Basil 3 Assignment

7/28/2019 Basil 3 Assignment

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Welcome to Basel III

SUB: BANKING INSURANCE


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Table of Contents

Topics:

1. Introduction

Why does it matter?

How has it been received?

What does it mean for consumers?

2. Overview

3. Studies on Basel III

4. Summary of proposed changes

5. US implementation

6. Basel III, the Banks, and the Economy

What is Basel III and who is making the decisions?

What is the timetable for Basel III?

7. Macroeconomic Impact of Basel III

8. Capital and Liquidity

What are the current rules?


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9. The Basel II revisions made four major changes to the risk

weighted asset calculations:

Will the originally proposed changes or timetable be modified?


Ratings.

Internal risk modeling

Trading assets.

What are the proposed changes?

Higher capital ratios.

Use of a leverage ratio as a safety net.

Tougher risk weightings for trading assets.

Elimination of softer forms of capital.

New liquidity requirements.

Contingent capital.

10. Banking Day backgrounder: Basel III

11. Basel III in the offing

12. Weaknesses of Basel III

Nothing in Basel III prevents that problem from recurring.

How effective will the new rules be?

What stays the same?


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What are the major areas of disagreement?

Net stable funding ratio.


Use of a leverage ratio.

What are the likely effects of Basel III?

13. Conclusion


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Introduction

BASEL III is a global regulatory standard on bank capital adequacy, stress testing andmarket liquidity risk agreed upon by the members of the Basel Committee on BankingSupervision in 2010-11.

This, the third of the Basel Accords developed in a response to the deficiencies infinancial regulation revealed by the late-2000s financial crisis. Basel III strengthens bankcapital requirements and introduces new regulatory requirements on bank liquidity andbank leverage.

The OECD estimates that the implementation of Basel III will decrease annual GDPgrowth by 0.05 to 0.15 percentage point. Outside the banking industry itself, criticismwas muted. Bank directors would be required to know market liquidity conditions formajor asset holdings, to strengthen accountability for any major losses.

It is the third set of banking rules agreed by central bankers and regulators from aroundthe world at meetings in Basel, Switzerland, hence the name. Banks will have to raisehundreds of billions of euros in fresh capital over the next few years. More specifically,they will have to increase their core tier-one capital ratio a key measure of banks'financial strength to 4.5% by 2015. In addition, they will have to carry a further"counter-cyclical" capital conservation buffer of 2.5% by 2019.

Why does it matter?

The idea is that if banks hold a bigger capital cushion they will be better prepared for

another downturn so we avoid a re-run of the financial crisis. Instead of holding capitalequivalent to just 2% of their risk-bearing assets, banks will have to hold 7% of top-quality capital in reserve.

How has it been received?

The deal is important because it removes much of the uncertainty that has dogged thebanking sector in recent months, and markets breathed a sigh of relief today because the


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new rules will be phased in over a much longer time period than expected. The BritishBankers' Association had called for a long timetable, warning that the rules "suck moneyout of the economy". The new rules were welcomed by the European Central Bank, theFinancial Services Authority and American regulators.

What does it mean for consumers?

There won't be a return to the era of cheap money as banks build up their capital reservesahead of the deadlines. UK banks have already made big efforts to raise their capitallevels since the crisis struck, and taxpayer-backed Lloyds Banking Group now has a coretier-one capital ratio of 9% while Barclays's is 10%.

Angela Knight, chief executive at the BBA, warned the move would end the "cheap-money era" as it becomes more expensive to run a bank, which will in turn be passed onto consumers through higher loan and mortgage costs.

Overview

Basel III will require banks to hold 4.5% of common equity (up from 2% in Basel II) and6% of Tier I capital (up from 4% in Basel II) of risk-weighted assets (RWA). Basel IIIalso introduces additional capital buffers, (i) a mandatory capital conservation buffer of2.5% and (ii) a discretionary countercyclical buffer, which allows national regulators torequire up to another 2.5% of capital during periods of high credit growth. In addition,Basel III introduces a minimum 3% leverage ratio and two required liquidity ratios. TheLiquidity Coverage Ratio requires a bank to hold sufficient high-quality liquid assets tocover its total net cash flows over 30 days; the Net Stable Funding Ratio requires theavailable amount of stable funding to exceed the required amount of stable funding over aone-year period of extended stress.

Studies on Basel III

In addition to articles used for references (see References), this section lists links torecent high-quality publicly-available studies on Basel III. This section may be updatedfrequently as Basel III is currently under development.

Date Source Article Title / Link Comments

Dec2011

OECD:EconomicsDepartment

SystemicallyImportant Banks

OECD analysis on the failure of bankregulation and markets to disciplinesystemically important banks.

Jun2011

BNP Paribas:EconomicResearchDepartment

Basel III: no Achilles'spear

BNP Paribas' Economic ResearchDepartment study on Basel III.


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Feb2011

OECD:EconomicsDepartment

MacroeconomicImpact of Basel III

OECD analysis on the macroeconomicimpact of Basel III.

Jan2011

Moody'sAnalytics

Basel III New Capitaland Liquidity

Standards FAQs

Basel III standards, key elements of newregulations, framework, and key

implementation dates.

May2010

OECD Journal:FinancialMarket Trends

Thinking BeyondBasel III

OECD study on Basel I, Basel II and III.

May2010

BloombergBusiness Week

FDICs Bair SaysEurope Should MakeBanks Hold MoreCapital

Bair said regulators around the world needto work together on the next round of capitalstandards for banks ... the next round ofinternational standards, known as Basel III,which Bair said must meet veryaggressive goals.

May2010

ReutersFACTBOX-G20progress on financialregulation

Finance ministers from the G20 group of

industrial and emerging countries meet inBussan, Korea, on June 45 to reviewpledges made in 2009 to strengthenregulation and learn lessons from thefinancial crisis.

May2010

The Economist

The banks battle backA behind-the-scenesbrawl over newcapital and liquidityrules

"The most important bit of reform is theinternational set of rules known as Basel3, which will govern the capital andliquidity buffers banks carry. It is here thatthe most vicious and least public skirmishbetween banks and their regulators is taking

place."

