Basel III: one of the biggest regulatory changes

Basel III is one of the biggest regulatory changes that the financial services industry has seen in decades. The regulation aims to strengthen the capital requirements of banking institutions and investment firms as well as introducing new regulatory requirements on liquidity and leverage.

It is critical that banking institutions and investment firms take steps to reset their business models in response to the new capital and liquidity standards. Banking institutions and investment firms who address the regulation now will put themselves in a better position to respond to competitive pressures and deal with the complexities and uncertainties of the wider regulatory landscape.

It is a future of more capital, more liquidity and less risk. And, inevitably, it is a future of lower returns on capital, higher costs of doing business and slower growth with ultimate effects being felt by investors and end-consumers. Close scrutiny of banking institutions and investment firms performance by investors, regulators and other stakeholders is likely to continue.

The reforms will also require banking institutions and investment firms to undertake significant process and system changes in order to achieve upgrades in the areas of stress testing, capital and liquidity management infrastructure and to move towards holistic balance sheet management. 

Meeting the higher capital and liquidity requirements to comply with the new rules will only be part of the challenge. The results of the Basel Committee on Banking Supervision (BCBS) comprehensive quantitative impact studies, as well as independent studies run by the industry, have already shown the potential for the rules to alter market dynamics. Putting risk as the centre of the business and understanding how the new rules can affect strategic initiatives is more important now than ever before. 

Before the crisis, there was a period of excess liquidity. As a result liquidity risk had, for many banking institutions and investment firms as well as supervisors, become practically invisible. When liquidity became scarce (particularly as wholesale funding dried up) as the crisis developed, banking institutions and investment firms found that they had insufficient liquidity reserves to meet their obligations.

Also, banking institutions and investment firms had insufficient good quality (i.e. loss absorbing) capital. Low inflation and low returns had let invastors to seek even more risk to generate returns. This led to increased leverage and riskier financial products. High leverage amplified losses as banking institutions and investment firms tried to sell assets into falling and shrinking markets, which created a vicious circle of reducing capital ratios and a need to de-lever, which increased asset disposals. Mark-to-market accounting mean that there was no hiding place as buyers dissapeared, prices dropped and trading asset valuations plummeted. 

Due to a lack of transparency, counterparty credit risk was misunderstood and risk concentrations were underestimated. The interconnectedness of the financial system meant that, when trading counterparties defaulted, the shocks were transmitted rapidly through the system; the necessary shock absorbers were not in place, nor was transparency over the linkages.

To make matters worse, the Basel II capital formulae for credit risk are "procyclical". This means that as a downturn develops the probability of borrower default and loss at default both increase, which means that regulatory capital requirements increase. This should be dealt with through Pillar 2 capital planning buffers but the risks had been underestimated by banking institutions and investment firms as well as supervisors. Under Basel II, Pillar 1 calculates the minimum regulatory capital requirements for credit, market and operational risk; Pillar 2 covers the supervisory review process where supervisors evaluate whether banking institutions and investment firms should hold more capital than the Pillar 1 minimum; and Pillar 3 aims to encourage market discipline by specifying disclosure requirements to be made by banking institutions and investment firms to the market. 

All the above meant that banking institutions and invesstment firms had to turn to their central banks for liquidity support and some to their governments for capital injections or support in dealing with assets of uncertain value for which there where no other buyers. Several major institutions are still dependent on state (i.e. taxpayer) support. 

In response to the crisis, the Basel III proposals have five main objectives:

1. Raise the quality, quantity, consistency and transparency of the capital base to ensure that banking institutions and investment firms are in a better position to absorb losses.

2. Strengthen risk coverage of the capital framework by strengthening the capital requirements for counterparty credit risk exposures. 

3. Introduce a leverage ratio as a supplementary measure to the Basel II risk-based capital 

4. Introduce a series of measures to promote the build-up of capital buffers in good times that can be drawn upon in periods of stress. Linked to this, the Committee is encouraging the accounting bodies to adopt an expected loss provisioning model to recognise losses sooner. 

5. Set a global minimum liquidity standard for internationally active banking institutions and investment firms that includes a 30-day liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio.

Basel III represents the core component for a sweeping wave of regulation that will fundamentally affect the profit generation capacity of the financial services industry. As such the banking institutions and the investment firms should move now, decisively, to comply with requirements, restore their profit generation capacity, and potentially revisit the way they do business in the future.