The Future of Basel III

The financial crisis called for reforms and revision of regulations and supervision on international and national basis. The regulatory standards in the economies were strengthened through the adoption of Basel II Capital Standards and the Basel Core Principles for Effective Bank Supervision (BCPs). Despite this the crisis emerged in the economies where the regulations and supervision were thought to be the best in the world. This crisis exposed the weaknesses in regulatory and supervisory frameworks and provided the basis of debate about the roles these have played in causing and aggravating the crisis. So this is the top priority for decision and policy makers and many countries are working to upgrade their regulatory and supervisory frameworks, although inevitably this has to be a multilateral arrangement if it is to succeed.

The latest Basel III proposals from the Basel Committee have been put forward to strengthen the banking system and to reduce risk of future financial crises. These proposals require the banking sector to raise far more capital in response to the global financial crisis. Under the new proposals the banks will have to maintain core capital ratio of 6 percent (formerly 2 percent before). Now the question arises would the increase in capital ratio would prevent financial crisis in future? Is the current crisis due to decrease in core capital ratio? 

The key areas covered by the Basel III proposals are Tier I Capital Base, Minimum Liquidity Standards, Leverage Ratios, Counterparty Credit Risk – Derivatives, Repos and Securities and Countercyclical Capital Buffers. The Committee intends to raise therefore both the quantity and the quality of the capital base to enable banks to absorb losses in crisis period. It also introduces a minimum liquidity standard for banks to meet their liquidity requirements for 30 days under any ‘acute’ liquidity situation. Under these proposals leverage ratio introduces additional safeguard against risk and measurement error. The committee also proposed to strengthen capital requirements for counter party credit risk exposures arising from derivatives, repos and securities financing activities. It also proposed building up capital buffers in good times that can be drawn down in periods of stress.

Capital standards designed to fortify the global financial crisis are eroding due to the debt crisis in the Euro zone, and the US. The U.S.economic growth for the first quarter was revised down to 0.4 percent, while the second quarter’s initial figure was 1.3 percent. In Europe, gross domestic product fell from 0.8 percent in the first three months of the year to 0.2 percent in the second quarter. . Concerns about   payments, and debt problems of Italy and Spain also darkened the prospects of Basel III. European Commission estimated that European Banks will have to raise about $500 billion in new capital to meet new capital rules that will hamper their ability to lend. The cost will be borne mostly by the relatively undercapitalized banks in Germany, France, Spain and Greece.

The European banks cannot raise required capital as required by Basel III and the US banks have also reversed course. Another question is regarding the quality of capital that would the quality of capital be able to meet the basic objectives of the implementation of Basel III to reduce the risk of future crisis. EU’s implementation proposals allowed the inclusion of securities (such as hybrid securities), if they meet specific criteria, in the calculation of capital ratios.

Bloomberg reported that At Landesbank Hessen-Thueringen, a state-owned lender based in Frankfurt known as Helaba, silent participations account for more than 50 percent of the bank’s 6 billion euros ($8.6 billion) of capital. Helaba withdrew from the Europe-wide stress tests in July after regulators refused to count some of those hybrid instruments as capital.  

Another issue is the double counting of capital in the insurance subsidiaries in European economies. The proposed rules do not require banks to deduct investments in these subsidiaries from capital. The EU proposals are also lenient on the liquidity standards tha require banks to hold enough cash or easily sellable assets to meet short- and long- term liability. It  modifies the rule covering debt payments coming in next twelve (12) months for thirty (30) days to allow counting covered bonds as liquid assets. Denmark, Sweden and Spain supported this as their banks have large holdings of the bonds that are backed by the cash flows from pool of mortgage loans.

With the current international economic condition it is highly difficult for banks to raise the required capital as per required by Basel III. Also the flaws in the Basel III need to be looked into and revised before proper implementation of Basel III. Central banks should also tightly monitor and supervise the banks’ credit activities to reduce the risk of future crisis.

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