BASEL III: Upcoming challenges for banks

The global financial system created a vacuum of financial regulatory reform and transformation. With the growth in housing defaults and the impact of sub-prime loans and collateralised debt obligations (CDOs) on the economy, the international community focused on forming a united banking front regulation. As per definition of Basel III accord, the system was first devised in 1988 by leading central bankers in the top 10 nations. The first step in the Basel Accord, this laid the groundwork and liquidity requirement for banking institutions in the largest nations. Sprung from the liquidation of a leading German Bank, the system was built to alleviate the pressures of one banking weakness on the entire system. Stipulating that international banking organisations were required to hold 8.o per cent liquidity with respect to the total assets on balance sheet, the reform brought about significant change in the 13 member states who adopted it. Basel II was the second round of regulatory reform on the banking industry. Designed in 2004, the accord focused on three main pillars of risk, which included credit, operational, and marketliquidity. Banks were categorised based on both Tier 1 and Tier 2 capital ratios and their propensity to possible liquidity crunches. Tier 1 capital is sometimes viewed as the key measure of a banks health, defining the overall degree of assets it has on the balance sheet (i.e. cash assets from earnings, common and preferential stock). Tier 2 capital on the other hand focuses on the other assets which could include hybrid investments, sub- ordinate debt, and overall general provisioning. The Basel III Accord has recently become a topic of hot debate as it provides a new bar for banking regulation and reform. Spurn from the recent credit crunch, the Basel III will look at a number of key measures to ensure the sustainability of the banking industry. These include: l Installation of a new measure of leverage control, which will set the maximum limit of the risk both a bank or hedge fund will be able to take l Credit risk limitations. Organisations are limited to amount of credit they can borrow based on their assets. It will ensure that Banks and other financials do not take on too much risk. l Liquidity Ratio changes. To alleviate the possibility of a credit crunch, firms will now need to pledge a section of movable cash or credit to ensure borrowing or lending is not hindered. l Banks will be required to have a 4.5 per centage of common equity by 2015. This level will be extended to 7.0 per cent past this date. The new Basel III accord has come under scrutiny by leading economists, and industry analysts as being too restrictive. Economically, the debate over how much of an impact the new Basel reform will have on both developed and emerging markets is leading to a significant divide between both corporations and regulators. 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 there are numerous changes to the framework that are being considered. The writer is the Executive Vice President, Corporate Banking Division of Prime Bank Limited and Associate Fellow Member of Institute of Islamic Banking and Insurance (IIBI), United Kingdom. He can be reached at e-mail: touhid1969@gmail.com