Summary of proposed changes First, the quality, consistency, and transparency of the capital base will be raised.

o Tier 1 capital: the predominant form of Tier 1 capital must be common

shares and retained earningso Tier 2 capital instruments will be harmonized

o Tier 3 capital will be eliminated. Second, the risk coverage of the capital framework will be strengthened.

o Promote more integrated management of market and counterparty credit

risko Add the CVA (credit valuation adjustment)-risk due to deterioration in

counterparty's credit ratingSo Strengthen the capital requirements for counterparty credit exposures

arising from banks derivatives, repot and securities financing transactions


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o Raise the capital buffers backing these exposures

o Reduce procyclicality and

o Provide additional incentives to move OTC derivative contracts to central

counterparties (probably clearing houses)o Provide incentives to strengthen the risk management of counterparty

credit exposureso Raise counterparty credit risk management standards by including wrong-

way risk Third, the Committee will introduce a leverage ratio as a supplementary measure

to the Basel II risk-based framework.o The Committee therefore is introducing a leverage ratio requirement that

is intended to achieve the following objectives: Put a floor under the build-up of leverage in the banking sector Introduce additional safeguards against model risk and

measurement error by supplementing the risk based measure with asimpler measure that is based on gross exposures.

Fourth, the Committee is introducing a series of measures to promote the build upof capital buffers in good times that can be drawn upon in periods of stress("Reducing procyclicality and promoting countercyclical buffers").

o The Committee is introducing a series of measures to address

procyclicality: Dampen any excess cyclicality of the minimum capital

requirement; Promote more forward looking provisions; Conserve capital to build buffers at individual banks and the

banking sector that can be used in stress; ando Achieve the broader macro prudential goal of protecting the banking

sector from periods of excess credit growth. Requirement to use long term data horizons to estimate

probabilities of default, downturn loss-given-default estimates, recommended in Basel II,

to become mandatory Improved calibration of the risk functions, which convert loss

estimates into regulatory capital requirements. Banks must conduct stress tests that include widening credit

spreads in recessionary scenarios.o Promoting stronger provisioning practices (forward looking provisioning):

Advocating a change in the accounting standards towards an

expected loss (EL) approach (usually, EL amount: =LGD*PD*EAD).

Fifth, the Committee is introducing a global minimum liquidity standard for

internationally active banks that includes a 30-day liquidity coverage ratiorequirement underpinned by a longer-term structural liquidity ratio called the NetStable Funding Ratio. (In January 2012, the oversight panel of the BaselCommittee on Banking Supervision issued a statement saying that regulators will


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allow banks to dip below their required liquidity levels, the liquidity coverageratio, during periods of stress.

The Committee also is reviewing the need for additional capital, liquidity or other

supervisory measures to reduce the externalities created by systemically importantinstitutions.

As on Sept 2010, Proposed Basel III norms ask for ratios as: 7-9.5%(4.5% +2.5%(conservation buffer) + 0-2.5%(seasonal buffer)) for Common equity and 8.5-11% fortier 1 cap and 10.5 to 13 for total capital (Proposed Basel III Guidelines: A CreditPositive for Indian Banks)'

US implementation

The US Federal Reserve announced in December 2011 that it would implementsubstantially all of the Basel III rules. It summarized them as follows, and made clearthey would apply not only to banks but to all institutions with more than US$50 billion in

assets:

"Risk-based capital and leverage requirements" including first annual capital

plans, conduct stress tests, and capital adequacy "including a tier one commonrisk-based capital ratio greater than 5 percent, under both expected and stressedconditions" - see scenario analysis on this. A risk-based capital surcharge

Market liquidity, first based on the US's own "interagency liquidity risk-

management guidance issued in March 2010" that require liquidity stress tests andset internal quantitative limits, later moving to a full Basel III regime - see below.

The Federal Reserve Board itself would conduct tests annually "using three

economic and financial market scenarios." Institutions would be encouraged to

use at least five scenarios reflecting improbable events, and especially thoseconsidered impossible by management, but no standards apply yet to extremescenarios. Only a summary of the three official Fed scenarios "includingcompany-specific information would be made public" but one or more internalcompany-run stress tests must be run each year with summaries published.

Single-counterparty credit limits to cut "credit exposure of a covered financial

firm to a single counterparty as a percentage of the firm's regulatory capital.Credit exposure between the largest financial companies would be subject to atighter limit."

"Early remediation requirements" to ensure that "financial weaknesses are

addressed at an early stage". One or more "triggers for remediation--such as

capital levels, stress test results, and risk-management weaknesses--in some casescalibrated to be forward-looking" would be proposed by the Board in 2012."Required actions would vary based on the severity of the situation, but couldinclude restrictions on growth, capital distributions, and executive compensation,as well as capital raising or asset sales."


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It was unclear as of December 2011 how these rules would apply to insurance, hedgefunds and other large financial players. The announced intent was "to limit the dangers ofbig financial firms being heavily intertwined".

Basel III, the Banks, and the Economy

By November, banking regulators are likely to complete an international agreement that willdetermine how strong banks must be. Tough new rules on capital and liquidity are beingnegotiated through the Basel Committee on Banking Supervision (Basel Committee). Theagreement, which is known as Basel III because it will be the third version of these rules, willhave a large effect on the worlds financial systems and economies. On the positive side, newlytoughened capital and liquidity requirements should make national financial systems and

indeed the global financial system

safer. Unfortunately, enhanced safety will come at a cost,since it is expensive for banks to hold extra capital and to be more liquid. It is beyond seriousdispute that loans and other banking services will become more expensive and harder to obtain.The real argument is about the degree, not the direction.

The banking industry argues that Basel III will seriously harm the economy. For example, theInstitute of International Finance (IIF) calculated that the economies of the US and Europe wouldbe 3% smaller after five years than if Basel III were not adopted. My own analyses, and those ofother disinterested parties, generally suggest a much smaller cost that would seem to beconsiderably outweighed by the safety benefits. As the recent crisis clearly attests, severefinancial crises can cause permanent damage to the worlds economy, imposing economic lossand emotional pain on hundreds of millions, if not billions, of people. It is worthwhile to give up

a little economic growth in the average year in order to avoid these major impacts, as my worksuggests would be the case. On the other hand, if the industry is right, the additional safety isprobably not worth the cost and a more modest regulatory revamp would be preferable.

What is Basel III and who is making the decisions?

Basel III is a set of proposed changes to international capital and liquidity Requirementsand some other related areas of banking supervision. It is the second major revision toan original set of rules, now known as Basel I, which was promulgated by the BaselCommittee in 1988. The committee was established in the mid1970s, after the failureof a small German bank (Herstatt) sent shudders through the global financial system as a

result of poor coordination between national regulators. The Basel Committee iscomposed of banking regulators from a number of industrialized countries, with a coremembership concentrated in the traditional banking powers within Europe, plus the USand Japan.

