What is Basel III
Basel Accord is a set of banking regulations & standards designed to maintain the integrity of financial system. The original set of standards were called Basel I, followed by II, and III. Basel III is a crucial regulatory response to financial crisis and a major step forward towards a stronger and stable banking system. These standards are developed by Basel committee in Switzerland and then each country copies the framework and applies into domestic financial sector. Basel III is a successor of Basel II and hence more rigid with its requirement so as to keep healthy financial system globally.
Basel III focuses on Capital adequacy requirements to have a more resilient banking system such that during stress times banks have enough liquidity to keep a fully functional banking system without government intervention. Also one of the goals of the Accord is to substantially lower the cost of economic loss given shocks in the economy.
Before we go any further on it, one must understand the functioning model of banking system. Banks have usually deposits as cash which we all deposit as a part of our salary, trading account or whatever else. Banks usually need to reinvest the capital it collected back into capital markets to generate more money. Banks usually use this capital to give out loans to consumers, bankers checks, short term loans to corporations or they even themselves go ahead and buy some assets such as US Treasury or Euro denominated bonds, Gold etc...
During crisis, banks usually go through difficult circumstances such as :
1. Asset values might start to go down faster than banks original predicted. These assets might lose 20-30% in their value within weeks or so.
2. Depositors might start drawing cash faster than bankers originally anticipated.
If these situations continue for a prolonged period, banks might themselves run into liquidity crisis where they don't have any more cash left to give back to depositors or any sort of money to lend out. So, their assets on the balancesheet are losing value and their cash deposits are depleting faster than anticipated. Under these circumstances, banks will run out to Central Government for protection. Governments also have to go through difficult choices at this time. Government usually have following 2 choices only:
1. They can let the financial institution fail and hence cripple the financial markets further. OR
2. Rescue them and hence adversing the moral hazard. (This one is really tricky as commercial banks have the benefit of taking risky bets knowing the central governments can bail them out while the end consumer might not receive any benefit from it. During good times banks can make money off the consumers and during bad times banks can make money off governments so they are in win-win situation)
So, now what Basel III Accord truly wants is to restrict banks from being too dependent on government bailout and hence making regulations for better functioning financial system.
4 Keys areas of Basel III regulations are:
1. Risk Management & Corporate Governance: During Financial crisis of 2008 till today, it was observed while Risk Management and Corp Governance policies were implemented across banking sector, they were pretty weak. Lack of governance influenced risky bets and hence the crisis. Basel III looks into this issue and make recommendation for improvement.
2. Better and More Capital: Basel III looks for better Quality and Quantity of Capital Requirement. The accord requires 7% of Risk Weighted Capital must be common equity with highly liquid assets. In Basel II, the requirement was only a mere 2%.
3. Systemic Risk: Systemic Risk is defined as the event in which the failure of few banking institutions can lead the financial system collapse and hence a system failure. Basel III looks into this issue and tries to provide solutions in at least 2 dimensions (Time and Cross Sectional)
4. Liquidity Management: Before financial crisis of 2008, all banks were taking a free ride on liquidity. It was treated as a free good with the impression that everyone will have access to it. However, after the crisis, it was no longer a free good. Central Governments across the globe (FED, BOE, ECB, RBA etc...) have to pump in liquidity to have money markets fully functioning. This is the first time when global liquidity rules are defined to ensure that there will be enough liquidity under stress times available in the banking sector to keep them functioning.
This is all for Basel III
-Nitin
Basel Accord is a set of banking regulations & standards designed to maintain the integrity of financial system. The original set of standards were called Basel I, followed by II, and III. Basel III is a crucial regulatory response to financial crisis and a major step forward towards a stronger and stable banking system. These standards are developed by Basel committee in Switzerland and then each country copies the framework and applies into domestic financial sector. Basel III is a successor of Basel II and hence more rigid with its requirement so as to keep healthy financial system globally.
Basel III focuses on Capital adequacy requirements to have a more resilient banking system such that during stress times banks have enough liquidity to keep a fully functional banking system without government intervention. Also one of the goals of the Accord is to substantially lower the cost of economic loss given shocks in the economy.
Before we go any further on it, one must understand the functioning model of banking system. Banks have usually deposits as cash which we all deposit as a part of our salary, trading account or whatever else. Banks usually need to reinvest the capital it collected back into capital markets to generate more money. Banks usually use this capital to give out loans to consumers, bankers checks, short term loans to corporations or they even themselves go ahead and buy some assets such as US Treasury or Euro denominated bonds, Gold etc...
During crisis, banks usually go through difficult circumstances such as :
1. Asset values might start to go down faster than banks original predicted. These assets might lose 20-30% in their value within weeks or so.
2. Depositors might start drawing cash faster than bankers originally anticipated.
If these situations continue for a prolonged period, banks might themselves run into liquidity crisis where they don't have any more cash left to give back to depositors or any sort of money to lend out. So, their assets on the balancesheet are losing value and their cash deposits are depleting faster than anticipated. Under these circumstances, banks will run out to Central Government for protection. Governments also have to go through difficult choices at this time. Government usually have following 2 choices only:
1. They can let the financial institution fail and hence cripple the financial markets further. OR
2. Rescue them and hence adversing the moral hazard. (This one is really tricky as commercial banks have the benefit of taking risky bets knowing the central governments can bail them out while the end consumer might not receive any benefit from it. During good times banks can make money off the consumers and during bad times banks can make money off governments so they are in win-win situation)
So, now what Basel III Accord truly wants is to restrict banks from being too dependent on government bailout and hence making regulations for better functioning financial system.
4 Keys areas of Basel III regulations are:
1. Risk Management & Corporate Governance: During Financial crisis of 2008 till today, it was observed while Risk Management and Corp Governance policies were implemented across banking sector, they were pretty weak. Lack of governance influenced risky bets and hence the crisis. Basel III looks into this issue and make recommendation for improvement.
2. Better and More Capital: Basel III looks for better Quality and Quantity of Capital Requirement. The accord requires 7% of Risk Weighted Capital must be common equity with highly liquid assets. In Basel II, the requirement was only a mere 2%.
3. Systemic Risk: Systemic Risk is defined as the event in which the failure of few banking institutions can lead the financial system collapse and hence a system failure. Basel III looks into this issue and tries to provide solutions in at least 2 dimensions (Time and Cross Sectional)
4. Liquidity Management: Before financial crisis of 2008, all banks were taking a free ride on liquidity. It was treated as a free good with the impression that everyone will have access to it. However, after the crisis, it was no longer a free good. Central Governments across the globe (FED, BOE, ECB, RBA etc...) have to pump in liquidity to have money markets fully functioning. This is the first time when global liquidity rules are defined to ensure that there will be enough liquidity under stress times available in the banking sector to keep them functioning.
This is all for Basel III
-Nitin
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