Part 1 – Why Basel III?
‘Basel’ is a word which makes many bankers alert even in any casual conversation! Why Basel III? What improvements Basel III has brought in over Basel II? These are the questions which are asked pretty frequently whenever a banker (or a central banker, for that matter) meets a person who is interested in banking regulation. So let us keep ourselves well prepared to respond to such eager questions and have a look as to what really has improved in Basel III!
Before we look into what improvements Basel III has brought over Basel II in banking regulation, let us first see what improvements did Basel II brought over Basel I. What can be termed as paradigm shift in Basel II over Basel I was that Basel II introduced ‘risk sensitive’ capital regulation while Basel I had ‘one-size-fits-all’ approach. But aftermath of collapse of Lehman Brothers (it is now over four years since this happened), Basel II regulations required a re-look, mainly for the following reasons:
- The main charge against Basel II was that the ‘risk sensitive’ capital requirements made it pretty pro-cyclical. Let me explain: In good times, when banks are doing well, and the market is willing to invest capital in them, Basel II does not impose any additional capital requirements on banks (i.e., when the market is willing to invest in banks, banks may not need the capital!). On the other hand, in stressed times, when banks require additional capital and markets are reluctant to supply that capital, Basel II requires banks to bring in more capital!
- This was one of the reasons for the increased stress during the time of crisis – As we saw during the crisis, it was the failure to bring in capital when under pressure that forced major international banks into a vicious cycle of deleveraging, thereby hurting global financial markets.
- Another charge against Basel II was that even as it made capital regulation more risk sensitive, it did not bring in corresponding changes in the definition and composition of regulatory capital to reflect the changing market dynamics. Let me explain a bit further – Under Basel II, the market risk models failed to factor-in the risk from complex derivative products that were coming on to the market in a big way! These models demanded less capital against trading book exposures on the assumption that trading book exposures could be easily sold and exposures unwound! This gave an incentive to banks to park many exposures in their trading book rather than in banking book to optimize capital! As we know now, much of these assets (now termed as toxic assets) and their securitized derivatives were the epicenter of the crisis.
- The next charge against Basel II concerns leverage. Note that Basel II did not have any explicit regulation covering leverage! It assumed that its risk based capital requirement would automatically mitigate the risk of excessive leverage! This assumption, as it turned out, was flawed as excessive leverage of banks was one of the prime causes of the crisis.
- Besides, Basel II did not adequately cover liquidity risk. Since liquidity risk, if left unaddressed, could cascade into a solvency risk, liquidity proved to be the undoing of virtually every bank that came under stress in the depth of the crisis.
- Further, Basel II exclusively focused on individual financial institutions, ignoring the systemic risk arising from the inter-connectedness across the institutions which aggravated the crisis.
The enhancements in Basel III over those of Basel II are given in the Part 2.
(This blog is based on various publications of BIS)