The Basel accords are not formal treaties and the members of the committee do notalways fully implement the rules in national aw and regulation. One prominent exampleof this is in the United States. We had not implemented the Basel II revisions for ourcommercial banks by the time of the financial crisis, which put any such changes on


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hold. It is not clear whether we would eventually have implemented them, despitehaving been closely involved in the negotiations that led to that agreement. In truth, fewcountries choose to implement every detail of the Basel accords and they sometimes findunexpected ways to interpret the aspects they do implement. Despite this, the accordshave led to much greater uniformity of capital requirements around the globe thanexisted prior to Basel I. In fact, the uniformity extends well beyond the countries

represented on the Basel Committee, as most nations with significant banking sectorshave modeled their capital regulation on the Basel rules.

The Basel Committee is loosely affiliated with the Bank for International Settlements(BIS) which is often referred to as the club for the worlds central bankers. The BISprovides certain financial services to central banks and also serves as a vehicle topromote cooperation between them. In addition, it provides support services to the BaselCommittee and several other multilateral bodies focused on the worlds financialsystems. Prominent among these is the Financial Stability Board (FSB) which wascharged last year by the heads of government of the Group of Twenty (G20) nationswith the mission of promoting financial stability around the world. In that capacity, ithas been a prominent advisor to the Basel Committee in its work on Basel III.

What is the timetable for Basel III?

The G20 heads of government have charged the Basel Committee with finalizing theBasel III rules in time for the G20 meeting in Seoul, Korea on November 1112, 2010.The process leading to that started with the issuance of consultation papers in Decemberof 2009 that outlined the changes proposed by the Basel Committee for the capital andliquidity requirements1. Comments were solicited by midApril of 2010 and many partiesresponded at length. In parallel, the Basel Committee, with assistance from the BIS andthe FSB, has been conducting a Quantitative Impact Study (QIS) to estimate thepotential effects on the financial markets and the economy of putting in place the

proposed changes. he intention is to implement Basel III by the end of 2012, although itseems clear that there will be transition periods, observation periods, or phaseins for anumber of the more important requirements, as well as grandfathering of certainfeatures of existing regulation. All of these exceptions would be intended to ease thetransitional impact of Basel III,

Macroeconomic Impact of Basel III

An OECD study released on 17 February 2011, estimates that the medium-term impact ofBasel III implementation on GDP growth is in the range of 0.05 to 0.15 percentagepoint per year. Economic output is mainly affected by an increase in bank lendingspreads as banks pass a rise in bank funding costs, due to higher capital requirements, totheir customers. To meet the capital requirements effective in 2015 (4.5% for thecommon equity ratio, 6% for the Tier 1 capital ratio), banks are estimated to increasetheir lending spreads on average by about 15 basis points. The capital requirementseffective as of 2019 (7% for the common equity ratio, 8.5% for the Tier 1 capital ratio)


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could increase bank lending spreads by about 50 basis points. The estimated effects onGDP growth assume no active response from monetary policy. To the extent thatmonetary policy will no longer be constrained by the zero lower bound, the Basel IIIimpact on economic output could be offset by a reduction (or delayed increase) inmonetary policy rates by about 30 to 80 basis points.

Basel III is an opportunity as well as a challenge for banks. It can provide a solidfoundation for the next developments in the banking sector, and it can ensure that pastexcesses are avoided. Basel III is changing the way that banks address the managementof risk and finance. The new regime seeks much greater integration of the finance andrisk management functions. This will probably drive the convergence of theresponsibilities of CFOs and CROs in delivering the strategic objectives of the business.However, the adoption of a more rigorous regulatory stance might be hampered by areliance on multiple data silos and by a separation of powers between those who areresponsible for finance and those who manage risk. The new emphasis on riskmanagement that is inherent in Basel III requires the introduction or evolution of a risk

management framework that is as robust as the existing finance managementinfrastructures. As well as being a regulatory regime, Basel III in many ways provides aframework for true enterprise risk management, which involves covering all risks to thebusiness.

Capital and Liquidity

Capital is one of the most important concepts in banking. Unfortunately, it can bedifficult for those outside the financial field to grasp, since there is no close analogy tocapital in ordinary life. In its simplest form, capital represents the portion of a banksassets which have no associated contractual commitment for repayment. It is, therefore,

available as a cushion in case the value of the banks assets declines or its liabilitiesrise. For example, if a bank has $100 of loans outstanding, funded by $92 of depositsand $8 of common stock invested by the banks owners, then this capital of $8 isavailable to protect the depositors against losses. If $7 worth of the loans were notrepaid, there would still be more than enough money to pay back the depositors. Theshareholders would suffer a nearly complete loss, but this is a considered a privatematter, whereas there are strong public policy reasons to protect depositors.

If bank balance sheets were always accurate and banks always made profits, there wouldbe no need for capital. Unfortunately, we do not live in that utopia, so a cushion ofcapital is necessary. Banks attempt to hold the minimum level of capital that suppliesadequate protection, since capital is expensive, but all parties recognize the need for such

a cushion even when they debate the right amount or form.

The subject of capital, and regulatory capital requirements, is a complex one and willonly be summarized here. A more complete discussion can be found in Bank Capital:A Primer. As explained in that paper, common stock is not the only type of securitythat is considered to be capital because of the protection it provides depositor and otherparties that regulators care about. Certain forms of preferred stock, and to a limitedextent debt, can also serve as capital.


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It is worth noting that bank regulation generally uses the reported accounting numbers asthe basis for calculating capital levels, without adjusting for market valuations except tothe extent they are captured by standard accounting rules, such as occurs with certainmark to market requirements. In particular, the market capitalization of bank stocks inthe heart of the crisis tended to be substantially lower than the accounting value of theequity of these banks. Essentially, the market believed that accounting. values were

overstated or that substantial new losses would occur in the future or the market wastoo low for technical reasons unrelated to expectations of future performance. None ofthese factors would directly affect regulatory capital levels, although regulators are alwayswise to note these divergences in case they indicate that the market has determined thatthe bakes are in worse shape than appears on the surface.

Liquidity refers to the ability to sell an asset, or otherwise convert it to cash, withoutincurring an excessive loss in doing so. Liquidity almost always increases the longer thetimeframe being considered. A house, for example, may be a very illiquid asset if oneneeds to sell it within a week, but may be quite liquid if one is given five years tomanage the sale. More broadly, the liquidity of a bank often refers to the matching ofits obligations with its funding sources. A bank with highly liquid assets would generally

be considered fairly liquid even if its funding sources were of quite short maturities,since the assets could be liquidated as needed to cover any loss of funding. A bankwith less liquid assets might be fine if its funding sources were locked in for longperiods, but could be in serious trouble in a panic if it relied on shortterm debt ordeposits that might flow away.


