housing values and its incentives for predatory lending and borrowing). It should be recalled that the process of securitisation that enabled the originateto-distribute lending model was an acclaimed financial innovation that accessed investors funds for housing loans and so placed competitive pressure on bank lending. The question for the prudentially-regulated banks that decided to undertake either sub-prime lending or underwrite the issue of MBSs (or otherwise establish an exposure to structured securities) is why their capital requirement (their capital ratios exceeded those of Basel I) did not motivate them to act more prudently (Butler, 2009). Truman (2009) argues that the answer appears to be that the motivation provided by their capital requirement to act prudently was outweighed by 46

the pressure posed by competing institutions that were making profits from their appetite for risk taking; greed outweighed fear. The related question is: why did their prudential regulator tolerate their risk exposures? There is now a growing literature criticizing the forbearance of financial and prudential supervision in the United States (Kane 2008; and Ashcraft and Schuermann, 2008). The role of ratings agencies and their supervision has also been criticized given the conflict of interest faced by the ratings agencies in assigning their AAA rating to securities based on sub-prime loans. Fortunately, this debacle was not replicated in Australia. Sub-prime lending was largely confined to three smaller loan originators (Pepper, Bluestone and Liberty Financial) and Australias banking system had very little exposure to the toxic securities (Debelle 2008: 43). Consequently the banks were not under competitive pressure to enter this segment of the loan market. The initial impact in Australia was in the inter-bank market, where the Australian banks became reluctant to lend to each other, preferring instead to increase their balances held with the RBA (Tett, 2009). The main impact in Australia has been via the higher credit spreads in overseas financial markets, which had a relatively greater impact on non-bank lenders (the loan originators) because domestic and overseas MBSs markets had been their funding source (BIS, 2009). Deprived of funds, these lenders switched into mortgage brokerage, leaving the banks with an even larger share of the housing-loan market. The Governments guarantee of ADI liabilities has further strengthened the position of the large banks within the Australian financial system (RBA 2008b: 2136). APRAs review of credit standards for housing loans in 2006 (as well as the RBAs efforts to contain Australias housing prices in 2002 and 2003) represented a stricter regulatory environment than occurred in the US. APRAs Chairman concluded a speech made in June 2007 with the following observations: In repeating our concerns about credit standards, I am conscious that APRA might be perceived to be crying wolf too often on housing lending. No one would welcome a continuation of Australias economic strength and the recent resilience of most housing markets from which ADIs have been major beneficiaries more than the prudential regulator. Nonetheless, the risk currents in housing lending have been moving, slowly but inexorably, in one direction only

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and this demands careful management by our regulated lenders, and constant vigilance on APRAs part (Laker 2007). Leeladhar (2007b) argues that the comparison between the US and Australias experience is instructive. Supervised banks in both systems employed similar levels of capital but many of the large US banks behaved less prudently than the large Australian banks and the Australian financial regulators displayed much more vigilance than the US regulators. Basel II represents a substantial improvement on Basel I because of its more extensive integration of the capital requirement within the prudential supervision framework through its greater risksensitivity and comprehensive coverage of banking risks (Brunnermeier, 2009). Shortcomings (particularly in the modelling of credit risk) revealed by the GFC are being addressed, which should ultimately strengthen Basel II. Of the concerns debated during the development of Basel II the main outstanding issue is its procyclical effect (Sakoul, 2009). It is unlikely to be evident during the current economic crisis because of the greater effects of the GFC; illiquidity of markets and the tightening of lending standards by banks. But Basel II should be modified to counter its pro-cyclical effect (Reddy, 2008b). The main lesson of the GFC for Basel II is that bank capital is a necessary but not sufficient requirement for a banks stability (Tucker, 2009). Wellink (2009) adds that prudential regulators need to be vigilant because the intended influence of the capital requirement on banks risk-taking behaviour can be outweighed when competing institutions profit from their greater risk appetite, especially when there is a too-ready acceptance of financial innovation. 2.6 Chapter Summary The literature review discussed herein is relevant to the subject under investigation. This chapter discussed theoretical literature on the challenges and opportunities of implementing the Basel II Capital Accord as a tool for effective risk management. An analysis of implementation progress in cases from the developed and developing worlds was important in dissecting the array of different challenges and opportunities being faced world-wide and deriving solutions there from.

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Chapter 3 Research Methodology 3.0 Introduction The feasibility of any research project is directly dependant on the reliability and validity of the methodology used. Different kinds of research approaches produce different kinds of knowledge about a phenomenon under study. Thus it is the purpose of this section to define and justify different research methods that were used in carrying out the research. 3.1 Research Design Hill (1997) argues that there are two types of research design namely positivism and phenomenology. Positivism gives an explanation of causal relationships between variables and makes use of quantitative data. Phenomenology approach on the other hand is based on the way people experience social phenomenon in the world they live in. It uses qualitative data (Hill, 1997). This study adopted a positivism design, as it is economical in data collection. It also gives a clear theoretical focus for the research and the researcher has control of the research process. The results from this design give easily comparable data (Hill, 1997).

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Study Population The study population consists of all individuals whom the researcher is interested in obtaining information and making conclusions (Fraenkel and Wallen, 1996). They elaborated that the population is split into two categories, the target and the accessible populations. The target population is the actual population to which the researcher would really like to generalise. However, this population is rarely available. Therefore, the population to which researcher is able to generalise is the accessible population (Fraenkel and Wallen, 1996). Saunders et al., (1997 go along with them as they define a population as a well defined group or set that has certain specified properties,). In this regard the study target population was constituted of individuals that were most likely to be knowledgeable about Basel II. The population of interest comprised of:a) Directors of commercial banks; b) Senior bankers with risk management responsibilities; c) RBZ banking supervision staff Basel II Capital Accord section; d) Economic analysts and commentators; e) Academics, scholars and economists;

Saunders et al., (1997), state that with resources allowing a researcher is to collect all the data that answers the research question and use it (census). He also acknowledged that due to various limitations the use of sampling techniques to reduce the amount of data are permissible, and so, the researcher used sampling method for the following reasons: a) b) c) Resources did not allow surveying the whole population. There were cost and time limitations to surveying the whole population. Accessibility to the whole population was not feasible.

Sampling Technique and Data Collection Ferber (1974) defined a sample as a small part of anything designed to show the style, quality and nature of the whole. The purpose of a sample is to approximate the measurement of the whole population well enough, within acceptable limits.

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There are two methods of coming up with a sample. Saunders et al (1997) report that random (probability) sampling ensures that the probability of each case being selected from the population is known and is usually equal for all cases. On the other hand, non-random (non-probability) sampling is such that the probability of each element being selected from the total population is unknown and cannot answer questions that require statistical inferences about the populations characteristics. 3.3.1 Probability Sampling In probability sampling, it is possible to specify the probability that a sampling unit will be selected from the population. This section presents some of the probability sampling methods.

