Question

Evaluate whether and if so how the regulatory changes in Basel III have responded to these

negative externalities/global financial crisis.

Answer 1

The main objective of Basel Committee is to provide a forum for cooperation to banking supervisory matters, enhance the understanding these supervisory issues and improve quality supervison across the globe. The Committee frames guidelines and standards for cross-border banking supervison. Basel III is a set of international banking regulations developed by the Bank for International Settlements to promote stability in the international financial system. The Basel III regulations are designed to reduce damage to the economy by banks that take on excess risk.

As you know, the Basel III framework is a central element of the Basel Committee's response to the global financial crisis. The initial phase of Basel III reforms, published in 2010 (BCBS 2010(a)), focused on addressing some of the main shortcomings of the pre-crisis regulatory framework, including:

• improving the quality of bank regulatory capital by placing a greater focus on going-concern loss-absorbing capital in the form of Common Equity Tier 1 (CET1) capital;
• increasing capital requirements to ensure that banks can withstand losses in times of stress;
• enhancing risk capture by revising areas of the risk-weighted capital framework that proved to be acutely miscalibrated, including the global standards for market risk, counterparty credit risk and securitisation;
• adding macroprudential elements to the regulatory framework, by: (i) introducing capital buffers that are built up in good times and can be drawn down in times of stress to limit procyclicality; (ii) establishing a large exposures regime that mitigates systemic risks arising from interlinkages across financial institutions and concentrated exposures; and (iii) putting in place a capital buffer to address the externalities created by systemically important banks;
• specifying a minimum leverage ratio requirement to constrain excess leverage in the banking system and complement the risk-weighted capital requirements; and
• introducing an international framework for mitigating excessive liquidity risk and maturity transformation, through the Liquidity Coverage Ratio and Net Stable Funding Ratio.

There are also clear social benefits from these reforms. During the global financial crisis, the weaknesses in the banking sector were transmitted to the rest of the financial system and the real economy, resulting in substantial costs. Ten years after the start of the crisis, the global economy is still recovering from its effects. These costs include much higher public debt, increased unemployment and substantial output losses. To give just one example, a recent study estimates that the cumulative output loss resulting from financial crises is in the order of 100% of GDP in net present value terms.¹ This output loss would probably have been much larger without the massive public sector interventions. The increase in banks' capital and liquidity resources will help mitigate both the probability and impact of future banking crises.

But a major faultline remained in the regulatory framework, namely, the way in which RWAs were calculated. At the peak of the global financial crisis, a wide range of stakeholders lost faith in banks' internally modelled risk-weighted capital ratios. The complexity and opacity of internal models, the degree of discretion provided to banks in modelling risk parameters, and the use of national discretions all contributed to an excessive degree of RWA variation.

The loss in the public's confidence in banks' reported capital ratios clearly highlighted the need for tighter limits to the way in which RWAs are calculated and greater transparency.

The recently finalised Basel III reforms seek to restore the credibility of RWA calculations, and as a result the public's confidence in the banking system, by:

• enhancing the robustness and risk sensitivity of the standardised approaches for credit risk and operational risk, which will make banks' capital ratios more comparable;
• constraining the use of internally modelled approaches, including by removing the use of the most advanced modelled approaches for certain credit risk asset classes and for calculating operational risk; and

• complementing the risk-weighted capital ratio with a finalised leverage ratio and a revised and robust output floor.

Collectively, the set of Basel III reforms addresses a number of shortcomings in the pre-crisis regulatory framework and provides a foundation for a resilient banking system that will help mitigate the impact of future banking crises and the build-up of systemic vulnerabilities. The post-crisis framework will also help the banking system support the real economy and contribute to economic growth.

The Basel Committee's standards are global minimum standards. The Committee has no supranational authority, its decisions carry no legal force, and it cannot impose fines or sanctions. Rather, once the Committee agrees on a standard, its member jurisdictions are responsible for converting this standard into law or regulation. So internationally agreed standards that are not properly implemented will ultimately have no impact in practice. It is therefore imperative that the Basel standards are effectively implemented by all the Committee's jurisdictions.