Although Basel III has more regulations than the ones stated but the question in everyone’s mind is that Basel II was supposed to protect us from crises like the one in 2008, so how can we be sure that Basel III will succeed where Basel II didn’t?
In the ever evolving financial world it’s no surprise that industry experts have ventured to Basel III. Its efficacy, however, is yet to be judged by its critics and proponents alike. But why did the experts felt a dire need to create this new Basel III, let’s review some of the reasons.
Why it came about?
In simple words: because Basel II accords were insufficient to prevent banks from excessive risk taking, resulting in the financial crisis of 2007–2008.
So what’s new in Basel III?
For one thing, it tightens banks’ capital requirements. It also requires higher weights for risky assets bringing more assets under the Risk Weighted Assets (RWA) calculations, which itself is modified under the new accords and is even said to demand a higher quality of capital; although how they’re going to achieve that last one is bit dicey. Basel III also tightens liquidity requirements and is expected to be implemented in phases with full compliance in 2019. A common list of what Basel III has changed versus Basel II is given below:
Common equity requirement 2%
Raised to 4.5%
Tier 1 Capital 4%
Raised to 6%
Tier 2 Capital 4%
Reduced to 2%
Can include hybrid capital requirements
Tier 1 capital can no longer include hybrid capital requirements
Tier 3 Capital requirements
Tier 3 capital eliminated
No capital conservation buffer
Introduction of capital conservation buffer at 2.5% of tier 1 equity
No counter cyclical buffer
Introduction of counter cyclical buffer at 0 to 2.5% of Risk Weighted Assets during high credit growth.
Trade finance risk weight increased to 100%
Liquidity coverage ratio to be increased to greater than 100% (requires a bank to hold sufficient liquid assets to cover its total net cash outflows over 30 days.)
Leverage ratio to be greater than 3%
Results of stress testing to be reported in financials
Credit valuation adjustment capital charge to be applied to cover Mark-to-market losses on risk to OTC derivatives.
Net Stable Funding Ratio to be greater than 100% (requires available amount of stable funding over a one-year period of extended stress)
Although Basel III has more regulations than the ones stated but the question in everyone’s mind is that Basel II was supposed to protect us from crises like the one in 2008. Not to sound cynical but that failed, so how can we be sure that Basel III will succeed where Basel II didn’t? Well for one thing, regulation is an ongoing, evolutionary process. Basel III is meant to plug in the holes left by Basel II. However, the more holes we plug in, the more new ones seem to pop up or more accurately, the ones overlooked become visible. The world economy and financial markets are dynamic and eve revolving ecosystem with players of all kinds.
In military aircraft training, pilots talk about countermeasures to missile fire, and then there are counter-countermeasures and then those counter-countermeasures have countermeasures of their own and so on. For example, a heat seeking missile has a countermeasure called flare deployment meant to confuse the missile. So the counter-countermeasure tells the missile computer to seek the heat signature which is higher i.e. that of the jet. So the pilot again deploys flares which have a higher heat signature and then the missile computer tells it to target the lower heat signature (the counter-counter-counter-countermeasure) and so on. Although this is just an empirical example, the purpose is to illustrate how banks and regulators, in the world of finance, will always find loopholes to increase their bottom-line, and someone will then try to plug in those loopholes, and then the newer, unnoticed loopholes will be found and then those will be plugged and so on ad infinitum. The process will go on; the point is not to find a perfect system that would cause our search to come to a standstill but rather a journey that sees us evolve with changing circumstances. The important thing in this ever evolving process is due diligence that be maintained at all times.
Shahan Arshad is a final year MBA student at KSBL(Karachi School for Business and Leadership). You can find him on Twitter @Shahankhan8
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