3.3.1.1 Simple Random Sampling This method involves selection at random from a list of the population of the required number of units from the sample (De Vaus, 1990). Random number tables or a computer can be used for the random selection of units. If properly conducted, it gives each unit an equal chance of being included in the sample and also makes all possible combinations of units for a particular sample size equally likely.

3.3.1.2 Systematic Sampling Systematic sampling involves choosing a starting point in the sampling frame at random and then choosing every nth unit (Marsh, 1992). For the sample to be representative, this method relies on the list being organised in a way unrelated to the subject of the study. However, this method has certain statistical peculiarities. Whereas the initial chance of selection of any unit is the same, once the first unit has been chosen, most units have no chance of inclusion and a few will be automatically selected. Similarly, most combinations of units are excluded from the possible samples that might be chosen. 3.3.1.3 Stratified Sampling Stratified sampling involves dividing the population into a number of groups or strata, where members of a group share a particular characteristic(s) De Vaus (1990). There is then random sampling within the strata. Sampling theory shows that in some instances, stratified sampling can 51

be more efficient than simple random sampling. This is because for a given sample size, the means of stratified samples are likely to be closer to the population mean (Marsh, 1992). This occurs when there is a relatively small amount of variability in whatever characteristic being measured within the stratum, compared to variability across strata. 3.3.1.4 Cluster Sampling Cluster sampling involves dividing the population into a number of units or clusters, each of which contains individuals with a range of characteristics (Moser and Kalton, 2001). The clusters themselves are chosen on a random basis. The sub-population within the cluster is then chosen. This method is particularly useful when a population is widely dispersed and large, requiring a great deal of effort and travel to get the study information. Cluster sampling has the valuable feature that it can be used when the sampling frame is not known. 3.3.2 Non Probability Sampling It is any sampling plan where it is not possible to specify the probability that any unit will be included in the sample. Some of the non probability sampling methods are summarized below. 3.3.2.1 Quota sampling Turner and Martin (1996) assert that in quota sampling, the strategy is to obtain representatives of the various elements of a population, usually in relative proportions in which they occur in the population. The common use of the term representatives in quota sampling has to be approached with care. They are representative only in number, not in terms of the type of units actually selected. All such means of gathering quota samples are subject to bias. Careful planning, experience and persistence can go some way in addressing obvious biases. 3.3.2.2 Convenience sampling Convenience sampling involves choosing the nearest and most convenient units to act as respondents up until the required sample size has been reached (De Vaus, 1990). This is probably one of the most widely used and least satisfactory methods of sampling. The term accidental sample is sometimes used but it is misleading as it carries some sense of randomness, whereas all kinds of largely unspecific biases and influences are likely to affect who gets sampled. 3.3.2.3 Judgemental sampling

52

The principle of selection in judgemental sampling is the researchers judgement as to typicality or interest (Moser and Kalton, 2001). A sample is built up which enables the researcher to satisfy her specific needs in a project. The rationale of this approach is very different from statistical generalisation from sample to population. It is an approach commonly used within case studies. 3.4 Sample Selection In this study a total of 55 individuals drawn from the 18 commercial banks in Zimbabwe constituted the sample. In picking samples, a convenience sampling technique was be used. Oakshott, L. (2001) stated that for a sample to be representative one needs to take at least 1% of the population. The researcher used a non-probability judgemental sampling strategy. The sample was selected in such a way that the chance of being selected within the population was unknown. Selection of subjects was subjective since the researcher used his experience and judgement on identifying participants who were knowledgeable on the subject matter to complete questionnaires. 3.5 Development of Research Instruments Saunders et al., (1997) identified three methods of collecting primary data, which are observations, semi structured and in-depth interviews and questionnaires. The researcher adopted the use of questionnaires and follow up interviews, where necessary, to allow respondents to record their own objective opinions based on the questions asked. The answers were then tested against secondary data discussed in the literature review section. The research will took into consideration validity, reliability and objectivity in the development of research instruments. In addressing these key issues about research instruments, the researcher carried out a pilot study before administering them in full to the sample. This was meant to assist in revealing any ambiguities, poorly worded questions, unclear choices and also to indicate whether the instructions to the respondents were clear (Fraenkel and Wallen, 1996). The feedback obtained from the pre-test was used in formulating the final research instruments. The researcher used the questionnaire as a data collection instrument because of its applicability to the positivism research design (Fraenkel and Wallen, 1996). The major advantage of using this instrument is that it can be administered to large numbers of people at the same time. This method is ideal, as it is cost effective and convenient in collecting data. The disadvantages of this method 53

is that it has a very low response rate since people have an anti-questionnaire phobia and also that the researcher is not readily available to provide clarity in areas of difficulty to respondents. 3.5.1 Questionnaires A questionnaire of 23 questions was dispatched to the target population. The instrument was developed on an extensive review of literature that examined challenges and opportunities of Basel II Accord. A sample of the questionnaire is attached (see Appendix I). Questionnaire construction and format included two broad types of questions:-

3.5.1.1 Open Ended Questions The essence of the study was to derive as much information as possible noting that an exploratory approach was used. Open ended questions afforded the researcher the opportunity to get new diverse ideas from respondents. 3.5.1.2 Closed Questions In questions which required guidance and limit participants along pertinent lines of thought, closed questions were applied. Closed questions analysis is easier because data will be categorised prior to data gathering. In view of the time constraints under which the research was expected to be complete, self administered questionnaires were be used noting the less time requirement these demand, minimum disruptions and convenience to respondents. 3.5.2 Face to Face Interviews Face to face interviews were also conducted. The researcher took a deliberate strategy of using face to face interviews to gather data from knowledgeable participants. The researcher felt that administering the questionnaire to individuals with expert knowledge would not encourage the generation of new ideas as they would also be limited to some extent by closed questions. The researcher anticipated that some intended respondents may not have been comfortable to give their responses in writing; hence the face to face interviews would give the researcher the opportunity to give some relevant background to the study and to clarify the purpose of the study. The researcher used the same questions in the questionnaire during the personal interviews so as to facilitate the analysis of the data. During the face to face interviews the researcher took some notes which were then be transcribed into the questionnaire format soon after each interview. Note taking and

54

transcribing of data was diligently done in order to minimise the chances of the researcher distorting the data by failing to recall responses given by the participants. Face to face interviews afforded the researcher the opportunity to judge the respondents comprehension of the issues at hand. With open-ended questions, the researcher was in a position to probe for additional information as well as seek immediate clarification where necessary. The researcher had the opportunity to provide more details on the scope and extent of some of the questions asked in order to allow the respondents to give better responses to the questions.