The core of the Basel rules on capital reflects a belief that the necessary level of capitaldepends primarily on the friskiness a banks assets. Since capital exists to protect againstrisk, it stands to reason that more is needed when greater risks are being taken. The

focus is on the asset side because liabilities are generally known with great precision,since a deposit or a bond must be repaid based on specific contractual terms. (This is amajor contrast with the insurance industry, where the future costs of promises to protectagainst various events, such as fires, are unknown.) Unlike bank liabilities, bank assetscan go down, or occasionally up, in value. In particular, bank loans may not be repaidand securities may default or may need to be sold at a time when their market valuehas declined.

The original, Basel I, rules grouped all assets into a small number of categories andapplied a riskweighting to each category. The total value of each asset is multiplied byits risk weighting and this adjusted amount is added across all assets to produce a totalriskweighted asset (RWA) figure. The percentage weighting for each category ranges

from 0%, for extremely safe investments such as cash and US government securities, to100% for riskier classes of assets. (In a few cases, the weightings now exceed 100% forcertain very risky assets, such as loans in default or imminent danger of default and theriskiest trenches of securitizations.) For example, residential mortgage loans often have a50% riskweighting, so that a $1 million mortgage would generate a riskweighted assetof $500,000. If a bank were trying to hold capital equal to 10% of its RWA, then itwould need $50,000 of capital to cover this mortgage.


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The Basel II revisions made four major changes to

the risk weighted asset calculations:

Refinement of categories. Basel II broke the categories down in much greater detail thanin Basel I, with more variation in the risk weighting, since it was realized that thecrudeness of the original simple categories was encouraging a great deal of gamingand misallocation of resources. In addition to the values were overstated or thatsubstantial new losses would occur in the future or the market was too low for technicalreasonsunrelated to expectations of future performance. None of these factors woulddirectly affect regulatory capital levels, although regulators are always wise to note thesedivergences in case they indicate that the market has determined that the baks are inworse shape than appears on the surface.

Liquidity refers to the ability to sell an asset, or otherwise convert it to cash, withoutincurring an excessive loss in doing so. Liquidity almost always increases the longer thetimeframe being considered. A house, for example, may be a very illiquid asset if oneneeds to sell it within a week, but may be quite liquid if one is given five years tomanage the sale. More broadly, the liquidity of a bank often refers to the matching ofits obligations with its funding sources. A bank with highly liquid assets would generallybe considered fairly liquid even if its funding sources were of quite short mturities, sincethe assets could be liquidated as needed to cover any loss of funding. A bank with lessliquid assets might be fine if its funding sources were locked in for long periods, butcould be in serious trouble in a panic if it relied on short term debt or deposits thatmight flow away.


The core of the Basel rules on capital reflects a belief that the necessary level of capital

depends primarily on the riskinessof a banks assets. Since capital exists to protectagainst risk, it stands to reason that more is needed when greater risks are being taken.The focus is on the asset side because liabilities are generally known with greatprecision, since a deposit or a bond must be repaid based on specific contractual terms.(This is a major contrast with the insurance industry, where the future costs of promisesto protect against various events, such as fires, are unknown.) Unlike bank liabilities,bank assets can go down, or occasionally up, in value. In particular, bank loans may notbe repaid and securities may default or may need to be sold at a time when theirmarket value has declined.

The original, Basel I, rules grouped all assets into a small number of categories andapplied a riskweighting to each category. The total value of each asset is multiplied by

its risk weighting and this adjusted amount is added across all assets to produe a totalriskweighted asset (RWA) figure. The percentage weighting for each category rangesfrom 0%, for extremely safe investments such as cash and US government securities, to100% for riskier classes of assets. (In a few cases, the weightings now exceed 100% forcertain very risky assets, such as loans in default or imminent danger of default and theriskiest tranches of securitizations.) For example, residential mortgage loans often have a50% riskweighting, so that a $1 million mortgage would generate a riskweighted assetof $500,000. If a bank were trying to hold capital equal to 10% of its RWA, then itwould need $50,000 of capital to cover this mortgage.


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The Basel II revisions made four major changes to the riskweighted asset calculations:

Refinement of categories. Basel II broke the categories down in much greater detail thanin Basel I, with more variation in the risk weighting, since it was realized that the

crudeness of the original simple categories was encouraging a great deal of gamingand misallocation of resources.

weaknesses inherent in using a small number of categories, the weightings had beenfairly arbitrary and influenced by political considerations. For example, Germanyparticularly wanted mortgages to carry a lower risk weighting than other bank loans.

Ratings.

Ratings from the major credit rating agencies became a significant factor in the riskweightings, which had not been true when only broad categories were used.

Internal risk modeling.

It was agreed that the sophisticated global banks could use their own internal risk ratingmodels to determine the risk weightngs for their own particular assets, with someexceptions. The idea was to align regulatory risk calculations with the considerably moresophisticated risk models that were being used b major banks in their own decision

making. This concept counts on the selfinterest of the banks to lead them to use thebest possible estimates of risk in their own management of assets.

Trading assets.

Basel II promulgated a different method for calculating the risk of assets that were heldin trading accounts, based on the assumption that the risk level of trading assets wasprincipally determined by how far the assets could realistically fall in value before abank could dispose of the investments. Thus a value at risk (VAR) approach wasused, utilizing statistical techniques to estimate from historical data how large a lossmight be taken in unusually unfavorable circumstances.

Capital adequacy under the Basel Rules is determined by calculating a ratio of the levelof capital to the total riskweighted assets. Basel I defined two tiers of capital, adistinction that has been retained. Tier 1, the strongest, consists mainly of commonstock and those forms of preferred stock that are most like common. Tier 2 adds in

certain types of preferred stock that are less like common stock and more like debt, aswell as certain subordinated debt securities. In addition, Tier 2 includes some accountingreserves that provide a protective function similar to other forms of capital 3. The twotiers are intended to ensure that there is enough total capital available to handle evenextreme occurrences and that the bulk of this capital is the stronger Tier 1 variety.Generally, banks have plenty of Tier 2 capital, so the practical focus has been onensuring there is enough of the stronger, Tier 1, form of capital.


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The Basel calculations include a number of deductions from the stated balance sheetfigures for capital. First, and probably most importantly, the Basel agreements require thededuction of goodwill, (which arises when a company or asset is purchased for morethan its book value), effectively treating it as worthless for these purposes. Second,

individual national regulators have chosen to fully exclude.

What are the proposed changes?

The financial crisis exposed or underlined a number of areas of weakness in the Basel IIrules. These problems led to many proposed changes under Basel III, including thefollowing.


