Thursday, July 5, 2012

Basel III: Issues & Ramifications

Basel III is a crisis driven job that is still being hotly debated and implemented in pieces without proper integration.

- What is Basel III and its implications?

BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed by the members of the Basel Committee on Banking Supervision in 2010-12 This, the third of the Basel Accords (see Basel I, Basel II) was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements introduces new regulatory requirements on liquidity and leverage.

Hidden in that very serious and prudent definition are many fundamental assumptions on what kind of assets are on bank balance sheets. The nature of these assets is what drives the capital and liquidity requirements. Some of these assets are deemed to be lower risk, that is have lower risk weightings, and hence have lower requirements in terms of capital and liquidity. The problem with that is that such risk weightings are backward looking and hence no guarantee of the future performance. Sovereign bonds and home loans are a case in point in that being rated as risk free or lower risk weighted than other assets historically many of these assets are what has caused the current crisis. Because these were perceived as risk free, banks loaded their balance sheets with them to getter better returns using less capital. Second, many assets such as trade finance loans which have rarely ever caused wide spread financial stress, are now being re-weighted or lumped together in new measurements which will make banks want to hold less of those assets. 

- What will it change in Mauritius if we adopt it in local context?

Our challenge will be to get Basel 3 amended in some form that indeed suits our local context! If we cut and paste enacts it straight up, it will hurt. Trade finance business for importers and exporters for example could become restricted by banks or cost such borrowers much more in future. This could hit our economy quite a bit.

Also, even there is another ratio called a liquidity coverage ratio which requires banks to hold assets that are easy to sell in the event of a market crisis. The LCR calls for banks to hold high-quality corporate and government bonds which are in short supply in countries with fledgling capital markets and nonexistent in much of Africa. This could put our ability to compete as an African regional financial centre as our banks would need to adjust our liquidity to this demand. Perhaps we even have to send our excess liquidity out of this region! Does that make sense?

- In what ways will it really be damaging to Mauritius as developing country?

There is nothing wrong with Mauritius banking sector in terms of taking on excessive risk. I have nothing but praise for how Mauritius always manages through crisis and has never had any industry or company bring us to our knees. Our skill and track record mean we have the potential to be the leading regional banking and finance centre. Indeed some of us have set up our banks to do just that! But the ever increasing capital and liquidity requirements may mean we just miss taking smart, calculated investment risks in our region as the rules make it prohibitively costly to do so. Nothing is ever risk free, not even sovereigns, and much of Basel 3 assumes the mix of assets and counterparties especially in our region are riskier than others. This region will scale up dramatically I believe in the future and Mauritius institutions will need to scale up to participate in that. We already are well ahead of Basel 3 minimums in many respects so we have been a force of good regulation to now. But some of the new requirements are very problematic and short term safety does not guarantee long term success.

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