3.6 Data collection Procedure Bryman and Bell (2003), classified data into primary and secondary types. Primary data is data collected by you and your known/ assigned agents, especially to answer your research question. In this research the main source of primary data was the questionnaire. Secondary Data comes from studies made by others for their own research. It is useful for three main purposes - filling the need for reference or citation, keeping the researcher from reinventing the wheel and justifying the sole basis of the research;

The most common source of secondary data in this research was through libraries and online devices like the internet. Other secondary data sources included:

a) Reserve Bank of Zimbabwe, Banking Supervision Annual Report (2005); b) Reserve Bank of Zimbabwe Monetary Policy Statement, January and July 2009; c) Government of Zimbabwe Acts such as the Banking Act (1999; d) BCBS Working papers, guidelines and presentations by various authorities;

3.7 Data validity and reliability According to Wegner (2000), bias is seen as the tendency of a pattern of errors to influence data in an unrepresentative way. This can be due to selection procedure, structures and wording of questions, interviews or recording. Validity relates to the extent to which the data collection 55

method or research method describes or measures what it is supposed to measure (Wegner, 2000). Validity is a measurement consideration which is concerned with soundness; effectiveness and accuracy of the measuring instrument. Validity is an attempt to determine if the instruments used actually measures what is required to measure. The validity of test is the ability of the findings to be generalised. The researcher is convinced that the findings can be generalised since a large and representative enough sample shall be used. Sampling techniques used made it possible for results to be valid. Data collection tools used assured validity of the findings of the research. The combination of primary and secondary data ensured that findings could be generalised. 3.8 Pilot Study To test the reliability and validity of the questionnaire, the researcher carried out a pilot test with a small number of people similar to those in the main study population. The pilot study evaluated whether questionnaire items adequately addressed the concepts specified by the research objectives. Five questionnaires were distributed and the researcher took time to analyse each question to determine if all of them were answered correctly. Where questions appeared to be ambiguous and difficult to understand, necessary adjustments were made. 3.9 Ethical Considerations The research was in line with ethical guidelines, in that participation was voluntary and confidential. The respondents had a choice to participate or not to. The responses were be kept as confidential as possible and no names were asked for on the questionnaires to avoid any form of intimidation or suspicion. 3.10 Data Processing, Analysis and Presentation Questionnaires were assigned unique codes as they came back from the respondents. A data entry template was developed using Epi info 6. The data was analysed using the Statistical Package for Social Sciences (SPSS) version 12. The researcher opted for this package because of its ability to handle both quantitative and qualitative data. SPSS also has the capacity to provide a wider range of statistical parameters than most other packages. The process of data analysis involved:

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i) Grouping together of similar responses and assigning of codes for open ended question (coding); ii) Data capturing and cleaning; iii) Programme development; iv) Running the programme to produce statistical tables and graphs; The study results were be presented using tables, graphs and charts. These findings were then presented in chapter four, together with their detailed discussion. 3.11 Chapter Summary This chapter presented the methodology to be used in conducting the study. The research philosophy and design was also explained under the chapter. Primary data sources ware mostly used, as secondary data sources from a Zimbabwean context were still scanty given the fact that the Basel II Capital Accord is gradually being introduced in the country of study, since a global launch in June 2004. The techniques for data collection were also presented and the merits as well as the demerits of each brought to the fore. methodology applied were presented in Chapter 4. The results obtained through the use of the

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Chapter Four

Data Presentation and Analysis

4.0 Introduction The chapter presents the study findings and discussions from the questionnaire that was sent to the study respondents. The study findings were discussed in relation to the literature review of the study. These findings formed the basis on which the study conclusions were made. A total of 55 questionnaires were sent to the study respondents and 47 were successfully completed and returned representing a study response rate of 85% which is high enough to warrant the validity of the study findings. 4.1 Banking Experience This section sought to establish the time that the respondent had been in the banking sector and the results are shown in figure 4.1 below.

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According to the findings summarised in Figure 4.1 above most (49%) of the respondents have been in the banking sector for above 10 years, 31% 6-10 years, 13% 1-5years whilst only 7% had less than 1 year in the banking sector. This shows that most of the respondents have been in the banking industry for a long time, and hence, they understand the principles of banking and factors contributing to a banks stability well. Their contributions were valuable for the study as there were coming from experienced and well informed respondents. In addition most (39%) of these respondents were managers, 33% risk managers, 19% were HODs and 9% were directors. Most of the respondents were from decision making positions and hence may have influence towards the adoption of the Basel II requirements within their organisations. It can also be said that due to their positions all of the respondents were well aware of the Basel II requirements and hence their responses were from an informed perspective thus adding value to the study findings.

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4.2 Bank Ownership

The study findings reveal that the majority (59%) of the respondents were from foreign owned banks whereas the remaining 41% were from local banks. This shows a balance in the ownership of the banks involved in the study and hence the findings would reflect a true picture of the situation in the banking sector toward the adoption or implementation of the Basel II requirement. The study was also representative of the population of the study given the almost fair balance of the local and foreign banks involved in the study.

4.3 Progress with Basel II Capital Accord Figure 4.4 shows the progress that has been made towards the implementation of the Basel II capital accord.

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The study findings reveal that most (45%) of the respondents held that their organisations were at the initial stage of the implementation of the Basel II Capital Accord, 37% said medium stage and 18% said there were at an advanced stage. A further analysis would entail that most of the banks have made significant progress towards the implementation of the Basel II Capital Accord given that collectively (55%) of the respondents said they were at medium and advanced stage of implementation of the Capital Accord. The complexity of the Basel II Capital Accord, as well as its interdependencies with International Financial Reporting Standards and local regulation worldwide, makes implementation of Basel II a highly complex project. Foreign owned banks have made significant progress as they are now in the medium and advanced stages of implementation of the capital accord in line with parent banks certifications compliance requirements in the developed countries where their head offices are registered. Regulatory authorities under most developed jurisdictions demand that all subsidiaries be compliant as well if the holding bank is to be certified Basel II requirements compliant. The Global Basel Survey carried out by Ernst and Young (2007), indicated that up to 89% of senior banking executives are beginning to appreciate the long term business impact of the Basel II on the banking industry world-wide. Key anticipated benefits attracting bank executives include more dynamic portfolio management, greater use of derivatives and hedging as well as increased use of risk based pricing. For a bank, a project will be driven by the structure of its business, beginning with its strategy and encompassing its risk measurement and capital calculation methods, business processes, data 61

requirements, and IT systems. With a structured and disciplined approach, banks can begin to achieve the Basel Committee's intended benefits of enhanced risk management and lower capital requirements. Given the liquidity constraints that most of the banks were facing, it might have been difficult for the banks to adopt the Basel II Capital Accord as reflected by the few banks that are now at an advanced stage of its implementation. According to the KPMG (2003) to be able to implement Basel II sufficiently, most banks will need to rethink their business strategies as well as the risks that underlie them. Indeed, calculating capital requirements under the New Accord requires a bank to implement a comprehensive risk management framework across the institution. The risk management improvements that are the intended result may be rewarded by lower capital requirements. However, these large implementation projects also will have wide-ranging effects on a banks information technology systems, processes, people, and business beyond the regulatory compliance, risk management and finance functions. 4.4 Gap Analysis The respondents were asked if their organisations performed a gap analysis between current risk management practice and the new capital requirement. The survey results are shown in figure 4.5 below.

