What to Expect from Basel III?

Petr Dvořák
2010 European Financial and Accounting Journal  
Dear readers,I would like to dedicate the third edition of European Financial andAccounting Journal to contemplate what could be anticipated from BaselIII. The development and global impact of financial crisis have been sointense that it could not remain without politic and regulatory response.Thus the officials come up with the new proposals for more strictregulations that would prevent the financial crisis of comparable sizefrom recurring.What changes will the enforcement of Basel III bring
more » ... the banks andwhat might be expected from them? In short, the equity capital shouldincrease and its quality should improve. This should become evident in agreater stability of the financial system.The increase in minimum capital (strictly speaking, the globalminimum capital standards) will be required from banks in two basicways. The first lies in implementation of a conservation buffer at 2.5%above the regulatory minimum, which should be instrumental to absorbadditional bank losses when the economy does not flourish and bankswould make greater losses consequently. Banks shall not haveautomatically the obligation to create this kind of capital, nevertheless ifthey fail to obey, they will be subjected to explicit restrictions on payingdividends to shareholders and bonuses to the managers. Banks will morelikely to avoid such situation, thus it could be expected, that they willimplement the capital increase voluntarily.The second form is countercyclical capital buffer, which should reducecriticized weakness of the current Basel II, namely its rather pro-cyclicalnature. The application of this buffer will be in competence of nationalregulators, who shall be able to increase the capital ratio by 2.5 percent ifthe volume of credits in economy grows faster than GDP. The capitalincrease should take place in the banks in advance in the time economygrowth and on the contrary in recession this generated capital will be usedfor to cover losses.The capital increase is mostly considered necessary because thecurrent capital buffer has turned up to be entirely insufficient. On the other hand it should be noted that the planned capital increase cannotensure the survival of all banks during the another financial crisis becausethe decline in assets values may of course be higher than the banks wouldbe capable to absorb even from increased capital. The significant role willbe played also by the assets valuation because banks could reach a newrequired level of capital ratio through a capital increase but also byreducing risk-weighted assets. The valuation and taking into account therisks involved is of a crucial importance for their determination.In addition to the quantitative increase in capital Basel III puts moreemphasis on its qualitative composition. This is reflected in the fact thatthe global minimum capital standards ratio based on common equity –capital increases. Thus banks will have to obtain new capital required alsoby an expansion of the authorized capital. In a theoretical point of view itshould contribute to increase commitment of shareholders to bankfunctioning of banks. The practical impact is questionable in this respect,since the financial crisis has shown us that the liability of shareholders ina number of large banks in particular did not work.The banks under theprospect of higher appreciation often launched themselves into relativelyhigh-risk operations that endangered the very existence of the banks (andin some cases led to their downfall), and the shareholders did not preventthem from doing so. The whole problem is not that simple as it seems tous today. It should be noted that what is clear to everyone now, before thecrisis it appeared very differently. Sophisticated methods of riskmeasurement, an objective rating valuations, elaborated regulation – theseare just some characteristics that no one questioned too much before thecrisis and which given a rise to rather positive expectations in their way.It is difficult to blame shareholders now that they did not identify the highrisks in that time. The problem is not that simple as it seems to be. Basedon this experience it is therefore not possible to assume that higher impacton shareholders in consequence of higher proportion of authorized capitalin the banks shall bring from their part significant pressure to reduce therisk undergone by these banks. Maybe it would work for currently knowninstruments and associated risks but the development cannot stopped andthere new instruments may bring new problems.So what can be expected from the new rules? For sure it shall bringthe higher ability of banks to cope with potential losses due to morecapital reserves. On the other hand, we have already learned enough fromthe history that absolutely no regulation ensure to provide fully stablesystem and it is doubly true about the financial system. Therefore, at the end it shall be decisive from the behavior of all entities resulting fromtheir inside motivation. And as their behavior will never be adequatelyguarded at all nor regulation can fully enforce such a caution. It can onlyregulate it in a certain way.Basel III shall stand in good stead to financial system but what shallbe its real implications and to what extent shall the aims be fulfilledwhich its creators input into it, or, conversely, how considerably banksshall seek to find (open up possibilities) and apply by which they shallendeavour to avoid new rules. This shall be possible to evaluate in thehorizon of 10-15 years. A timetable for Basel III implementation isallocated till 2019.
doi:10.18267/j.efaj.51 fatcat:g7rjtw6kmjaffjnu6vzh5oifty