The consultative document did not specify figures, but made clear that the minimumacceptable Tier 1 and Tier 2 riskweighted capital ratios would be raised. This will havemajor effects, but is difficult to discuss further until the proposed levels are known.Speculation centers on an increase of a couple of points in the minimum ratios, but thisis not clear.

Use of a leverage ratio as a safety net.

Most broadly, the crisis pointed out the problems with using riskweighted assetcalculations that are intrinsically based either directly on historical experience, in the caseof the internal ratings used by the large banks, or indirectly, in the case of the risk

weightings that are set by the Basel Committee. The value of many assets fellconsiderably more sharply and quickly than was suggested by historical experience, insome cases because good quality data did not exist for very many years and therefore

had only reflected the favorable market conditions of recent times. In response, there isbroad agreement that a straight leverage ratio should be given more regulatory weight.In this context, a leverage ratio is simply the ratio of capital to total assets with noriskweighting of the assets. This has the major disadvantage that as much capital wouldhave to be held to back a U.S. government bond as to back a risky loan, but it doesavoid the problems caused by inappropriately low risk weightings. The Basel III rulestherefore propose to include a leverage ratio as an additional test of capital adequacy toserve as a safety net to protect against problems with risk weightings.

Tougher risk weightings for trading assets.

A second major problem was that the risk weightings for trading assets were clearly set

too low, again reflecting an excessive reliance on favorable recent history. This hasalready been dealt with in a major set of changes that took effect in what might beconsidered Basel Imia, through a substantial toughening in the methodology fordetermining risk weightings of trading assets. It appears that capital requirements in theseareas have roughly doubled, on average, compared to the old methodology. These ruleschanges are retained under Basel III.

Elimination of softer forms of capital.


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The financial crisis demonstrated that some securities that were considered capitalinstruments were unusable as a practical matter in a severe financial crisis. Capital isonly useful if it can be made to absorb losses in order to protect other parties, butregulators were effectively blocked from forcing that loss absorption in the case ofsubordinated debt, which had counted in certain cases as Tier II capital. Since these

were legally debt instruments, the holders could force a bankruptcy or insolvencyproceeding if they were to suffer a loss. Putting a major financial institution intoinsolvency was viewed as a very risky move by policymakers, especially after theinsolvency of Lehman Brothers caused severe market turmoil. As a result, subordinateddebt will no longer count as capital even for Tier II purposes and other soft forms ofcapital are being eliminated or subjected to tighter onditions.

Exclusion of some balance sheet items from capital. Following a similar logic, the BaselCommittee decided that certain balance sheet items should be excluded from capitalbecause they might not truly be aailable to absorb losses in a crisis. For example, abank or bank holding companys ownership stake in an insurance company would nolonger count as capital, on the theory that it represented capital at the level of the

insurer and should not be required to do double duty. Put another way, an insurer couldeasily be hit by the same financial crisis as the bank and its own loss of capital wouldcause problems both t the insurer and then at the bank which was counting on the valueof its investment. Minority interests, which represent partial ownership of a part of thebanking group by outside parties, would also cease to count. Yet another category isdeferred tax assets which represent the value of previous losses which can be used tooffset taxes on future profits. Since the value of these assets is dependent on futureprofits, Basel III moves to effectively exclude them. (They were already limited in somecountries, such as the US, where only tax benefits foreseen to be used over the nextyear were allowed.)

Higher capital requirements for counterparty credit risks. The crisis also showed how

much counterparty credit risk existed, causing the committee to tighten the rules forwhen capital must be set aside and how much must be earmarked for these risks. Thisincludes making a distinction on the amount of capital needed to back exchangetradedderivatives, which carry low counterparty risk, and over the counter derivatives, whichwill now require more capital.

New liquidity requirements.

The Basel Committee had largely ignored liquidity in the past, leaving it as one of themany items on which national regulators had discretion to regulate as they pleased.Some countries, such as France, had explicit liquidity requirements, but most viewed it

only as a subjective item to keep an eye on. However, the financial crisis highlightedthe fundamental fact that financial institutions depend for their survival on managingliquidty in order to prevent a fatal run on the bank if confidence in their financialstrength evaporated. As a result, Basel III proposed two tough new liquidity tests thatwould be standardized globally.

First, minimum liquidity levels would be based on a type of stress test using standardizedcalculations. Effectively, the test mimicked a freezing of the financial markets for aperiod of [x] months during which it became extremely difficult to raise new funds and


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existing liabilities, such as shortterm debt, would generally roll off at maturity. Coredeposits were assumed to be drawn down to some extent, but mostly to remain at thebank. Noncore deposits, such as certificates of deposit, were assumed to roll offcompletely as soon as they could be withdrawn. Maturing debt was assumed to roll offand not be replaced. Liquid assets could be used to cover cash needs, but haircuts ofvarious sizes were applied to reflect the fire sale in the financial markets caused by the

adverse conditions.Second, a net stable funding ratio test was created. This measured the level of

liquid assets to the level of liabilities that matured in a year or less. Theintention was to force banks to move more of their borrowing to multiyearfunding sources or to invest more heavily in fairly liquid assets.

Contingent capital.

Basel III endorsed the general idea of adding contingent forms of capital, but proposed

further study rather than immediate implementation, given the numerous technical issuesto be resolved. Contingent forms of capital are basically debt securities which would

convert to equity under preagreed terms in the event that a bank ran into problems. It

can be thought of as a prearranged debttoequity swap and serves the same purpose ofreducing debt to equity ratios and allowing a troubled institution to recapitalize otside ofan insolvency proceeding.

Countercyclical capital requirements. Basel III also endorsed the idea that capitalrequirements should be higher in good times and somewhat lower in bad times. Thiswould achieve the purpose of leaning against the wind and slowing banking activitywhen it overheats and encouraging lending when times are tough. It is unclear at thispoint how this might be implemented and the degree of discretion that nationalregulators would have.

Banking Day backgrounder: Basel III

Banking Day's guide to the new global rules designed to forestall the next financialcrisis.The Basel Committee on Banking Supervision is finalizing the next generation ofglobal banking rules - the Basel III Accords, often simply called "Basel III". Essentially,these rules aim to protect the world economy from the worst effects of future financialcrises. And they aim to minimize the risk that governments will have to spend moneyprotecting private banks and their creditors.The new rules aim to avoid the failure of Basel II - imperfect and under-adopted rules

now discredited by the 2008 global financial crisis. They take a more critical view ofleverage in general, and of risk "insurance" and trading in debt between banks and otherplayers. They ask the banks to hold a larger "buffer" of capital, and more liquid assets.

