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Basel III and Systemic Risk

Monday, January 25, 2016

by Quantifi

One of the key shortcomings of the first two Basel Accords is that they approached the solvency of each institution independently. The recent crisis highlighted the additional ‘systemic’ risk that the failure of one large institution could cause the failure of one or more of its counterparties, which could trigger a chain reaction. Basel III addresses this issue in two ways. Firstly by significantly increasing capital buffers for risks related to the interconnectedness of the major dealers. Secondly by incentivising institutions to reduce counterparty risk through clearing and active management (hedging). Since Basel III may not explicitly state how some of the new provisions address systemic risk, some analysis is necessary.