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Basel III - Leading the way to herald a paradigm shift in Risk Management

Guest post by
Sukruti Suresh, Senior Associate Consultant, Infosys

 

The financial crisis of 2008-09 paved way for a regulatory reform that was revolutionary. The impact of this crisis was so severe that the losses it caused led to a near collapse of the financial system and crippled the economy to a large extent. Considering market sentiments, the need for a new set of reforms was at an all time high. This led to an intervention by the Regulators on a global scale. Slowly and steadily, the economy regained a semblance of stability. The next obvious step in the process of recovering and stabilizing was a detailed analysis of the cause of the unparalleled failure of the financial system the world witnessed. There seemed to be a collective failure of Banking, regulation as well as supervision. With massive amounts of the tax payers' money being pumped towards reviving or "bailing out" crumbling financial markets and institutions, finding the cause and solution for the problem was the need of the hour. This eventually resulted in a complete rework of existing regulations which included changes in capital management, liquidity, Governance etc. The events that transpired in 2008-09, led to the revamping of the Basel 2 regulations and paved way for the Basel 3 regulations.

Post the financial debacle of 2008-09, the Basel Committee for Banking Supervision took upon itself the responsibility of coming out with a set of regulations, which were essentially a revamped version of the capital adequacy requirements as per the Basel II guidelines. The result of this revision came to be known as the Basel III Framework.

The structure of implementation of the proposed changes is such that each area of change or revision has its own timeline and manner of planning, deliberation and actual implementation. The entire purpose of Basel III is to provide a level playing field for all banks stand to be threatened as national regulators of countries around the world are not able to come to a common conclusion over several key issues. The primary reason for this being the varied starting points with regards to the impact of the financial instability and crisis on different countries.

The primary objectives of Basel III are:

  • Fortify global capital and liquidity regulations to ensure a more sound & buoyant banking sector.
  • Enable the bank's ability to absorb stress and shocks resulting from financial and macro economic scenarios.

In order to ensure this, a 5 pronged approach has been suggested. The areas to be covered under this approach are as follows:

  • Intensifying/Consolidating the capital components (Tier1, Tier 2 & Tier 3)
  • Intensifying/Consolidating Risk Management practices
  • Introduction & monitoring of an Overall Leverage Ratio
  • Dealing with Pro-cyclical nature of the previous versions of the Basel accords
  • Management of Liquidity Risk

Intensifying/Consolidating the capital components (Tier1, Tier 2 & Tier 3)

Basel 3 proposes that the Tier 1 capital should consist of going concern capital in the nature of common Equity and some equity-like debt instruments which are subordinated in nature as well as instruments where dividend payments are optional. Similarly, components of Tier 2 capital also stand to be scrutinized. Basel 3 proposes to eliminate all Tier 3 all together. Basel 3 repeatedly propounds the theory that equity is the best form of capital as it most successfully writes off losses faced by banks. Several deductions that have been recommended to be removed while computing Tier 1 capital are goodwill, minority interest pertaining to 3rd parties involved in subsidiary take over, banks investments- either in its own shares or in shares of other banks and financial institutions etc.

The primary goal of this proposed change seems to be a sense of quality and transparency in terms of the capital base of the Bank. There also needs to be a clear demarcation regarding the extent or ratio in which a particular tier of capital would bear the brunt of a loss. Capital composition must be detailed to the most granular level, thus avoiding any misuse or lack of clarity of capital formation.

For more on the changes proposed in the Basel 3 regulations, watch out this space...

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