All these new rules reflect a deepening belief by global regulators that the bankingsystem is prone to bouts of dangerous over-optimism - a view the Reserve Bank ofAustralia has held for at least two decadesfew believe Basel III alone will prevent future crises. As Bank of England governor


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Mervyn King has put it: "it is no criticism of Basel III to say that it is not a 'silverbullet' ... In the area of financial stability, it makes sense to have both belt and braces."Animportant question is whether the current global financial system can benefit from astrong set of rules for banks' capital and liquidity, or whether banks and other financiersoutside the formal banking system will simply work around them. Global banking

regulations, including Basel rules, tend to have unintended consequences.

Basel III in the offing

Banks worldwide are awaiting updates on Basel III regulations, while Bangladesh is coping with the

previous ones.

Basel III, the upgraded version of recommendations on global banking laws andregulations, is preparing to phase in over the next two years, although Bangladesh hasjust started implementing the previous version. The country will at first assess theimpacts of the new rules.

The new set of rules aims to strengthen the global financial industry to make it resilient,and ward off the 2008-like global crisis.

Leading central bankers and national regulators who gathered in Swiss city of Basel lastmonth said they were aiming to introduce proposals to strengthen international financialrequirements on the banks by the end of 2012. The agreed reforms, which have been inthe offing for several months, are part of a 'comprehensive response' to the financialcrisis, the Basel Committee on Banking Supervision said in a statement.

The group of regulators and the Bank for International Settlements agreed that the bankswould be required to lift their reserves substantially under the new rules, and increase keycapital ratios. Most of the capital requirements are in relation to risk-weighted assets.

The Basel III reform would also be the cornerstone of the world's response to thefinancial crisis, and an endorsement by Basel's oversight body will pave the way for theG20 summit of leaders in November to give their seal of approval.
http://www.thedailystar.net/newDesign/photo_gallery.php?pid=157803


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According to 27 top central bank governors, the new rules will go a long way in restoringthe confidence lost during the latest financial meltdown.

Basel III has been debated, anticipated, and repudiated for months. Now that it hasarrived, only the anticipation is over. The debating and disagreement continue.

Some say the move will certainly strengthen bank capital positions. However, there is acertain blithe assumption that raising capital requirements will result in an increase inbank capital. They say bank can raise capital ratios either by increasing capital orreducing activities.

However, the banking sector in Bangladesh has just started to implement Basel II-basedcapital regime from January 2010. And the banks are not thinking of Basel III at themoment. But, Bangladesh Bank (BB), the central bank of the country, said it is closelyfollowing the ongoing revisions of the financial sector regulations in global forums.

Atiur Rahman, the BB governor, hinted that the new capital and liquidity requirementsand regulatory and supervisory recommendations would be phased in gradually in thecountry's financial sector.

But he said these would not be implemented without assessing the impacts of the newrules.

Basel III will be phased in gradually only after due assessment of their likely impacts,Rahman said.

The basics of Basel III is that large internationally active banks will have to hold levels of

common equity equal to at least 7 percent of their assets, much higher than the roughly 2percent international standard or 4 percent standard for large US banks.

Basel III also mentions, by 2015, the banks will have to begin building a 2.5 percentbuffer of capital that must be fully in place by January 2019. If the banks fall below thebuffer, regulators could force them to hold onto more of their earnings to augment theircapital, which means the companies will have less money on hand to pay dividends oroffer large compensation packages.

Local bankers also believe Basel III is stringent in terms of capital requirements. But theysaid Bangladesh is far away from implementing the new Basel rules.

Touhidul Alam Khan, executive vice president (corporate banking division) of PrimeBank, said the main feature of Basel III is that it increases the quality of tier I capital byeliminating some types of capital, such as contingent convertible bonds that used to beallowed in this category. The way the banks determine how much capital reserve theyneed to set aside to recover from losses is the core concept of Basel III.


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Tier I capital is composed of equity capital and retained earnings, while tier II issupplementary capital, and tier III is short-term subordinated debt covering market risks.

As Bangladesh is in stage of implementing Basel II, we may think well ahead about tier1 capital rule under Basel III, which ultimately will be fully effective from January 2015,

with the capital conservation buffer phased in between January 2016 and January 2019,he said.

Khan, an expert on Basel II in Bangladesh, also said, before implementing Basel III, topbanks here have to take steps to restructure their own internal risk rating models todetermine the risk weightings for their assets.

regardless of the effect of Basel III, the main burden for preventing imprudentbank behavior will continue to fall on national prudential regulators such asthe Australian Prudential Regulation Authority The economic cost of BaselIII

Holding capital, maintaining liquidity and restricting dealings with counterparties allcomes at a cost. (Steve Waldman notes that the opposite of "liquidity" is "commitment".)

Estimates of the economic cost of these measures vary widely. In June 2010, banklobby group the Institute of International Finance predicted Basel III and other measureswould cost the US, the euro zone and Japan 3.1 percent of economic growth and nearly

10 million jobs over five years. The reforms would force banks to raise $US700 billion ofnew tier-one capital and issue $US5.4 trillion of long-term wholesale debt by 2015, itsaid. The IIFs estimate of economic impact looks zalarmist. Studies by the FinancialStability Board and the Basel Committee released in August 2010 argued that if the ruleswere phased in over four years, then for every 1 per cent rise in capital ratios, growthwould fall by only 0.2 per cent over the four-year period. And they said an increase of 25per cent in liquid assets held by banks would have less than half of the effect of a 1 percent rise in capital ratios over the same period.

The Reserve Bank governor, Glenn Stevens, noted in a speech in July 2010 that theexperience of the last decade suggests surging credit and leverage doesn't do that much

for growth, implying that restraining it slightly more may have a low cost. And ifregulation stabilises the global financial system, he added, it is worth some cost. But weneed to ensure the benefits outweigh the costs, including "unintended consequences" suchas slower economic growth.

Weaknesses of Basel III


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Basel III retains several flaws of the previous Basel II rules. In particular: Basel III relies heavily on an underlying mechanism - capital ratios -

which spectacularly failed to prevent the global financial crisis. The crisisoccurred even though most banks' capital ratios appeared strong. (LehmanBrothers reported 11 per cent Tier 1 capital just days before its collapse.)

