Change to the Basel framework must, and will, happen. But many bankers question whether version III will be any more successful than efforts I or II. Writer Geraldine Lambe

What is it?

The latest proposed iteration of the Basel framework, which aims to build stronger buffers into the financial system. The proposals - dubbed Basel III - cover capital, liquidity and provisioning, and will raise defences and constrain the pro-cyclical build up of leverage in the system. These could be in force by the end of 2012.

Who dreamed it up?

The Basel Committee, a club of bank supervisors, under instruction from the G-20. The main provisions are to:

- Raise the quality, consistency and transparency of the regulatory capital base. Under the new rules, Tier 1 would largely comprise (a stricter definition of) common equity, and some existing Tier 1 capital will be disqualified.

- Introduce a global minimum liquidity standard for internationally active banks that includes a 30-day liquidity coverage ratio requirement underpinned by a longer-term structural liquidity ratio.

- Introduce a consistent leverage ratio and monitoring mechanisms for all internationally active banks.

- In addition to the trading book and securitisation reforms, the proposals strengthen the capital requirements for counterparty credit risk exposures arising from derivatives, repos and securities financing activities.

- Introduce measures to encourage the build up of capital buffers in good times that can be drawn on in times of stress. Also, to promote more forward-looking provisioning based on 'expected losses', which captures actual losses more transparently and is less pro-cyclical than the current 'incurred loss' provisioning model.

What's in the small print?

Not so much hidden in the small print, as not yet fully understood - many of the provisions will have a dramatic effect. For instance, when working out the leverage ratio, proposals suggest that netting of repo and derivative contracts - a significant risk mitigation mechanism - may not be recognised. Basel III may also include sold derivative positions and other items at their notional values. This will balloon bank balance sheets.

What does the industry say?

Bankers know they are on shaky ground if they criticise Basel, but most are very worried by what the various provisions add up to. "The issues which are the focus of Basel III are entirely the right ones, but the design, content, and particularly the calibration, are causing concerns in the industry," says Andrew Cross, managing director of Credit Suisse in shared services, who has global responsibility for measuring and reporting all the bank's credit risk, country risk, market risk and economic risk capital.

The problem is that each separate working group has taken a "belt and braces" approach to their part. For example, in the case of Tier 1, Basel III will call for both higher quality and higher levels of capital.

"While the approach is understandable, the danger is that proposals will not be edited or recalibrated," says Mr Cross.

How much will it cost?

Everything will hinge on how much capital and long-term debt banks will have to raise and hold, and the impact this will have on banks' return on equity. This will not be known until the final recalibrations have been carried out following the consultative period.

What do the regulators say?

Regulators are unlikely to humour bankers' complaints. At a round table in Brussels last October, Stefan Walter, secretary-general of the Basel Committee on Banking Supervision, said: "There will be pressure from the industry, saying that capital requirements are too high. But the greater risk is that we end up undershooting the mark."

The law of unintended consequences?

If the rules are so strict that banks are disincentivised to take risk, they will not be much use in providing credit to companies or individuals. If the leverage proposals were to be introduced as they stand, banks would be under intense pressure to reduce balance sheets - and would look for the easiest route. A first target would likely be financing - with a drastic cutting of repo and stock lending/borrowing businesses. These are not particularly risky areas, but they involve billions of dollars. A withdrawal would cause a liquidity squeeze.

Could we live without it?

We must have something. It remains to be seen whether Basel III will do a better job than its predecessors.



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