Basel III
The Financial Stability Board (FSB) has called for the emergence of a “more disciplined and less pro-cyclical financial system that promotes a balanced economic development”, in the aftermath of the financial crisis that occurred a year earlier.
Banking prudential rules have changed significantly since then with the adoption of structural reforms that already have been enacted or with others that are ongoing with the main regulators. These new rules that have been put forward globally under the aegis of the Basel Committee, have then been endorsed at the European level with revised directives, in particular those relating to banks’ capital requirements (“Capital Requirement Directive”, (CRD)), before being transposed by domestic banking regulators.
Why such a Banking supervision reform ?
The Basel III reform which was adopted on December, 2010 16th, and was subsequently revised in June 2011, started from the evidence that the depth of the crisis mainly resulted from the excessive growth of banking on-balance sheet and off-balance sheets exposures (via OTC derivatives transacted between banks for instance), whilst at the same time, the level and quality of their capital requirements held to cover their risks deteriorated. Furthermore, many of them did not accumulate sufficient reserves to face a liquidity crisis.
In this context, the banking system proved unable to cover realized losses that occurred from structured credits and securitized products first, and then to allow for the re-intermediation process of a portion of off-balance sheet exposures. During the depths of the financial crisis, the uncertainties over the quality of balance sheets, banks’ solvency and the risks resulting from their interdependence (since a bank’s default may trigger another bank’s default, thus potentially generating a systemic risk), have all caused a crisis of confidence and a widespread liquidity crisis.
What are the key regulatory changes put forward by the Basel III reform ?
This reform was implemented in two stages: an interim phase (also called “Basel 2.5”) with the CRD 2 and 3 Directives that should be implemented from early 2011, followed by the move towards Basel III starting in early 2013 with the adoption of the CRD 4 Directive. These measures relate to the following issues:
- Solvency ratio: adoption of a more stringent definition of tier-1 capital, of counter-cyclical buffers and of minimum “core tier-1 capital” (set at 9% from June, 30th 2012).
- Liquidity ratios: will be calculated on a stress-tested basis and will require significant buffers of liquid assets at any time
- Leverage ratios: harmonization efforts to avoid excessive indebtedness and balance sheets’ growth
- Market risk: adoption of a more conservative VaR calculation method
- Systemic risk: additional capital charges applicable to the largest financial institutions to prevent systemic risk.
- Risk transfer operations (securitization): higher capital charges (risk weightings) applicable to all parties (originators, sponsors, investors)
- More controlled Directors and traders’ compensation schemes in order to reduce excessive risk-taking
- Derivatives: continued standardization efforts.
Our beliefs:
The Basel III reform requires the construction and the development of new innovative models to improve the consideration of counterparty trading book or systemic risk for example.
Basel III also requires the evolution of existing models to meet the requirements of the new reform for example for the calculation of the ratio of credit or market risk.
Regulators urge financial institutions to gradually adopt advanced approaches that use internal models and that must be certified by the “Autorité de Contrôle Prudentiel” (the French Banking regulator).
These advanced approaches also help increase financial institutions’ operational efficiency, an important source of enhanced productivity and value to their clients through a better pricing of commitments in a fierce competitive landscape and very uncertain macroeconomic context. In addition, they allow financial institutions to optimize capital, a rare and essential commodity nowadays.
Last but not least, the move towards advanced approaches allow financial institutions to improve their public image vis à vis capital markets, rating agencies, regulators favored by a more robust risk supervision framework. Consequently, they contribute to improve the tactical and strategic planning of financial institutions by achieving an optimal risk/return ratio, and subsequently to focus their development towards the most profitable clients and sectors.