Majority (74%) of the respondnets concurred that their organisations have done a gap analysis whilst 26% were of a different view. There is enough evidence from the study findings that shows that the banks have carried out a gap analysis between current risk management practice and the new capital requirements. This enables the modelling of the impact of capital burden under the possible approaches and management decisions on credit and operational risk approaches and 62

credit risk mitigation techniques. This assists in coming up with a plan for the implementation of the Base II Capital Accord after realising the gap that exists between the practices.

4.5 Readiness for the Basel Requirements The respondents were asked on their assessment of the readiness of their organisation for the Basel II Accord with respect to the capital requirements.

From the study findings most (47%) of the respondents held that their organisations were partly prepared for the Basel II Accord with respect to the capital requirements, 29% said they were fully prepared and 24% were not yet prepared. The results are not conclusive on the readiness of the banking institutions to the Basel II Capital requirements. This is due to the fact that collectively, a majority (53%) suggested that they were partly and fully prepared. Building capital to reduce the risks and the costs of insolvency is the central feature of Basel II. Due to the economic turmoil that rocked the country for the past decade the operations of the banking sector were negatively affected as there were liquidity constraints within the banking sector and the economy as a whole. This therefore explains the reason why not many banks were ready for the capital requirements as prescribed by the Basel II Accord. On the same vain critics of the Basel II put forward that the Basel II Capital Accord may increase procyclicality and volatility of credit, both nationally and internationally. They argued that even some of the regulators participating in the Basel Committee have acknowledged the concern that risk-sensitive regulation requires banks to increase capital during economic downswings, reflecting the increased potential credit losses of their portfolios,

63

particularly because it is difficult to raise capital in slowdowns, this would lead to increased cost and reduced lending during slowdowns. This could accentuate the risk of a credit crunch and a deepening of the economic downturn via lower investment and demand and increasing risks to banking stability. Paradoxically therefore, Basel II could not only accentuate volatility of investment and output (so damaging for future growth, especially in developing economies); it could also increase the risk of systemic bank failures, that higher macro-volatility combined with risk sensitive models used simultaneously by all banks is likely to generate. 4.6 Basel II and Value Addition In this section the respondents were asked if the application of the Basel Accord adds value with regard to enhancing banks risk management policies and the results of the survey are presented in Figure 4.7 below.

The study findings reveal that most of the respondents (47%) strongly agree that the application of the Basel II Capital Accord adds value with regards to enhancing banks risk management policies, 33% further agree, 11% agree, 7% strongly disagree and an insignificant 2% remained neutral. From the study findings it can be said that Basel II Accord adds value with regards to enhancing the banks risk management practices, this is because the Accord sets out the capital requirements which encompasses all the aspects of the risk that the banking sector are faced with. One of the 64

main features of the Basel II accord is that it allows banks a wide choice of regulatory regimes for the assessment of both credit and operational risk, the most advanced of which rely on banks internal risk models to calculate appropriate risk charges. 4.7 Level of Basel II Capital Accord Awareness The level of staff and management awareness of the Basel Accord is presented in Figure 4.8 below.

From the study it is clear that most of the organisations have educated their staff on the Basel Accord as shown by the level of awareness which according to majority (53%) of the respondents is said to be moderate, 16% said it is very high whereas 31% thought it was low. For the successful implementation of any change effort in any an organisation it requires that everyone in the organisation to be aware of the changes to be implemented and their effects on the way things were done. Making aware the change to the employeees would ensure their commitment to the change effort and also that results in the availability of accurate data for the change to be instituted successful. The same also goes for the adoption of the Basel II Accord as this mean changes to risk management of the organisation. In internationally owned banks, the Basel II awareness is much higher than in indigenous banks. As an example, at one of the commercial banks owned by Nedbank South Africa, (MBCA Bank Limited) all staff members underwent a Basel II awareness course organised by the holding company to achieve uniformity in awareness level in all its subsidiaries, in-order to satisfy South Africa Reserve Banks (SARB) regulatory requirements. The bank has put in place the necessary 65

Basel II Framework in anticipation of the regulatory authority further requirements. All new staff members are trained on Basel II as part of the induction processes. Hence the general level of awareness was in particular high at this institution. 4.8 Degree of Priority for Basel II This section sought to establish the degree of priority that Banks in Zimbabwe attached to address the Basel II regulatory framework.

According to the findings half of the respondents said that Banks in Zimbabwe viewed adoption of the Basel II framework as important, 43% as very important whilst an insignificant 7% viewed as not important. These findings are also confirmed by the fact that almost all (94%) of the respondents concurred that the banking institutions in Zimbabwe view the Basel regulation as an opportunity rather than as a constraint to their operations. This therefore explains the degree of priority that is attached to the implementation of the regulation by the banking institutions. Of the banking institution that attached high priority (very important) 75% of them were foreign owned banks. Given the opportunities that the Basel II framework brings to the banking sector high priority should therefore be attached to its implementation. Implementing Basel II in the local sector offers various benefits and opportunities for the local financial services sector. According to KPMG (2003) Basel II encourages banks to improve their systems for managing risks as well as their due diligence procedures and also it gives banks and supervisors a vital tool Pillar 2, with which to assess the risk profile of institutions and in particular to take account of certain risks that are sometimes difficult to quantify but whose impact can be great such as interest rate risk, refinancing risk and reputational risk. 66

Basel II sets out to promote stress tests as one of the tools for managing and assessing risks (Mazingaizo, 2010). Basel II stipulates that the stress tests conducted by banks must incorporate the effects of a large increase in credit and market risks as well as those of a rise in liquidity risk. With the rapidly changing developments in global financial markets and financial innovation, local financial institutions will need to continue investing in robust management of capital, improving risk management structures and practices commensurate with their risk appetite. In light of the above it therefore presents the need for the banking institutions to highly prioritise the Basel II capital accord implementation.

