The proverb goes: what doesn’t kill you makes you stronger. This is clearly what happened to the European financial markets, after the recovery from the crisis that opened the debate about the fact that some banks would not be able to survive. It promoted the implementation of stricter regulations in terms of prudential regulation, as we see with Basel III. This new regulation means that the European financial institutions have sounder balance sheets and larger capital buffers today. It could be easily inferred that the level of risk has been significantly reduced.
The body of legislation of Basel III has been created in response to the big recession, and it is part of the continuous effort to enhance the banking regulatory framework. Basel III has largely been created in order to respond to the failure of the regulatory framework of Basel II, which was not able to prevent the rise of the big financial crisis. One of the causes could be the presence of too many liquid markets: this is exactly the point that was successfully overcome with the new regulatory framework. Many of the causes of the big financial crisis find their source in the risks that Basel II largely underestimated.
What changed between Basel II and Basel III?
The new regulatory framework has adopted a two-pillar approach in order to fight the weaknesses emerged from the 2007- 2009 crisis. The first one attempts to increase the dimension and the quality of equity for the financial markets, with a particular focus on the leverage ratio and risk-weighted capital. The second pillar deals with internal model-based approaches, trying to improve the deficiencies highlighted by the big economic recession.
Minimum Capital Requirement
Basel III introduced tighter capital requirements in comparison to Basel I and Basel II. Banks' regulatory capital is divided into Tier 1 and Tier 2, while Tier 1 is subdivided into Common Equity Tier 1 and additional Tier 1 capital. The distinction is important because security instruments included in Tier 1 capital have the highest level of subordination. Common Equity Tier 1 capital includes equity instruments that have discretionary dividends and no maturity, while additional Tier 1 capital comprises securities that are subordinated to most subordinated debt, have no maturity, and their dividends can be cancelled at any time.
Tier 2 capital consists of unsecured subordinated debt with an original maturity of at least five years. Basel III left the guidelines for risk-weighted assets largely unchanged from Basel II. Risk-weighted assets represent a bank's assets weighted by coefficients of risk set forth by Basel III. The higher the credit risk of an asset, the higher its risk weight. Basel III uses credit ratings of certain assets to establish their risk coefficients. In comparison to Basel II, Basel III strengthened regulatory capital ratios, which are computed as a percentage of risk-weighted assets. In particular, Basel III increased minimum Common Equity Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall regulatory capital was left unchanged at 8%.
Basel III introduced new requirements with respect to regulatory capital for large banks to cushion against cyclical changes on their balance sheets. During credit expansion, banks have to set aside additional capital, while during the credit contraction, capital requirements can be loosened. The new guidelines also introduced the bucketing method, in which banks are grouped according to their size, complexity and importance to the overall economy. Systematically important banks are subject to higher capital requirements.
Leverage and Liquidity Measures
Additionally, Basel III introduced leverage and liquidity requirements to safeguard against excessive borrowing and ensure that banks have sufficient liquidity during periods of financial stress. In particular, the leverage ratio, computed as Tier 1 capital divided by the total of on and off-balance exposures, was capped at 3%.
The strengthening of the regulation was a huge turning point for financial markets. This is having a profound impact on the way banks view capital and deposits from investors in terms of undertaking new business opportunities – directing it to the credit businesses – and mostly in terms of paying more attention to risk, which makes the banks more resilient.
Moreover, through the new implementation, banks have increased the possibility to extend more liquidity, limiting the credit crunch phenomena, which in large scale has a corrosive effect on economic growth. For example, a credit crunch makes it nearly impossible for companies to borrow because lenders are scared of bankruptcies or defaults.
As highlighted so far, Basel III overcomes the damages caused by a bad credit allocation based on Basel II’s principles, which are now considered obsolete. However, I would say that a better regulation is essential, and Basel III is not enough on its own. It's just one piece of the puzzle. The promotion of financial stability requires a broad institutional framework of which prudential regulation is just a component that plays an important role. What absolutely matters is the structure of the bank.