The changes introduced by Basel III in response to the international financial crisis have strong implications not only in regard to capital requirements and the introduction of new liquidity and leverage requirements, but also for the governance, organization, processes and system-related risks of financial institutions.
While the crisis is having a more moderate impact on the Latin American region than on the US or Europe, and its effects could certainly slow the region’s growth, the outlook remains positive. However, it should also be taken into consideration that the current growth cycle could lead to future situations similar to those experienced in Europe and the United States if some action is not urgently taken, mostly measures addressed in the Basel regulations.
Basel III therefore brings a substantial improvement in prudential risk regulation, which also impacts on all areas of management and raises new questions.
The need for organizations to improve risk management is emphasized by the new regulatory requirements, but it requires a strong effort by all parties involved. Management Solutions believes that sharing experiences and views on this subject can help the financial sector as a whole to find solutions to common problems.
With this in mind, Management Solutions, an international consulting firm, organized a convention bringing together a select group of experts (regulators, heads of risk from large international groups and from national market leaders as well as independent experts), with the aim of sharing its experience of the Basel II compliance process as well as its views on the new Basel III impacts.
This Convention was intended to follow up on the initiative organized by MS in 2008 to mark the entry into force of Basel II, in order to review the progress made since.
Conceived from a global perspective, the Convention was held during the month of May in five locations: Argentina, Brazil, Chile, Mexico and Peru, with the aim of examining differences at national level and thus enrich the analysis. Having the opinion of national supervisors, major national and international financial institutions and independent experts turned the Convention into a unique framework in which to share experiences on the impact of Basel on the risk management function in financial institutions.
This document sums up the main matters addressed throughout the Convention, which looked at current implementation experiences and analyzed how the role of supervisory authorities has changed over time.
The Basel capital accords: BIS I and II
The Basel Accords are recommendations on banking regulation and supervision issued by the Basel Committee on Banking Supervision. Although not binding, in practice over 100 countries have adopted them and integrated them into their local regulation. The Basel Accords are essentially intended to ensure banks are able to absorb the losses arising from the risks inherent in their activity.
The Basel Committee on Banking Supervision was created in 1974 in response to the bankrupcy of German bank Herstatt, which highlighted the need to promote banking regulations that would establish minimum capital requirements for financial institutions based on their level of risk.
The first agreement issued, known as Basel I or BIS I, was published in 1988 and set the minimum capital for financial institutions at 8% of their risks. This was a step forward to ensure banks would be able to cope with their losses. However, Basel I had serious limitations; in particular, it assumed that all counterparties had the same credit quality, and financial innovations in the nineties created possibilities for arbitrage.
As a result of all this, in 2004 Basel II - or BIS II, was published with a view to converging risk measurement by supervisors with risk calculations from financial institutions themselves. The goal was to standardize banking legislation and regulations on risk and for this Basel II went beyond a minimum percentage of capital and encouraged the development of internal management procedures that would be appropriate for the risks involved.
Basel II is structured around three pillars:
- Pillar I: focused on the methodology required for the calculation of regulatory capital to adequately cover credit, market and operational risk, incorporating a standardized method and advanced methods.
- Pillar II: focused on enhancing supervisory powers and on increasing the capacity for self-assessment of capital levels for financial institutions with an economic capital model that adequately integrated all risks.
- Pillar III: focused on improving the transparency of information for third parties, requiring financial institutions to provide clear information on their risk profile as well as on the activities and controls used to mitigate their risks.
Finally, Basel III – or BS III, was published in 2010, partly motivated by the shortcomings identified in the financial crisis that began in 2007. Its aim can be summarized as ensuring the solvency and liquidity of financial institutions, avoiding procyclicality.
To achieve these objectives, Basel III established six major steps:
- To increase the quality, consistency and transparency of capital: Basel III changes the type of instruments that can be included in Tier 1 and Tier 2 capital, and removes the concept of Tier 3 capital. It tightens requirements by incorporating a capital conservation buffer of 2.5%, which, if not met, restricts dividend and bonus payments. Requirements are increased gradually, following a schedule proposed by Basel.
- Requirements for systemic institutions: Basel III introduces an additional capital requirement for financial institutions deemed to be systemically important, set at between 1% and 2.5%.
- Expanded risk coverage: Basel III promotes integrated management of market and counterparty risk, introduces CVA-related impairment risk, increases capital requirements for derivative and repo exposures, and proposes other measures to encourage OTC derivatives contracts through central counterparties.
- Limited leverage: in order to control leverage levels in the financial system, Basel III introduces a tier 1 capital ratio of at least 3% of bank exposure, which must be met by 2018.
- Mitigation of procyclicality: among other measures to reduce procyclicality in the financial system, Basel III introduced a countercyclical capital buffer of between 0% and 2.5%, which should be built up when the economy is booming to be used during periods of stress.
- Liquidity measurement and control: among other monitoring tools, Basel III proposed two liquidity ratios: the liquidity coverage ratio (LCR), short term, and the net stable funding ratio (NSFR), long term. Both must be greater than 100%; in its most recent study on liquidity, published in April 2012, the Basel Committee noted that there was still work to be done to meet this objective.
Expected implications of Basel III
When fully implemented, it is expected that the Basel III regulations will have several benefits mostly relating to increased financial stability, among which the following are particularly significant:
- Prevention of new systemic crises.
- Mitigation of market procyclicality.
- Increased transparency and strengthened investor confidence.
- An improved model for measuring, controlling and managing solvency, liquidity and leverage.
- Integration of market risk and credit risk at the wholesale level.
However, the implementation of regulations is also expected to entail risks in some areas, among which are:
- The rising cost of credit and a possible reduction in credit activity as a result of higher capital and liquidity costs.
- A short-term squeeze in liquidity in the system and the risk that public information on liquidity may lead to high market volatility.
- A potential disincentive or rising costs for certain businesses as a result of higher capital requirements.
- Some disincentive to investment in financial institutions and insurance companies.
In any case, financial institutions and regulators agree that the benefits clearly outweigh the risks and as a result there is a widespread, positive positioning towards the Basel III regulations.
In Latin America, most entities have defined their roadmaps and continue to make progress in the implementation of the Basel recommendations, either under the standard method or under advanced methods.
Meanwhile, though Basel III is currently at the stage of being integrated into the regulations of each country, the reality is that many banks are already adapting to its requirements. Some countries are even ahead of the established implementation schedule, while in some other countries the degree of progress is smaller and efforts continue to focus on full compliance with Basel II – though in some cases incorporating certain elements of Basel III.