4.9 Challenges of Basel II Implementation Table 4.1 shows the challenges that the Banking institutions are facing towards the implementation of the Basel II Capital Accord. Table 4.1 Challenges of Basel II implementation Challenges Data and Systems infrastructure management Lack of skilled resources to keep Basel II standards Increased disclosure requirements Improvements to the credit processes Lack of time Implementation cost % of respondents 51 75 53 34 25 87

The challenges that the banking institutions are facing towards the implementation of the Basel II Accord are implementation cost (87%), lack of skilled human resources to keep Basel II standards, data and systems infrastructure management (51%), increased disclosure requirements (53%), improvements to the credit processes and 25% said lack of time. The respondents further added that the other challenges that the sector is facing towards implementation of Basel II Accord is that government policy tends to be at variance with what the banking sector needs in order to build a world class financial sector, for example the indigenisation laws which tend to shy away investors who would finance the implementation of the Basel II regulation and also that liquidity problems are a major concern. Already the technical guidance issued by the Reserve Bank of Zimbabwe requires that the core capital of a banking institution should exceed 50% of the capital base of the 67

institution. Although this is meant to strengthen the capital base for an institution, it might be a challenge for local financial institutions to meet these requirements. An analysis of countries across the world that have fully or partially implemented Basel II has revealed that compliance with Basel II is fraught with the following challenges: i. Lack of resources and qualified personnel in modern risk modelling approaches: Banks are required to make relevant budgets for Basel II implementation and this should cover IT requirements and all the training requirements. In some instances banks have been hiring consultants to assist them with Basel II. It is a fact that there are few professionals in Zimbabwe with qualifications such as CFA, which are important risk qualifications laying the foundation for easier implementation. Most of those that have acquired such have left the country in search of greener pastures. ii. Executive ownership and change management: Implementing Basel II will require high level management commitment and may require changes to risk management in any institution. Typically a project management team reporting to the Managing Director and the Board will have to be in charge of the implementation process. Hard questions on internal impact, customer impact, business impact, regulatory impact and market impact will need to be asked throughout the implementation process and post implementation. This is in line with Helbekkmo et al. (2005) who argued that Basel II adoption is faced by the challenges of improvements to the credit process - re-engineering internal credit rating systems using both default probability and transaction structure without destroying underlying knowledge, accurate credit risk factor estimation and calibration across many different portfolios - measuring risk factors can be quite challenging. Finding the right data gathering and calibration strategy for different portfolios can also prove to be an impediment. An appropriate model customised scoring models must be applied and finding the most suitable tools and processes for specific task of calculating risk capital and estimating the amount of capital for holding against operational risk. An efficient strategy for data gathering and management - working out which data is useful to solve a problem at hand and how efficiently gathering data are hurdles to be considered. Tarusenga (2007), concurred with the fact that data availability and its management to date is very often cited 68

as one of the major problems to implementing the Basel II risk control framework. An overarching economic capital framework for enterprises risk management - banks that do not as yet have in place robust economic capital framework find it hard for them to comply with Pillar I and Pillar II. 4.10 Opportunities from Basel II Implementation This section sought to establish the opportunities that banking organisation would enjoy as a result of the Basel II Capital Accord full implementation. The research findings are presented in Table 4.2 below. Table 4.2 Opportunities from Basel II implementation Opportunities Improved quality of risk disclosures Allocation of capital more efficiently Integrated data management Support for supervisory reviews Better risk adjusted pricing models Banks improved safety and soundness % of respondents 63 61 39 44 53 57

According to the findings summarised in Table 4.2 majority of the respondents (63%) concurred that the opportunities that are likely to be accrued by fully implementing Basel II accord is improved quality of risk disclosures, 61% said capital is allocated more efficiently, 57% said banks safety and soundness is enhanced/improved and 53% said it provides better risk adjusted pricing models. Basel II, will assist banking institutions to better assess and manage risks linked to securitisation transactions and to improve their financial reporting, two crucial areas in which the 2007-2009 global financial crisis have highlighted that significant progress needs to be made. With the rapidly changing developments in global financial markets and financial innovation, local financial institutions will need to continue investing in robust management of capital, improving risk management structures and practices commensurate with their risk appetite. Basel II is providing an opportunity to fundamentally overhaul their business processes. Fifty-five percent of banks interviewed for the Oracle study say that through their efforts to get ready for Basel II they expect to be able to merge their risk management and finance functions. Basel II compliance is clearly stimulating banks to think about how they could run their businesses more efficiently. The pressure on banks to centralize on one standard set of data as a consequence of 69

Basel II opens up a wealth of additional possibilities, both for streamlining business processes and creating innovative new products. In addition, banking operations that will run on a single instance of data as a result of Basel II compliance initiatives are able to interact with their customers at a much more intelligent and innovative level. It appears likely that banks not only adopt more sophisticated measures for managing credit risk, leading to more efficiency and stability in the market, but will use the opportunity provided by Basel II compliance measures to think about how they can build on their existing operations through the use of strategic differentiators. 4.11 Advantages of Implementation of Basel II The advantages of implementing Basel II standards are shown in Table 4.3 below Table 4.3 Advantages of implementation of Basel II Advantages % of respondents More flexibility-individual approach to banks 59 Use of internal models for risk management and for calculation of 65 capital requirements Lower capital requirements 44 The advantages of Basel II Accord according to most (65%) of the respondents is that it enhances the use of internal models for risk management and for calculation of capital requirements, 59% said it ensures more flexibility as it employs individual approach to banks and 44% said lower capital requirements. Compliance with Basel II will require increased capital commitments from all banks, as well as increased transparency and reporting to both regulators and the marketplace. To conform to these regulations, financial services firms are expected to rely heavily on new technology infrastructures. The more successful banks are likely to secure considerable competitive advantage by reducing their regulatory capital requirements, thus increasing their capital. By the same token, financial services providers that fail to create the necessary IT environments will operate at a significant competitive disadvantage. Basel II is providing an opportunity to fundamentally overhaul their business processes. Basel II compliance is clearly stimulating banks to think about how they could run their businesses more efficiently. The pressure on banks to centralize on one standard set of data as a consequence of Basel II opens up a wealth of additional possibilities, both for streamlining business processes and creating innovative new products. In addition, banking operations that will run on a single instance of data as a result of 70

Basel II compliance initiatives are able to interact with their customers at a much more intelligent and innovative level. It appears likely that banks will not only adopt more sophisticated measures for managing credit risk, leading to more efficiency and stability in the market, but will use the opportunity provided by Basel II compliance measures to think about how they can build on their existing operations through the use of strategic differentiators. According to Weder and Wedow (2006), the adoption of Basel II allocates capital more effectively thereby enhancing risk management by requiring changes in an organisations technology and business processes. Other benefits to accrue to banks that embrace Basel II requirements are as follows: Basel II is intended to improve the safety and soundness of a financial system by placing increased emphasis on a banks internal control and risk management processes and models, the supervisory review process and market discipline. Basel II substantially changes the treatment of credit risk and also requires that banks have sufficient capital to cover operational risks. Calculating capital requirements under Basel II Accord requires a bank to implement a comprehensive risk management framework across the institution. The risk management initiations are rewarded by lower capital requirements. 4.12 Appropriateness of Basel II Accord to Zimbabwe Sixty of the respondents believe that the Basel II Capital Accord can be applied in developing countries such as Zimbabwe irrespective of the fact that it was a tool developed in industrialised countries. Forty of the responses did not agree to the fact that the Accord is appropriate for developing countries, citing that, in the developing world, the tool is appropriate for internationally owned banks whose registered head offices are in developed jurisdictions.