Banks responded to higher capital costs by pushing business of theirbalance sheets and into the "shadow banking system" where capital rulesdid not apply.Bank of England governor Mervyn King: "When sentiment changes onlyvery high levels of capital would be sufficient to enable banks to obtainfunding on anything like normal spreads to policy rates, as we can see atpresent That is what happened in 2007-08. Only very much higherlevels of capital levels that would be seen by the industry as wildlyexcessive most of the time would prevent such a crisis."Economist Raghuram Rajan in the Financial Times: "The minimum hurdlethat reforms should meet is whether they would have prevented the last

crisis. Any feasible level of required capital would not cross this hurdle, solet us not rely too much on it to avert the next crisis." Basel III continues to rely too much on credit ratings. The IMF, among

others, has argued in recent papers that "markets need to end theiraddiction to credit ratings" and remove "the mechanistic use of ratings inrules and regulations". Instead ratings should be used as one of severaltools to manage risk.

Banks remain trusted to use their own internal models to measure risk,

using models such as value-at-risk which have been shown to havesubstantial flaws in many situations.

Risk weightings still allow banks to create very high effective leverage.

Under Basel III, banks need to hold equity against their risk-weightedassets. This provides an incentive to find low-risk-weight assets which canthen be leveraged. One attractive asset will be sovereign debt; AA-ratedsovereign debt will still carry a zero risk weighting. Housing will continueto require less capital than business lending. Lending to most businesses,in contrast, will require capital of about 8 per cent.

The essence of the global financial crisis was risky assets - mostly US sub-primemortgages - that had been carelessly assessed by the market and classified incorrectly asrisk-free, then dispersed to all corners of the financial system. The risky assets wereprecisely those which were regarded as "safe" under Basel II - but which in fact were not.

That is, the risky assets had low "official" risk but high real risk. (The risks were alsocorrelated: many of them had a good chance of going bad at the same time, magnifyingtheir likely economic impact.) Basel II gave market players enormous incentives to seekout such assets - in effect, to find the best regulatory arbitrage.

In a crisis where a large number of assets fall substantially in value, it matters littlewhether a bank's capital is 5, 10 or 15 per cent. It will still be overwhelmed.


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To add to the problem, there is no asset so safe that it cannot be made unsafe byoverbidding and overbearing.

Nothing in Basel III prevents that problem from recurring.

Beyond the issue of banks' safety is another issue which Basel III cannot address. Thefinancial system inevitably breaks down if creditors are willing to lend to foolishinvestors. The bail-outs of creditors during the global financial crisis may have raisedexpectations that creditors will be rescued from future poor decisions.

The most severe critics of the system believe Basel III does little to address underlyingproblems with the global financial system. Adrian Blundell-Wignall, the former RBAeconomist who is now Deputy Director of Financial and Enterprise Affairs at the OECD,has gone further than most: his personal view is that the Basel II system proved so flawedthat such frameworks might not be worth using.

How effective will the new rules be?

These are easily the toughest global banking rules yet agreed. But there is noguaranteezthey will save the banks from their next episode of over-optimism. The 2008crisis showed that when the web of global lending unravels, even well-capitalizedinstitutions are at risk.

Strong and sophisticated regulators will continue to be needed. And they will continue tohave to make tough calls about the risks taken by individual institutions and overall riskswithin the financial system.

What stays the same?

Regulators, with the concurrence of world leaders, have chosen to keep the essentialstructure of the Basel II approach intact while trying to improve the mechanisms of theaccod. This is not to minimize the extent of the changes described above, which arequite significant, but rather to emphasize that they are consistent with the overallframework of Basel II. The two possible exceptions to this general statement are theleverage ratio, which does not take the riskbased approach that is at the heart of BaselII, and the addition of a liquidity test. In practice, the leverage ratio is likely to be setat levels that leave the riskbased ratios as the key determinants of the capitalrequirements, muting the effect adding a leverage ratio. For its part, the liquidity test is

not truly inconsistent with the capital tests, but should probably be viewed as asupplement that is in the spirit of the original Basel accords.

One aspect that remains the same has come under a great deal of criticism from someacademics and market observers. Basel II and III both allow the sophisticated globalbanks to use internal risk models as key determinants of their capital reuirements. Theargument in favor of this is that banks devote far more resources than regulators can todeveloping sophisticated approachs to evaluating the risk they are taking on and theyhave a strong incentive to get it right, in order to maximize their own profitability over


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time. Unfortunately, we now know that the risk modeling leading into the crisis wasseriously flawed by a combination of excessive reliance on a liited historical record andperverse compensation incentives. There is good reason to believe that the modeling isbetter now, both because of extensive efforts to fix the problems and because thehistorical record now includes a much worse set of event, automatically increasing theirconservatism. However, many remain skeptical that the basic flaws have been fixed.

A related issue is that capital requirements for trading assets are still calculated withextensive reference to Value at Risk alculations. Basel III adds layers of conservatismthat appear to roughly double the capital requirements on average. However, the VARconcept appears to work better for evaluating daily or weekly risks than for somewhatlonger holding periods. For this reason, some observers are skeptical that the VARapproach works effectively when applied to less liquid assets.

In both cases, the Basel Committee has chosen to retain the role of standard risk models,despite an awareness of their flaws. The consensus of the committee is that the benefitsoutweigh the disadvantages and that there is no clearly superior approache available.

What are the major areas of disagreement?

There is broad agreement within the Basel Committee, at the G20, and even in thefinancial markets, that capital requirements need to be raised in light of the financialcrisis. However, there are disagreements, particularly between the banking industry andthe committee, on the specific approaches being taken to achieve this purpose. As willbe discussed further below, the industry argues that the committee is going overboard inmany areas and doing so in ways that will significantly, and unnecessarily, raise the cost

of providing loans and other banking services. Some of the key areas of discord are:

Net stable funding ratio.

There seems to be a reasonable degree of acceptance that Basel rules need to coverliquidity, but the industry has pushed back very hard on the net stable funding ratio test.They believe that it would force very substantial and expensive changes to how theyfund themselves and invest their assets an that the gain in safety would be marginal.They have more support from disinterested observers on this than they do on theircomplaints about the higher capital requiremnts, although opinion is divided in theacademic community. Whatever the merits, it appears that the industry has succeeded in

giving the regulators great pause on this topic and the test may be dropped fromtheinitial Basel III rules and studied further. The liquidity stress test has generated lessopposition, although it is certainly not without controversy either. As a result, it mightbe included in Basel III or might be put off along with the other liquidity test.



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This fight will spring up in full fury once specific capital ratios are specified, but thebanking industry has already made clear that they believe only moderate changes arenecessary, especially given all of the other ways in which capital levels are beingincreased in the Basel III proposals.

Use of a leverage ratio.

