Basel III & Systemic Risk

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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.

Whereas Basel III represents progress, there are several ongoing challenges. The first set of challenges has to do with the regulation itself. The timeline provides for a phased implementation period extending out to 2019. Another crisis could certainly occur within that time. While quantitative studies have shown limited impact of the higher capital requirements on the real economy, banks may choose to curtail or exit certain lending businesses if the returns are too low. A consequence could be the expansion of the unregulated and relatively opaque sector of the shadow banking system to fill the credit gap.

The second set of challenges is structural. Banks are moving toward active management of counterparty risk.  However, there is limited or no liquidity in CDS contracts needed to hedge a significant number of counterparties and institutions will continue to manage a substantial portion of counterparty credit risk through traditional reserves and exposure limits. The residual counterparty risk portfolio is essentially a pool of loans and therefore fraught with the complexities of CDO structures.

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