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Under the pre-crisis rules, banks were allowed to increase their leverage to unprecedented levels. This increased risk in the financial system and when the crisis hit, the implicit guarantees resulted in massive public bailouts around the globe.
The Basel Committee’s capital reforms, known as Basel III, substantially raise capital requirements from pre-crisis levels to reduce the probability of bank failures and the associated risks to taxpayers and to financial stability. Recently, much has been made of the perceived shortcomings of Basel III. Some argue that Basel III, which comes into effect next year, is not enough. Others argue that Basel III is too complex and should be replaced by a simple leverage ratio, calculated as tangible equity to non-risk weighted assets.
In Mr Ingves's view, the Basel III agreement fundamentally enhances national and global financial stability by both raising the level of capital required by banks, and by simplifying the regulatory framework. The Basel Committee supports a regulatory framework that is both prudent and as simple as possible. Hence the Basel III agreement introduces several simplifying changes to the regulatory framework. For instance, the definition of capital now focuses on tangible common equity, the truest form of loss-absorbing capital. Moreover, all components of the capital base and associated deductions such as goodwill or deferred tax assets must be disclosed in a fully comparable manner. By standardising and simplifying the measure of capital, Basel III makes the regulatory framework easier to understand, and will enable market discipline to work better.
Another important step has been the introduction of a non-risk based leverage ratio as a supplement to the risk-based requirement. This is a “belt and suspenders” approach to capital regulation. The leverage ratio will help contain the buildup of excessive leverage in the system, serving as a backstop to the risk-based regime and safeguarding against banks’ attempts to “game” the risk-based requirements.
Mr Ingves believes Basel III strikes a reasonable balance by strengthening overall bank-capital requirements while continuing to recognise that there are a wide range of risks within a bank’s business. Going forward, the Committee will look to simplify the framework further, while ensuring that it appropriately measures and responds to the risks it is supposed to mitigate.