Third Try for Basel

Will the new Basel III international capital standards be more effective than previous versions in preventing bank meltdowns?

Back in 2006, when the Basel Committee on Banking Supervision was revising its initial standards for the amount of reserve capital that banks had to hold against their lending activities, it looked like the changes would be a boon to some banks and corporate clients. Under the so-called Basel II standards, banks would no longer have to hold the same amount of capital for all commercial loans, for example. Less risky loans would require less capital, potentially letting some banks increase leverage and making borrowing cheaper.

Of course, Basel II, which wasn’t supposed to be fully adopted in the United States until 2011, never made it to the finish line — the worldwide financial crisis intervened.

Now, the successor of Basel II has almost the reverse purpose of its predecessor. Basel III isn’t supposed to make capital standards more flexible for individual institutions and loan types, as Basel II was. Rather, its purpose is to provide banks with greater insulation from risk across the board, especially in the event of another banking crisis. But will Basel III be any more of a success than Basel II?

Under Basel III, standards for capital, leverage, and liquidity are much stricter. By 2015, banks will have to hold more loss-absorbing common equity, equal to 4.5% of their assets, up from the present 2%. Four years after that, banks will have to hold an additional 2.5% of so-called Tier I common equity as a “capital conservation buffer.”

In rare circumstances, when credit growth is excessive, the Basel standards also include a “countercyclical buffer” of another 2.5% of common equity. At the same time, the standards will gradually pare down the kinds of capital that count as Tier 1 common equity.

But even if imposed as is in the United States, Basel III may suffer the same fate as Basel II. The Basel III transition period is lengthy — one of the deadlines is as far out as 2022. “We don’t know what the world might look like by then,” says Cory Gunderson, managing director of the financial-services practice at consulting firm Protiviti. “The financial industry tends to find itself in crisis every 7 to 10 years. The odds of other issues coming up while the [Basel III] effort is being fully transitioned are pretty high.”

Basel III capital

In addition, some observers question the effectiveness of higher minimum capital requirements. Some banks threatened by the financial crisis had plenty of capital reserves, points out a recent paper by lawyers from Clifford Chance, which was supplied to CFO by regulatory information service Knowledge Mosaic. United Kingdom-based Northern Rock had Tier 1 capital of more than 11% before suffering a bank run and coming under public ownership, for example. Of other large U.K. banks, only Royal Bank of Scotland had Tier 1 capital of less than 8%. (Those ratios aren’t directly comparable with Basel III’s, since the new standards will remove many previously qualifying forms of capital from Tier 1 calculations.)

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