Basel III: Rules for a New Generation

AP Photo/KEYSTONE/Georgios Kefalas
By Tommaso Cotroneo


These rules, commonly known as the Basel III framework, represent, alongside the Dodd-Frank Act passed in the United States, the key response from regulators to the financial crisis started in 2007.

To get a feeling for the Basel III framework, start by thinking about the business that you typically do with your bank. On the one hand, you put your hard earned cash on deposit and earn interest on it. On the other hand, you ask for a loan to start a business or a mortgage to buy the home of your dreams. The loans and mortgages are assets for the bank, as it earns interest and makes money out of them. In order to extend loans, a bank needs to have cash to begin with. A lot of this cash comes from deposits. Another part comes from the bank getting into debt by issuing bonds that investors can buy in the market; this is called wholesale funding. The final, and crucial, part of financing that a bank needs in order to give out loans is the money directly coming from its shareholders, which is also called the bank’s capital.

We have just built a basic bank’s balance sheet that looks like:

Assets (loans, mortgages, etc…) = Deposits + Wholesale funds + Capital

Basel III is addressing the composition of this balance sheet in at least four key ways, with the aim of making the institutions more secure. In summary:

1) Quantity and quality of capital. Customers can withdraw deposits whenever they want. The “run” on banks like Northern Rock two years ago is a good reminder of that. Similarly, investors can stop buying a bank’s bonds if they want to. So both deposits and wholesale funds can come and go. Shareholders’ money, on the other hand, is there to stay, meaning that a bank ought to be safer the more capital it has. Basel III requires that going forward a bank’s capital should be at least 8 per cent of its assets, in essence forcing banks to reduce their leverage.

2) Risk coverage. Banks also run large trading operations. The main aim of a bank’s trading arm is, and remains, to generate profits for the shareholders by buying and selling assets at the right price and to protect the value of the bank’s asset with the use of derivatives. When trading you hopefully make money a lot of times, but also inevitably lose some every now and then. To make sure that traders do not bring the bank down, Basel III rules will require a higher level of capital to support the trading books and cushion the potential losses. The net effect of this provision will likely be for banks to cut down on some of their most aggressive trading operations (e.g. investing in commodities or hedge funds).

3) Cyclicality. Now, one thing that you really do not want to happen is for banks to stop lending money at times of economic crisis. This is a recipe for a vicious circle that can only exacerbate the crisis. In order to avoid this, Basel III will require banks to hold a buffer of capital above the 8 per cent indicated in point (1), to make sure that they do not suddenly end up being undercapitalised and forced to stop doing business when the times get tough.

4) Liquidity. At the heart of the financial crisis that we lived through was liquidity. Go back to our basic balance sheet and look at it this way. Times are tough and more and more customers want money from their deposits back. To pay them back I could sell assets. Unfortunately, too many of my assets (CDO’s, subprime mortgages, etc…) are too complex and do not have buyers any more. As I am stuck trying to sell my assets, I will try the other side of the balance sheet. I try and borrow more wholesale funds. But you know what? Nobody trusts my institution anymore, so they will not lend me money or they will ask for a very high price for it. With some simplification, this is the mechanism that almost brought the world to a halt. To address this, Basel III is looking at both sides of the balance sheet. Going forward it will require: a) more assets to be of a high quality “liquid” nature (like cash and highly rated government bonds); b) more of the wholesale funding to be of long dated and stable nature, so as to minimise the risk of having to renew it at times of stress.

It all seems to make a lot of sense, and is definitely inspired by the best intentions. Is it going to work though? Time will tell, but there are a number of points that make me a bit sceptical:

1) Timing: Most of the reforms will only be fully effective in 2018. That is eight years – and likely a full economic cycle or more – from now. This opens the way to watering down a lot of the principles, in particular as these have to be passed into national laws by the different member countries;

2) Real Economy: The jury is still out as to whether the net effect of more stringent capital requirements will be banks lending less money to corporates in order to reduce the total assets they hold. Less lending, even without becoming a credit crunch, is a negative for the real economy, in particular as it nurses the effects of a large crisis;

3) Jurisdiction: Basel III rules do not apply to central banks and other government institutions. It is safe to say that the most significant trend in the last two years has been transfer of risk onto governments and central banks balance sheets as these institutions have stepped in to rescue the private sector. And, unless we seriously think about regulating the public sector, that is where the next crisis will explode.


9 November 2010


Photo Credit: AP Photo/KEYSTONE/Georgios Kefalas