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No 40% Yes 60%

Figure 4.10 Appropriateness of Basel II Accord to Zimbabwe

4.13 Categories of Banks that have Benefited from Basel II in Zimbabwe Table 4.4: Categories of Banks that have benefited Bank Category International banks operating in Zimbabwe Indigenous and newly formed banks None at all All Banks % Responses 68% 12% 5% 15%

Findings shown in Table 4.4 clearly demonstrate that there is a general belief that international banks operating in Zimbabwe are the ones which have realised most benefits accruing from Basel II implementation since its introduction in the country in 2004. International banks operating in Zimbabwe have taken the lead by being pro-active and being sensitive to world class capital management techniques whilst indigenous banks have tended to trail behind in the process. Whilst most indigenous banks are being encouraged to start implementing the initial phases, internationally owned banks are now beginning to reap first more advantages from the strategic, business and financial performance aspects of the Accord. The impact of holding risk based capital on the financial performance of banks is illustrated in Figure 4.11 below. This information is based 72

on a face-to-face interview that the researcher had an opportunity to hold with one of the respondents from Standard Chartered Bank of Zimbabwe. The illustrative example was based on three live loans of the same amounts but different risk profiles.

Return on Capital Under Varying lendings categories

16% 14% 12%
Capital (%) 32% Return on Capital (%) 28% 24% 20% 16% 12% 8% 4% 0% Low risk lending High risk lending Medium risk lending

10% 8% 6% 4% 2% 0%

Basel I Capital Requirement Return on Capital Under Basel I

Basel II Capital Requirement Return on Capital Under Basel II

Figure 4.11: Illustration of the impact of Basel II on a banks financial performance The illustration demonstrates that under Basel I, regardless of the risk profile, the capital requirement remains flat at (10%) whilst under the Basel II Accord, capital requirements tended to vary depending on the risk profile, hence optimising performance on the return on capital.

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4.14 Level of RBZ Contribution

Low

72%

Moderate

23%

Very high

5%

0%

20%

40%

60%

80%

Figure 4.12 : Level of RBZ contribution The majority of the respondents (72%) were of the opinion that the RBZ as the leaders in monitoring and supervision of commercial banks must increase its involvement in the Basel II rollout programme. The study, however, revealed that RBZ is also working on implementation rollout challenges which include the need for well-trained, educated professionals to fill roles that are traditionally not as well paid as comparable within the commercial banking services sector, creation of regulation that will demonstrate the linkages among risks and providing incentives for banks to evaluate risks through stress-testing and scenario analysis. SARB adopted a strict deadline under which all banks in South Africa had to be compliant with the Banking Act and accompanying Regulation relating to Banks which, with effect from the 1 st of January 2008, is based on Basel II. Nedbank Group (2006), noted that due to upholding risk standards high, South African Banks are regarded highly world-wide. The RBZ embarked on a gradual phased roll out programme which entails divided commitment to the implementation process. Hence, the call made by the majority of the respondents that a higher level of commitment and contribution be demonstrated by the central bank in Zimbabwe.

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4.15 Chapter Conclusion The chapter has presented findings on the progress that has been made in the economy towards implementation of the Basel II Accord in the banking sector and the readiness of the banking sector towards the implementation of the Basel II Capital Accord. Findings on Basel business value, level of awareness, challenges, opportunities and advantages of Basel II were also presented. These findings formed the basis on which the conclusions were made. The next chapter presents the study conclusions and recommendations.

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Chapter 5

Conclusions and Recommendations

5.0 Introduction This chapter presents the study conclusions and recommendations. The chapter will either accept or refute the study proposition and finally the chapter will present the area of further study. The study was able to address the research objectives, questions and problems by revealing that even though Basel II has its implementation challenges, its opportunities if tapped into, will provide answers to the puzzle of modern day capital adequacy management problems. Basel II Capital Accord brings about a comprehensive set of new rules to the game of commercial banking in Zimbabwe. The new Accord is much more than a new formula for calculating regulatory capital as it seeks to improve risk management, banking regulation and supervision around the world. While vast and complex, the new rules are simply about best practise as they cover all relevant issues for risk management and banking supervision. For all commercial banks in Zimbabwe to be stable, they need to understand, measure, manage and optimise true economic risks inherent in their balance sheets. Basel II provides the catalyst to truly transform commercial banks to become world class at risk and capital management given that risk-taking is at the core of commercial banking institutions. Under Basel II, risk drives capital requirements. The study confirmed that risk taking is inherent in providing commercial banking services worldwide and in Zimbabwe. The identification, assessment and management of various risks which include capital risk need to be constantly varied in line with global trends using techniques such as the Basel II Capital Accord in mitigating the need for policy paradigm shift from old to modern mechanisms of risk management. There is sufficient evidence to support the view that the introduction and implementation of the Basel II Accord posses some challenges, which require a holistic approach in addressing for the benefit of all commercial banks in Zimbabwe. Despite the problems highlighted, the study demonstrated that the Basel II Accord has merit and its importance 76

continues to be regarded highly by mostly internationally owned banks since it was introduction in Zimbabwe. The study also highlighted that bank monitoring and supervision policies that were in place prior to the introduction of the Basel II Accord now need to be revamped by incorporating value laden modern advance strategic risk management tools such as Basel II. However the policies set need to be enforced constantly and diligently. 5.1 Conclusions of the Study The study presents the following conclusions i. Most of the banks have made significant progress towards the implementation of the Basel II Capital accord, given that most of the banks were at medium and advanced stage of implementation of the Capital Accord. The complexity of the Basel II Capital Accord, as well as its interdependencies with International Financial Reporting Standards and local regulation worldwide, makes implementation of Basel II a highly complex project for Zimbabwes commercial banks. The banks are faced with implementation challenges such as high implementation costs, lack of skilled human resources to keep Basel II standards, data and systems infrastructure management and increased disclosure requirements. In addition, government policy tends to be at variance with what the banking sector needs in order to build a world class financial sector, for example, the indigenisation laws which tend to drive away investors who would finance the implementation of the Basel II regulation. Liquidity problems are a major concern.

ii.

There is a moderate level of Basel II Capital Accord awareness within the staff and management of the banking institutions. This shows that Banking instititutions in Zimbabwe have generally done a fair bit of awareness campaigns of the Basel Accord within their organisations.

iii.

