The Legacy of Basel III and the case for Basel IV

Basel III was formulated to address the issues of under capitalization and illiquidity spirals that triggered the collapse of banks in the great recession.  However, a new financial landscape has emerged, including Fintechs and platform lending. Thus, the systemic risk that was inherent in banks is significantly stymied. Basel III has served its purpose, but it is now spent. It is time for Basel IV.

By gatuyu t.j

After the global financial crisis, the banking industry has witnessed fundamental changes, most substantial being an overhaul of the regulatory framework in an attempt to seal gaps that triggered the crisis.

One of the issues cited as a trigger of systemic risk against banks during the crisis is banks were under-capitalized, with limited ability to absorb losses. It is true that banks had accumulated too much debt matched with insufficient equity, hence making them prone to illiquidity.

This made most of the post crisis regulations to be targeted towards creating stable banks. Basel III regulations on banks are the most famous, perhaps only second to Dodd Frank Wall Street reforms . Basel III is an international banking regulations made by the Bank of International Settlement, a central bank for central banks, with aim of enhancing supervision and risk management within the banking sector.

Basel 3

One of the undoing on banks during the global financial crisis was the illiquidity spirals, where falling prices of assets prompted banks to reduce supply of credit, causing further asset price falls and insufficient capital. The banks ran out of liquidity forcing central banks to pump large amounts of liquidity.

The other undoing was insufficient capital. This is where, as it turned out, many banks were undercapitalized and did not have enough capital to withstand large shocks. The insufficiency was exposed by contagion, where one bank defaults on borrowings from another bank, caused other bank to default as a consequence.

These kinds of systemic risks, contagions and illiquidity spirals had not been foreseen by the earlier Basel I and II. As a background, the frame of Basel I was geared towards regulating capital adequacy of active banks, to ensure they had adequate “capital cushion” to cover unexpected losses.

The frame of Basel II was aimed at providing incentives for banks to enhance their risk measurement and management capabilities. Basel III took into account failings of these regulations especially on capital regulation.

It is why a fundamental inclusion of Base III did was sharpening the definition of ‘capital’, making it stricter in contexts of banks. The second issue was outlining higher minimum capital requirements. The third issue was providing on how to manage capital risks by introducing risk weights to ensure appropriate leverage.

Further, to deal with insufficient capital, the Basel III introduced capital buffers. Such include a counter-cyclical capital buffer, an idea that financial crises are more likely when banks give out more loans. The capital buffer is aimed to incentivize banks to hold more capital when the economy is booming. Theory shows that the period systemic risk builds up. Counter-cyclical buffer is set by banks at their own discretion.

The second form of capital was the capital conservation buffer. Unlike the counter-cyclical capital buffer which can be 0, and where almost all countries have not provided for it, conservation buffer is designated as 2.5% of the total capital of a bank.

The aim of a conservation buffer is to account for losses that come from illiquidity spirals and from losses in securities holdings. To ensure this buffer, there was formulated the liquidity coverage ratio and the net stable funding ratio.

Banks are required to have a certain amount of liquid assets to their relatively short term liabilities and to hold certain amount of their funding as stable funding. This averts bank runs on account of maturity mismatches.

Basel III introduced additional rules for the ‘too big to fail’ banks. These are specific large or systemically important financial institutions, which have to comply with even stricter capital requirements. The two target liquidity, and not just capital and riskiness.

The liquidity coverage ratio requires banks to have relatively more liquid assets, such as government bonds or high quality corporate bonds. Loans, for example, would not be very liquid, because they are difficult to sell.

These additional buffers constitute the core of Basel III, which has tried to remedy wrongs in the financial system. After other measures such as forward looking IFRS 9 on accounting for financial instruments, the banking system may be in better health than it was before the crisis.

However, though the repairing of financial institutions and focus on the basic rebuilding of balance sheets and profitability, not to mention trust, innovation and customer centric thinking has been largely ignored.

This has allowed the rise of market based finance, where platforms are instruments for financial intermediation. It has also led to the growth Fintech businesses which has grabbed a share of the banking industry.

In this new, fractured financial landscape, traditional banks face the challenge of protecting market share from challengers, answering new regulation, and managing the core fundamentals. Basel III has served post crisis era well. Time is ripe for Basel IV.

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