What is it?

A set of reforms to improve regulation, supervision and risk management in the banking sector.

Why do we need it?

The financial system is regulated to protect investors, ensure the solvency and soundness of financial institutions, keep efficiency and transparency in the markets as well as ensure a stable financial system. Regulators are there to reduce the risk of failure and contain any situations that occur. Micro-prudential regulation aims to limit the risks within intermediaries in order to reduce the possibility of an individual institution’s failure. This is the traditional regulation used before the 2007-2009 crisis, but failed to prevent systemic risks.

The financial crisis showed that not all institutions held sufficient capital and that the quality of the capital was sometimes poor and not available to absorb losses as they materialized.

Macro-prudential regulation aims to make institutions internalize the costs that their behavior imposes on others. It is now the focus of global regulators. Capital requirements may vary according to the intermediary’s contribution to systemic risk or with the business cycle—with a higher requirement in upswings to create a capital buffer against shocks. Institutions may also be required to take out extra insurance or to issue contingent convertible bonds. Due to macro-prudential regulation, some progress has been made in moving the world’s over the counter (OTC) derivatives markets to a centralized infrastructure.

Where does it come from? Capital requirements monitor a bank’s balance sheet by requiring that they hold a minimum level of capital and restricting the types of assets a bank can hold. The idea is that the capital buffer will help institutions absorb shocks and losses without going insolvent. Under the risk-based capital requirements of the Basel accord of 1988, minimum capital standards were linked to off-balance-sheet activities such as loan commitments and trading positions in futures and options. The Basel accord required that banks hold capital of at least 8% of their risk-weighted assets (RWA). Basel II tweaked the capital requirement to be based on the assets held by the individual bank. It however didn’t place enough importance on macro-prudential and systemic risk.

What changes does it bring?

The reforms in Basel III include a new definition of capital. The revisions made to raise Tier 1 capital’s quality and quantity (now 6%) should help prevent financial institution insolvency. Those in Tier 2, simplifying and reducing it to 2% of RWA, will help make sure depositors and senior creditors are repaid should failure occur. Tier 3 capital was removed all together. Aside from increased capital requirements, Basel III introduces stressed value-at-risk capital requirements for re-securitization; the introduction of a capital charge for potential mark-to-market losses and higher capital requirements for OTC derivatives.

The introduction of a leverage ratio, to be used in addition to the risk-based capital framework of Basel II, will be up to individual regulatory bodies to apply at their discretion.  The proposed new global liquidity standard entails a liquidity coverage ratio that requires the availability of high-quality and highly-liquid assets to exceed the net cash outflows of the next 30 days. This is to ensure that institutions can survive strain that may last up to 30 days. The other component of the new standard is the net stable funding ratio, requiring long-term financial resources to exceed long-term commitments.

Instability arises when banks have used short-term liabilities to finance long-term assets—resulting in what we call a liquidity and maturity mismatch—and market liquidity dries up due to a shock, such as a sudden reversal in capital flow. Banks will then be forced to sell off assets, leading to downward movements in prices. This places the entire system at risk.

Basel III will also introduce two new capital buffers: a 2.5% capital conservation buffer and a countercyclical buffer of 0-2.5%.

What happens next?

Global regulators have yet to agree on a way to deal with the “too big to fail” institutions. The “too big to fail” concept refers to the largest institutions, who’s failure would surely lead to the entire financial system crumbling. After the recent crisis, some of these banks consolidated to create even bigger ones. Since they know that they will not be allowed to fail they feel like they can take greater risks.

The implementation deadline for Basel III is 2019.   FL