Why Basel III is Necessary
During the Great Recession, a handful of major banking institutions put national economies at risk. To avoid economic collapse, governments stepped in, which cost taxpayers dearly. To prevent a reoccurrence, Basel III was developed to force banks to manage their risks more prudently. Basel III is an international voluntary regulatory framework designed to strengthen bank capital. Implementation has been repeatedly extended with introduction now scheduled for 1 January 2022.
Financial Crisis and Shadow Banking
The Great Recession was caused by over-speculation in real estate, loose lending standards, and the eventual downturn in the US real estate market. As a result, confidence in subprime loans—and the investment banks that held them—eroded. Money market funds and the repurchase agreements used as funding degenerated and led to panic in the shadow banking system.
In the US, shadow banking developed when traditional banking became unprofitable in the 1980s due to disintermediation. Money market mutual funds replaced demand deposits and junk bonds reduced corporate lending. Keeping loans on the balance sheet became unprofitable, which led to securitization and a transfer of credit risk. However, the financial crisis exposed flaws in securitization. It began when Bear Stearns’ clearing bank refused to provide intraday credit, which Bear needed to pay its outstanding repos. As a result, clearing banks withdrew to protect their assets, leading to a collapse in repo and asset-backed commercial paper prices.
The final straw was the meltdown in repos that began at Lehman Brothers’ UK subsidiary which left clients without collateral. The resulting fire sale created mark-to-market losses, margin calls, and further liquidations. The breaking of the buck by the Reserve Primary Fund triggered a run on the shadow banking system that required unprecedented support by the Treasury Department and the Federal Reserve.
Financial institutions that make up the shadow banking system include finance companies, investment banks (the largest US investment banks had to merge with commercial banks after the crisis), money market funds, and hedge funds. Private equity and venture capital firms could fall into this category if the funds they manage are highly leveraged.
Property and casualty insurers generally do not operate in shadow banking; however, as AIG demonstrated, they can become involved. Insuring against defaults and credit events theoretically reduced risk on debt, but instead obscured the risk in the system that it created.
Many of these institutions had little direct regulation prior to the financial crisis. However, the implicit commitments made by regulated banks to shadow banks led to an underpricing of the embedded risks.
Implied credit and liquidity support, the presence of asymmetric information between financial firms and investors, and the lack of transparency require regulation to achieve efficiency. In addition, the sheer size of the market warrants supervision because shocks can destabilize whole economies. In 2007, shadow banking held USD 22 trillion in liabilities while commercial banks held USD 14 trillion. Basel III reforms strengthen the regulatory requirements where there is contractual support for shadow banking activities.
Financial Crisis and Traditional Banking
While lack of regulation of shadow banks may have created the crisis, the interconnectedness of the financial system meant that counterparty defaults were transmitted through the entire system. When wholesale funding collapsed, banks found they had insufficient liquidity. In addition, banks lacked good quality capital. To generate returns, they had relied too heavily on riskier financial products and leverage. Without the necessary shock absorbers, the downturn became more severe. In addition, the capital formula used in Basel II was procyclical, making the probability of default and the amount of loss at default greater.
Banks and supervisors underestimated the risks. The minimum requirements for capital were too low and leverage was too high. Consequently, as the crisis unfolded, banks had to seek liquidity from their central banks and governments to deal with assets for which values were questionable and there were no buyers. Basel III addresses these problems by raising the quality, quantity, and transparency of a bank’s capital in order to better absorb losses; strengthening risk management by increasing the capital requirements for counterparty credit risk exposure; introducing a leverage ratio; initiating measures to increase capital in good times that can be used when markets deteriorate; and setting a minimum 30-day liquidity coverage ratio as a global standard.
Basel III uses the same basic framework as Basel II, but common equity increases to 4.5% of the risk weighted assets. In addition, Tier 1 capital has to be at a minimum of 6% of risk weighted assets, with Tier 1 and Tier 2 capital equaling at least 8%.
To incorporate a countercyclical capital buffer, the capital conservation buffer needs to be 2.5% above Tier 1 capital requirements. This design would dampen lending when the economy is booming and encourage lending when times are tough. Also, Basel III introduces an enhanced leverage ratio to discourage the growth of excessive leverage. To reduce credit risk, Basel III introduces stress testing using three-year historic and current market data to monitor the risk.
As a result of Basel III, bank transparency, liquidity and capitalization will improve, a countercyclical buffer will be introduced, and supervision of shadow banks will be developed. But what will it cost?
Basel III Costs
Although independent, the Basel Committee calculates a net benefit from adherence to the Basel III proposals because of the reduction in costs associated with fewer incidences of banking crises. However, looking at its expense estimates alone, the Committee expects costs be 38 basis points for a one-percentage-point increase in the capital ratio.
The banking industry believes the net stable funding ratio will be very expensive and gain little in safety. The academic community, however, is divided on this opinion with estimates ranging from an increase of 15–45 basis points on loans to break even.
Unfortunately, these studies may underestimate the costs going forward. Under Basel I and Basel II, banks generally held more capital than required. Under Basel III, banks have had to raise capital, which could reduce lending, so the actual costs of adherence could be higher. Also, an increase in capital costs will reduce return on equity, which could make it more expensive for banks to raise additional capital.
Conclusion
Therefore, increased regulation may increase costs and thus reduce lending; however, the crisis began as a consequence of too much leverage, so trimming back may be an effective way of creating long-term stable growth. Fractional reserve banking is unstable by nature and competition entices risky behavior. Because of the importance to the economy, banks need to be regulated. The shadow banking system is equally vital to the economy and is, in fact, banking. Initiating regulation on shadow banks should make the financial system more resilient.
About the Author
Rick Cloutier, CFA, is the chief investment strategist for Washington Trust Bank with over 25 years of portfolio management and investment experience. He is responsible for directing the portfolio management, research, and trading activities for the bank’s multi-asset class strategies. He is also responsible for overseeing the client portfolio manager team and portfolio analytics team. Rick has written numerous articles for Investopedia and wrote a weekly column for the Fall River Herald News in Massachusetts. His research has appeared in numerous journals, including the Journal of Investment Management and Financial Innovations, the Journal of Business Management and Economics, and the International Journal of Revenue Management. He provided a nightly commentary on WALE radio and authored the novel Caveat Emptor. Rick earned his MBA at Boston University.
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