There is a heated debate on this topic. Virtually all regulators agree that a simpleleverage ratio is a useful way of checking to see if the riskbased approach is leading toexcessively large balance sheets. Some countries, notably the US, believe that this issuch a useful ratio that it ought to be mandatory and binding, so that a banksminimum required capital would be the greater of the riskbased figure and the onederived from the leverage ratio. Others, notably France, believe it is simply one usefulsupplemental measure and that how it is used should be up to national discretion. Theyfurther point out various technical problems that could make it very difficult to achieveuniformity, such as the differences between US and international accounting standards.Some analyses have suggested that the two different accounting regimes could show totalassets on the balance sheet that diffeed by as much as 100%, so that a fixed leverageratio could require twice as much capital in one country as another. At a minimum,there will have to be an approach that adjusts the leverage ratio for such differences.

This ratio will probably remain controversial for a long time, if for no other reason thanthe fact that US banks have been operating under a leverage ratio for some time andare already cofigured to deal with it, while European banks have not. In a nutshell,many European banks have larger balance sheets than US banks, but focus more onlowerrisk assets, since this is what the Basel rules effectively encourage. Adding aleverage ratio would force them to operate more like US banks in their asset allocations.

The most likely result is that the Basel Committee will choose to elevate the importanceof the leverage ratio, but do so in a manner that allows the development of greaterconsensus over time. For example, there has been talk of an observation period ofseveral years before it becomes binding, which, in practice, would allow for it to remainnonbinding if a true consensus cannot be built. Another possibility is for it to bebinding, but set at a low enough level that it would rarely be the determinant of theminimum capital requirements, since the riskbased approach would almost always yield ahigher requirement.

Elimination of softer forms of capital. Everyone agrees that common stock provides thestrongest form of capital protection. The problem is that common stock is also by farthe most expensive form of capital for a bank to raise. Therefore, banks have availedthemselves of substantial amounts of softer, and cheaper, forms of capital. Therefore, theindustry has been fighting back against the elimination of some of these forms and hasalso been pushing for transition peiods in which some or all of these forms of capitalwould continue to count as capital. The European and Japanese banks feel particularlystrongly about this, as they have relied somewhat more on these forms than have theAmerican banks.

Exclusion of some balance sheet items from capital. Banks in every country gainconsiderable benefit from at least one of the balance sheet items that will no longercount as captal and therefore put forth arguments as to why they should continue to


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count. The Europeans are particularly concerned, because many of their corporatestructures include investments in insurers and minority interests in their banks to a muchgreter extent than is true in the US. On the other hand, the US banks are concernedabout deferred tax assets and about mortgage servicing rights, which are of lesserconcern to the Europeans. There are legitimate arguments in almost all cases, which iswhy these items had been counted as capital in the past, but the committee strongly

wants to ensure that common stock, and not softer forms of capital, really doesconstitute the core of capital. This difficult balancing act will be resolved by classichorse trading among the different countries on the committee, balanced by a desire tomaintain the overall integrity of the Basel III proposals.

Virtually every part of the Basel III proposals has been objected to by someone, so theabove should not be viewed as a complete list, but merely the most important andcontroversial items.

Will the originally proposed changes or timetable be

modified?

Despite the various controversies, it appears unlikely that the core Basel III proposals willbe dropped, with the exception of the liquidity provisions. Nor does it appear likely thatthe timetable for initial implementation will be altered significantly. The G20 heads ofgovernment show a strong desire to finish this at their Seoul meeting in November andit appears that there is suffcient consensus to achieve this. It is possible, of course, thatsome disagreements will effectively be declared to be implementation details that can bedelayed modestly, even if an objective observer might consider them to be morefundamental concepts rather than just details. That said, it would be a surprise if therewere a major delay in a core part of the Basel III proposals, with the exception of theliquidity requirements. The one thing that might create a postponement would be theonset of a new recession or severe financial crisis, such as the Euro crisis wasthreatening to become. Leaders are not going to want to risk slowing their economies

further under those circumstances.

As noted earlier, it is highly likely that there will be a number of arrangements to easethe transition once the initial implementation date isreached, such as phasing out variousforms of soft capital over a period of years and perhaps phasing in the new higher Tier1 capital atios.

What are the likely effects of Basel III?

There is very considerable disagreement about the effects of Basel III. Virtually everyone

accepts that banks and the financial system would be safer as a result of these changes,but that this would come at the cost of slower economic growth in most years due tohigher credit costs and reduced availabiliy. However, the magnitude of these effects is atissue and very much affects ones view of the tradeoff. As noted earlier, the IIF, anindustry group, calculated that the economies of the major economies would be about3% smaller as a result of Basel III than they otherwise would be five years on 4. This isa very large impact and the G20 leaders would probably reject Basel III if theybelieved these figures. Nor is the IIFs analysis even the most pessimistic. For example,


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the French banking association offered calculations that suggested a 6% hit to the Frencheconomy.

On the other hand, various disinterested observers have concluded that the effects wouldbe much smaller. My own calculations, for example, suggested that a large increase incapital requirements in the US might only increase average loan pricing about 0.2

percentag points, with little effect on availability5. (I did not analyze the effects of theliquidity rules, which could be larger, and I assumed a long enough transition effect toavoid abrupt changes.) An increase in loan pricing of this magnitude would likely havequite minimal effects on economic growth. (Consider how small an effect there is on theeconomy of a 0.25% rate move by the Fed, which is the smallest change they normallymake.)

My discussions with European and US policymakers and regulators strongly suggest thatthe key decisionmakers are heavily discounting the industrys analyses, instead buyinginto the Basel Committees own apparent view that the drag on the economy would berelatively small and more thn offset by the benefits of greater systemic safety. Thisthinking may either be confirmed or altered on the basis of the committees Quantitative

Impact Study which should be pubicly available in September. If the Basel Committee isright, the lowered growth rate during noncrisis years may be more than offset by theavoidance of truly severe recessions brought on every few decades by widespread, severefinancial crises. A recession as rough as the one we recently went through causespermanent losses to the economy in addition to the awful transtory effects. The longterm unemployed may find they are never able to return to work and some plant andequipment is junked or deteriorates after beig out of service for long periods. There arealso very longlasting effects of the sharp increase in national debt that tends toaccompany such severe recessions. It is difficult to pin down the permanent shrinkage inthe economy, but most observers would agree that it is quite significant. In addition, ofcourse, the temporary shrinkage of the economy adds up to a considerable loss beforethe economy recovers to more normal levels.

Conclusion

Basel III will happen, roughly on schedule, and will make a major difference to theoperation of the financial system. Banking will be safer, but more expensive, withextensive ramifications throughout the economy. Despite the dry nature of discussions offinancial regulation, the Basel III process bears watching closely.

Documents

Basil 3 Assignment