A Summary Of The Updated Basel III Proposals And Rules

A summary of the updated Basel III Proposals and Rules

Basel III Overview and Update - June 2010

Firstly, some Basel II History (Basel III Overview is below)

• Basel II was implemented by many European and Worldwide banks in 2006.

• The existing guidelines were found to be unsuitable to ensure adequate bank liquidity during the Credit Crunch conditions. Basel II rules are now being reviewed in conjunction with the industry.

• There are a number of criticisms of Basel II, including that the rules are influenced by the industry, and they are very dependent on rating agencies.

• There were a number of weaknesses exacerbated by the credit crunch including,

• Excessive leverage in the banking and financial system and not enough high quality capital to absorb losses;

• Excessive credit growth based on weak underwriting standards and under pricing of liquidity and credit risk;

• Insufficient liquidity buffers and overly aggressive maturity transformation, both direct and indirect (for example, through the shadow banking system);

• Inadequate risk governance and poor incentives to manage risks towards prudent long term outcomes, including through poorly designed compensation systems;

• Inadequate cushions in banks to mitigate the inherent procyclicality of financial markets and its participants;

• Too much systemic risk, and connected financial players with common exposures to similar shocks, and inadequate oversight that should have served to mitigate the too-big-to fail problem.

Basel III Key Facts

• Basel III is an update to the existing Basel II guidelines

• The updated rules will affect the Capital Requirements Directive that banks use to determine the minimum capital they should hold to adequately fund them through periods of financial stress

• Basel III is currently in the consultation phase and here are numerous changes to the framework that are being considered.

• There are two new rations that will be used in Basel III, see below.

New Proposed Ratios to measure and monitor Liquidity Risk

Liquidity Coverage Ratio

Introduction of a Liquidity Coverage Ratio - to promote the short-term resiliency of the liquidity risk profile of institutions by ensuring that they have sufficient high quality liquid resources to survive an acute stress scenario lasting for one month.

Net Stable Funding Ratio

To promote resiliency over longer-term time horizons by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis. The Net Stable Funding Ratio has been developed to capture structural issues related to funding choices.

Volcker Plan to restrict proprietary trading

The Volcker rule was designed to prevent excessive risk-taking at financial institutions. It was suggested by Paul Volcker who is an American economist and former Federal Reserve Chairman.

The Volcker plan will generally prohibit banks and bank holding companies from engaging in proprietary trading activities and from sponsoring and investing in private equity and hedge funds. The Senate bill contains a version of this rule but the House bill does not.

This rule as specified in the Senate document requires regulators to implement regulations for banks, their affiliates and bank holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds. Nonbank financial institutions supervised by the Federal Reserve will also have restrictions on their proprietary trading and hedge fund and private equity investments.

Regulations will be developed after a study by the Financial Stability Oversight Council and based on their recommendations.

Commentary

This rule will involve splitting up large financial institutions if they wish to trade using their own cash. Institutions will also be prohibited from investing in hedge funds. This is commonly described as removing the Casino part of financial institutions. An obvious question is though, what about client funds, but this is dealt with in other parts of the new legislation.

Surely this will mean that organizations such as Barclays, Citibank and RBS will have to go through tremendous structural change, unless they limit trading on behalf of clients only. It is less likely that firms such as Goldman Sachs will be as affected as they would be determined to be a Non Bank, thereby subject to fewer changes. However, considering a good chunk of their profits are from Proprietary sources, it is uncertain how much they will be changed.

OTC Trading Regulations

Regulation Changes to OTC Derivatives in the USA

It is likely that the new regulations would require swaps dealers and major swap participants to be regulated by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).

The bill would also require that derivatives eligible for clearing must generally be cleared and traded through an exchange unless one of the parties to the swap is an end-user that is hedging commercial risk.

Their is also the controversial "push-out" provision. This provision states that no federal assistance i.e. Taxpayers money (including Federal Reserve loans or Federal Deposit Insurance Corporation (FDIC) insurance) may be given to any swaps entity, which includes a swap dealer.

This would likely prevent a bank from being a swap dealer because banks cannot, in practice, give up the right to receive Federal Reserve loans or FDIC insurance. The House bill does not include the push-out provision, so it is not clear what will happen when the House and Senate bills are reconciled to form the new law.

Changes Proposed by the Bank of International Settlements in Basel

The BCBS (Basel Committee on Banking Supervision) has also put forward a set of proposals aimed at the systemic risks posed by derivative activities.

• OTC derivative exposures will be subject to higher capital requirements based on stressed inputs and longer margining periods that reflect the liquidity.

• derivatives exposures that are not cleared through central counterparties that meet the revised CPSS/IOSCO standards will be subject to higher capital requirements, thus increasing incentives to use such central counterparties.

• exposures among major, interconnected financial institutions have a higher degree of correlation compared to exposures to the corporate sector and would therefore require relatively higher capital.

Systemic Risk Supervision

The bill would establish an oversight committee under the Federal Reserve

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