The opportunities that are likely to be accrued by fully implementing Basel II accord are improved quality of risk disclosures, capital is allocated more efficiently, banks safety and soundness is enhanced/improved and it provides better risk adjusted pricing models. With the rapidly changing developments in global financial markets, local financial institutions 77

will need to continue investing in robust management of capital, improving risk management structures and practices commensurate with their risk appetite. Basel II provides an opportunity to fundamentally overhaul their business processes. Basel II compliance stimulates banks to think about how they could run their businesses more efficiently.

iv.

Basel II has proved to be an effective tool of capital risk management for financial stability in many jurisdictions worldwide. In the quest to solve the research problem, the researcher noted that even though Basel II was originally designed to strengthen the solvency problems of internationally active banks, banking institutions in Zimbabwe can successfully adopt it with or without amendments.

v.

The study also noted that whilst the banking industry players in Zimbabwe are generally aware and appreciate the usefulness of the Basel II Accord, implementation approaches by commercial banks are mostly still weak across this industry in Zimbabwe, demonstrating the need for a collaborated RBZ/banking industry efforts to move with speed in effecting required changes to capital risk management rules currently in operation.

vi.

Locally owned banks levels of appreciation and awareness was noted to be still low compared to internationally owned banks which have to play according to the dictates of their holdings companies in the developed world, where Basel II certification requires subsidiary banks to confirm compliance as well. In most local banks, small pockets of staff which is knowledgeable about the Accord exist. These include Senior Bank Management staff under the risk, compliance, legal and governance section of the commercial banks.

vii.

Strategically, the researcher noted that the Accords implementation by both locally and internationally owned banks provide a competitive edge. As risk management is at the core of banking business, the need to view it as an enabler was highlighted. Generally in Zimbabwe, the study noted, Basel II strategic implications since 2004 are yet to be realised noting that the majority of the banks during the period under review found it difficult to 78

come up with a strategic budget for Basel II implementation, as survival strategies and funding were key for banks. Zimbabwes decaying economy during the period under review meant that most banks had to grapple with negative macro-economic fundamentals such hyper inflation and foreign currency shortages as top priorities. Internationally owned banks are ahead in the implantation process, due to, amongst other reasons support from holding companies who viewed total Basel II compliance as a strategic move for all their subsidiaries. viii. Implementation opportunities investigated and analysed demonstrated that the Basel II Accords successful implementation is hinged to a large extend on the regulatory authorities implementation programme in Zimbabwe, since the basis of the model of the Accord is that banking institutions will have to follow local regulatory authorities implementation programme requirements. The study also revealed that internationally owned banks are far ahead of indigenous banks in terms of implementation stages reflecting the seriousness of ensuring financial stability and soundness for banking stakeholders. All internationally owned banks in Zimbabwe have put in place the necessary framework for Basel II implementation, but RBZ as the regulatory authority has taken the route to gradually rollout the Accord in sympathy with indigenous banks low levels of preparedness.

ix.

The research shows that whilst there is increased activity towards Basel II implementation, most locally owned commercial banks are yet to reap its benefits, noting that they are still in the initial stages of the accords implementation. Whilst Basel II is noted to be generally applicable in Zimbabwe, general levels of awareness in indigenous commercial banks remains low, and this is hampering implementation progress.

In summary, it can therefore be said that Basel II on the whole is a step forward for the banking sector in Zimbabwe. It is for the good of the banks, that adopting Basel II has become mandatory in Zimbabwe. It will help the local banks to match up to the international standards 79

and enable them to complete with international banks. Today, when it is very competitive for any bank to survive, with the so many players on the market, it is very important to take any opportunity coming in the way which will help to take the system a step ahead. Hence, if any bank with lack of financial and technical skills is unable to adopt Basel II, it will lag behind from the ones who will be adopting it as it will give an edge to the banks who will be operating under the regulations of Basel II.

5.2 Recommendations of the Study The study was able to suggest solutions to the research questions proposed. In view of the major findings of this study and conclusions, the following broad recommendations are presented: i. The study noted that adopting the Basel II Capital Accord protects investors capital much better than Basel I as already proved in jurisdictions studied under this study. It is against this background that Basel II is a world class modern capital risk management tool which must be implemented as a mandatory way of protecting investors capital. Basel II was noted to have strategic, business and financial implications which are centred on core banking activities (lending money and deposit taking) and other operational financial services which involve credit risk, market risk and operational risk management. ii. A mandatory awareness campaign programme must be imposed to all Zimbabwean commercial banks staff in Zimbabwe to enable them to understand Basel II Capital Accord as an opportunity and a means to of raising the operations bar to international standards through, improved risk management, transparent performance measurement both internally and externally, as well as addressing the portfolio economics inherent in the local market. Educating stake holders must place emphasis on the fact that Basel II is a catalyst to proper risk based capital requirements. Staff that work in Risk Management, Legal, Compliance and Governance Departments must go for comprehensive training which will assist in coming out with rollout plans suitable for different banking institutions in the country. The RBZ must partner with Universities, Colleges and other training institutions on the training aspect in the process of rolling out Basel II projects to improve the skills 80

base. For example, establishing comprehensive Basel II e-learning products, covering different courses on the new Accord will benefit bank staff and other interested stakeholders. iii. Some banks, for example, MBCA Bank Limited, have made it mandatory for all their staff to go through an Anti-Money Laundering awareness course, at the end of which an evaluation test must be passed. In the same way, RBZ may make it mandatory for all bank employees to attend at least an awareness programme as a pre-employment condition inorder to raise awareness levels.

iv.

For the successful implementation of any change effort in any organisation, everyone in the organisation should be made aware of the changes to be implemented, and their effects on the day to day operations. In this light, banks need to employ proper change management techniques for Basel II implementation, to help staff accept the changes that it brings about. Creating increased awareness for Basel II will earn employees buy-in and adequate support for its implementation projects from all staff members. In addition, the banks should seek Basel II buy-in at board level, to ensure full stakeholder support.

v.

As has been witnessed in Zimbabwes banking past, failure of a bank due to capital inadequacy problems triggers knock-on effects to other banks liquidity positions throughout the market. There is therefore need for moving with pace in the implementation of the Basel II Capital Accord by all commercial banks in the country. The collapse of one bank due to non compliance with the Basel II Accord requirements can result in the erosion of the industry benefits of its implementation. In this regard, the RBZ, as the regulator must take full ownership of the project, provide incentives and support to the banks, as well as move with speed in the implementation process. Annual progress reviews for all the banks should be put in place, as part of RBZ supervision, and timeframes must be agreed upon, depending on the position of a bank in the Basel II implementation journey. This will force banks to give Basel II implementation the attention it deserves. 81

vi.

