Basel III and macro-prudential policy in the EU
During the recent crisis several gaps in the regulatory and supervisory framework for financial institutions were revealed. It became apparent that the quality and quantity of the capital base of many financial institutions were insufficient to withstand severe shocks. In addition, the abundant liquidity that characterised the financial system in the years preceding the crisis suddenly disappeared, exposing several institutions to liquidity shortages. To avoid a complete financial meltdown, governments provided an unprecedented amount of financial support and central banks had to significantly increase their provision of liquidity during the initial stages of the crisis.
These events led to many different policy responses, resulting in a major overhaul of the regulatory and supervisory framework. Under the aegis of the G20, a tremendous amount of work has been done by the Financial Stability Board and the Basel Committee to reform the regulatory and supervisory framework in order to address the core causes of the crisis. A major component of this reform was the revision of the Basel II framework with the aim of strengthening the capital base of banks and introducing stricter liquidity risk requirements and an absolute leverage ratio.
The revision of micro prudential regulation - Basel III
The recent agreement reached on the Basel III framework and its full endorsement by the Group of Central Bank Governors and Heads of Supervision is an important piece of work that delivers on global financial reform and constitutes a cornerstone of the new regulatory system.
The five main elements of the new framework are as follows.
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First, under the new definition of regulatory capital, both the quality and consistency of the capital base will be improved. This will help ensure that sufficient high quality capital is available when it is most needed, namely at times of stress. Particular emphasis will be placed on the core elements of Tier 1 capital. Tier 2 capital elements will be simplified, and existing Tier 3 capital will be abolished. Enhanced disclosure requirements will further improve the transparency of the capital structure of banks. Overall, Constâncio is confident that stricter conditions for what should count as regulatory capital will contribute to restoring confidence in the ability of banks to weather future periods of stress. This in itself will substantially reduce the probability of future banking crises, thus improving long-term economic and social welfare.
· Second, the introduction of counter-cyclical capital buffers should protect the banking sector from periods of excessive credit growth. As witnessed during the crisis, the build-up of excessive credit levels in an economic upturn is often followed by large losses on this outstanding credit when economic conditions deteriorate. These losses may in turn have a destabilising effect on the banking sector. The buffering mechanism consists of two elements. First, a capital conservation buffer range – equal to 2.5% of risk-weighted assets and made up of Tier 1 common equity – would be established above the minimum. The second element, currently under development, consists of the possible extension of the buffer range up to an additional 2.5% in periods of excessive credit growth (known as a “counter-cyclical buffer”). An important additional benefit of this measure would be that it might mitigate the credit cycle.
· As a complementary measure to improving the quality and quantity of the capital base, the third element of the framework consist of the strengthening of the risk coverage of the capital framework by revising the prudential rules on securitisation and trading book activities, and by putting forward proposals for the revision of the counterparty credit risk framework. This would imply higher risk weights and thus result in higher capital requirements for these activities.
· Fourth, the planned introduction of a non-risk based leverage ratio should serve as a credible supplementary measure to the risk-based requirements to contain the build-up of excessive leverage and address model risks associated with the risk-based capital framework.
· Last, but not least, since it constitutes a building block in the new framework, is the development of a liquidity risk framework aimed at improving banks’ resilience to liquidity shocks. The liquidity risk framework consists of two main measures: a short-term measure (Liquidity Coverage Ratio) establishing a minimum level of high quality liquid assets to withstand severe stress over a one month period and a long-term measure (Net Stable Funding Ratio) designed to ensure that the maturity structure of assets and liabilities are better matched, requiring banks to fund long-term assets with more stable types of liability. Work is underway on the important details and precise calibration of these ratios.
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