Basel III: A paradigm shift

On October 29, 1929, when share prices on the New York Stock Exchange collapsed, a decade of excessive optimism and speculation came to a sudden and spectacular end precipitating a ten year slump. In response, the US passed far-reaching regulation and post September 2008 a similar response has come from political decision makers. In the aftermath of the crisis, the G20 have repeatedly demonstrated their commitment to reinforce the regulation of the financial industry. While the first drafts of the new regulatory framework, dubbed “Basel III” have been met with heavy criticism by both industry and lobby groups, the example of the political reaction to the 1929 crash illustrates just how far politicians are willing to go subsequent to a catastrophe of such a massive scale.

When examining the new regulation currently in development, a shift in paradigm becomes apparent. While the Basel II framework comprised a variety of positive reforms, it was naturally infused with the idea of a self-regulatory approach. However, the recent crisis illustrated the inadequacy of this prevailing philosophy, as the existing regulatory framework failed to identify the systemic risks inherent to the profoundly interconnected global financial system. To enhance the stability of the financial system, responsible authorities are seeking to not only improve the surveillance of the financial industry, but to also address factors deemed to be at the root of the crisis, notably balance sheet mismatches, high on- and off-balance sheet leverage and overly rapid growth of financial institutions.

Key changes

The prospective regulation is conceived as a reinforcement of the prudential regulation of capital and liquidity, proposing changes along several axes, including the following key aspects:

• Increase in the amount and quality of capital of banks in order to enhance their loss-absorbing capacity and thus their resilience to crisis situations. Amongst others, this includes a more transparent and comparable definition of capital,

• Introduction of a non-risk based leverage ratio, which is designed to limit the total exposure a bank can bear relative to its available capital,

• Amendment of the existing large exposures regime, increasing requirements related to the identification of connected clients and the treatment of exposures to schemes,

• Introduction of the Liquidity Coverage Ratio and the Net Stable Funding Ratio, designed to improve resiliency to short-term liquidity shocks as well as to medium- term protracted stress situations.

Big impact on business models

The impact of this prospective regulation on the financial industry, even taking into account any potential alleviation, is not to be underestimated. Indeed, supervisory authorities in Luxembourg and abroad have expressed their conviction that certain business models are likely to cease to exist as a result of the regulatory reform. Furthermore, the transition to the new capital and liquidity regime, in particular regarding the implementation of the proposed ratios and metrics, will force Luxembourg institutions to invest significant time and resources. George Soros is quoted for saying: “Once we realise that imperfect understanding is the human condition, there is no shame in being wrong, only in failing to correct our mistakes.” While the changing regulation might be perceived as a threat by many market participants, it should thus equally be acknowledged as an opportunity to initiate necessary steps towards improving their risk management frameworks. It might not be possible to entirely prevent a future crisis from recurring, but acting now could significantly mitigate the potential impact.