Basel III: Enhancements to Basel II: System-wide changes & Increased Stress Testing

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Basel III seeks to enhance the Basel II framework by addressing both firm-specific risk as well as system-specific systemic risk factors. Earlier we had looked at the changes that will be made to the micro-prudential firm specific framework. In this post we will discuss some of major improvements being made to the Basel II framework on a macro-prudential system-wide basis as well as the greater role that stress testing will play in the process. These measures include:

1.       Introduction of a non-risk based leverage ratio:

Leverage Ratio is the ratio of the bank’s Tier 1 Capital to Total assets of the bank including its off balance sheet exposures and derivatives.

The purpose of introducing a leverage ratio is to avoid the build-up of excess leverage that could potentially lead to a deleveraged “credit crunch” in stressed conditions.

There are some concerns that the risk-weighted assets approach and the leverage approach will not work well together and will continue to allow for regulatory arbitrage. This is because based on the leverage ratio set by the supervisor, banks will continue to use the arbitrage present in risk weights to shift ‘promises’ within the financial system in such a way as to lower their capital requirements or not hold more capital than they are required to.

2.       Introduction of a countercyclical capital charge:

This buffer will be set by the supervisor of the jurisdiction in which the bank operates. It is determined by monitoring its credit growth rate against measures such as the GDP growth rate. The charge will fall in the range 0% – 2.5% of risk weighted assets and will depend on what the supervisor believes will be the expected credit losses that banks will face in the future during periods of stress, after periods of excessive credit growth, rather than on losses incurred in the past. This charge acts as a damper to periods of rapid credit growth as it causes the cost of credit to increase. The charge is built up as risks increase and is released when the risks dissipates.

There are concerns however that this charge could lead to decreased credit due to decreased availability and increased borrowing cost hence leading to fewer borrowers having access to funding.

3.       Additional requirements for systemically important financial institutions (SIFIs):

SIFIs have a greater impact on global financial systems and thus tend to be a greater source of risk to them. The requirements include an additional systemic capital surcharge, contingent capital such as bonds that convert to equity at some trigger point, etc.

4.        Additional capital requirements for systemically important markets and market infrastructures (SIMIs):

Certain markets, such as OTC derivatives, have a greater degree of interconnectedness and hence a greater level of systemic risk. In order to reduce the risk of these markets Basel III aims to provides favorable capital treatments for OTC derivatives that are traded through central counter party clearing houses as opposed to higher capital requirements for OTC derivatives settled via bilateral agreements.

5.       A larger role for stress testing:

Under Basel III, there will be increased stress testing. This is accompanied by a lower reliance on a bank’s internal models. The supervisor would need to thoroughly investigate and prudently validate these models; their limitations would need to be properly understood; stress testing should be carried out aggressively to capture tail events, large deviations and systemic risks; correlation, volatility and market liquidity need to be stressed.

In this post we addressed some of the main enhancements made in the Basel II framework at a macro-prudential level. We have also discussed the greater importance that stress testing will have in the process.

Please note: the Bank for International Settlements (BIS) gives a complete compilation of the documents that form Basel III.