Zimbabwes big international banks which are ahead in the Basel II implementation process should be encouraged to share information on Basel II implementation with indigenous smaller banks, for a fee if necessary, in the spirit of improving industry stability, which will be beneficial to all players in the industry.

As Zimbabwean commercial banks are working on accessing international capital markets following transition to the multicurrency regime in February 2009, Basel II will play a big role in the process by improving the local banks ratings. In light of this e, all stakeholders in the Basel II projects in Zimbabwe need to move in tandem with internationally accepted risk management techniques if the commercial banking sector is to remain relevant in Zimbabwes future. The need to implement the Basel II accord cannot therefore be over-emphasised.

5.3 Suggestions for Further Studies Other researchable issues of interest include a critical analysis of the appropriateness of the Basel II Accord in managing capital risk under different pro-cyclicality economic regimes. Certain schools of thought have already suggested introducing Basel III to counter weaknesses noted so far under Basel II during the Global Financial Crisis and this area can be explored through research. Given that Basel II in Zimbabwe has focused on the Banking industry only, studies can also be done on adoption feasibility of Basel II application to non banking institutions. In post implementation period, it will be interesting and important to study the actual impact of Basel II implementation on the Zimbabwe commercial banking sector.

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Appendices Appendix (i): Cover Letter 8150, Cold Comfort Tynwald Harare 3rd December 2010 92

Dear Sir / Madam Ref: Research Questionnaire on Basel II Capital Accord As part of my Masters in Business Administration degree programme with the University of Zimbabwe, I am conducting a research entitled: Basel II Capital Accord: A critical analysis of its application, suitability and implementation in Zimbabwes commercial banks (2004 2010). To this end I kindly request your assistance by responding to this questionnaire. Your response will be treated as confidential and will not be used for purposes other than those intended for the research. Should you need any clarifications with regard to matters relating to the questionnaire, please contact me on 077 3 806 622 or alternatively on my email address: Augustinzu@mbca.co.zw. Should you be interested in the findings of the study, please indicate at the end of the questionnaire. Thank you in advance for your time and assistance. Yours faithfully, Augustin J. Zulu Appendix (ii) QUESTIONNAIRE ON BASEL II CAPITAL ACCORD

Part I - Details of the respondent Banking Experience (Tick the applicable) a) Less than 1 year b) 1-5 years c) 6-10 years d) Above 10 years [ [ [ [ ] ] ] ] 93

Position in Organisation General Information Bank Ownership a) Local b) Foreign

____________________________

[ ] [ ]

Part II Commercial Banks Awareness of the Basel II Capital Accord 1. How far, in your opinion has your organisation progressed with the implementation of the Basel II Capital Accord? At Initial Stages Medium Stages At Advanced Stages

2. Have you done a gap analysis between current risk management practice and the new capital requirements? a) Yes [ ] b) No [ ]

3. What is your assessment of your readiness for the new Basel proposals with respect to capital requirements? a) Fully prepared [ ] b) Partly prepared [ ] c) Not yet prepared [ ] 4. The application of the Basel II Capital Accord adds value with regards to enhancing banks risk management policies. On a scale of 1 to 5 indicate by circling whether or not you agree with this statement, where: = = strongly disagree disagree 94

= = =

neutral agree strongly agree

5. In your opinion how do you rank the level of Basel II Capital Accord awareness by staff and management in your organisation? Very high b. Moderate c. Low

6. How does your bank perform education of its employees in areas relevant for Basel II? (You can select more than one answer) a) Internally training within the bank b) On the level of the group that the bank belongs to c) By means of seminars held by experts from other institutions d) With assistance of external consultants e) We do not organize training [ ] [ ] [ ] [ ] [ ]

7. Do you view Basel II regulation as an opportunity to enhance the risk management process, or as a regulatory constraint? a) Opportunity [ ] b) Constraint [ ]

8. What degree of priority do you address to the new Basel regulatory framework? a) Very important [ ] b) Important [ ] c) Not important [ ] 9. In your view what sort of challenges are being faced by commercial banks that are working towards Basel II Accord implementation in Zimbabwe? 95

a. b. c. d. e. f.

Data and systems infrastructure management Lack of skilled resources to keep Basel II standards Increased Disclosure requirements Improvements to the credit processes; Lack of Time Implementation cost

Other challenges: _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _______________________________________________________________ 10. In your own opinion what can be done to counter challenges highlighted under Question 9. above____________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ __________________________________________

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11. What opportunities are likely to accrue to your organisation as a result of the Basel II Capital Accord full implementation in Zimbabwe? How do you rank realisation of these benefits by your bank [1=very high; 2=average and 3=not at all] a. b. c. d. e. f. Improved quality of risk disclosures [1] [2] [3] [1] [2] [3] [1] [2] [3] [1] [2] [3] [1] [2] [3] [1] [2] [3] Allocation of capital more efficiently Integrated data management Support for supervisory reviews Better risk adjusted pricing models Banks improved safety and soundness Other opportunities (please specify) ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ________________________________________________________________________ ___________________________________ 12. Do you think that Basel II is more appropriate for developing countries banking sectors? a. Yes Why? _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ ______________________________ 13. In your opinion, which of the following category of banks have benefited from the Basel II Capital Accord since it was introduced in 2004? (Tick one option) a. b. International banks operating in Zimbabwe Indigenous and newly formed banks 97 b. No

c. d. Why?

None at all All Banks

_________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ ______________________________ 14. How do you rate the level of contribution by the regulator Reserve Bank of Zimbabwe towards ensuring banks compliance with the Basel II Capital Accord? a. Very high b. Moderate c. Low

15. Which approach will you be ready for? a) Standard approach [ ] b) Foundation approach [ ] c) Advanced approach [ ] 16. Which approach best suits your organisation? a) Standard approach [ ] b) Foundation approach [ ] c) Advanced approach [ ] d) Dont know [ ] 17. What difficulties do you foresee in implementing the Basel II requirements? a) Integration capabilities [ ] b) Database Design [ ] c) Models [ ] d) Budget High capital requirements [ ] e) Data gathering [ ] f) Human resources [ ] g) Other, specify [ ] 18. The priority attributed to the implementation of Basel II by the management of your bank can best be described as: a) High [ ] b) Medium [ ] c) Low [ ] 98

d) Not a priority

[ ]

19. What do you see as possible advantages of the implementation of Basel II standards? a) More flexibility individual approach to banks [ ] b) The use of internal models for risk management and for calculation of capital requirements [ ] c) Lower capital requirements [ ]

20. In your own view, what sort of policy recommendations can you suggest to the Reserve Bank of Zimbabwe over implementation of the Basel II Accord by commercial banks in Zimbabwe? _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ __________________________________________

21. In what ways can your bank effectively adopt the Basel II requirements? _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ _________________________________________________________________________ ________ END OF QUESTIONNAIRE THANK YOU

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