Basel III and Systemic Risk

Basel III substantially raises the amount and quality of core Tier one capital from 2% to 7%, plus introduces an additional countercyclical buffer of up to 2.5% and a discretionary surcharge for ‘systemically important’ institutions, i.e., the big dealers.

Basel III fixes known mispricing of securitisation risks, which is very important given the fundamental role of securitisation in the global banking system. Another key innovation is the inherent recognition that the risk-weighted capital ratio alone is not sufficient. Basel III supplements the capital model with a leverage ratio and liquidity requirements. Each of these enhancements has a systemic risk management objective.

Restricting the leverage of major dealers is clearly important from a systemic risk perspective. Basel III adds a minimum Tier one balance sheet leverage ratio of 3%, subject to further calibration. There are two reasons for this addition. First, countries that imposed a leverage ratio, e.g., Canada, seemed to fare better during the crisis. Second, the leverage ratio serves as a form of safety net for the capital ratio, which is vulnerable to arbitrage in both the numerator (capital) and denominator (risk-weighted assets).

In addition to the leverage ratio, Basel III introduces a short-term liquidity coverage ratio and a longer term net stable funding ratio, designed to address the duration mismatches in bank assets and liabilities. Banks fund a substantial portion of assets in the repo markets and when these markets froze due to declining mark-to-market collateral values, inter-bank lending also dried up causing systemic shocks. The link between liquidity and leverage amplified these shocks. This linkage comes from widening haircuts on repo collateral, which banks must fund with their own capital. Ultimately, these liquidity requirements are intended to prevent another ‘run’ on the shadow banking system and global seize-up of credit.

One of the critical sources of liquidity risk came from short-term funding of securitised assets in the repo markets, a practice that banks had ramped up to take advantage of regulatory arbitrages. Basel I and II under-priced risk weights for securitisations allowing banks to increase leverage (and returns). They further increased leverage by manufacturing additional

super senior collateral through re-securitisation (e.g., CDO-squareds). The fact that Basel made no distinction for re-securitisations encouraged this activity. Banks also moved securitised assets from the banking book to the trading book to access the more favourable capital treatment. Basel III (II ½) firmly addresses all of these regulatory arbitrages while providing a detailed ‘carve out’ for dealers with sufficiently robust risk management processes.

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