Basel III: no Achilles’ spear

May-June 2011 Conjoncture 3 Basel III: no Achilles’ spear Laurent Quignon n Greek mythology, Achilles’ spear had the virtue of healing the wounds that it had inflicted. The macroeconomic impact studies carried out on behalf of the Bank for International Settlements (BIS) suggest that the same will be true of the Basel III prudential reforms that will apply to banks. In other words, the effects on new constraints on financing for the economy could be neutralised in the long term by the benefits of improved financial stability. But some factors in this analysis invite a degree of scepticism. The financial crisis laid bare the shortcomings of the existing prudential framework and made a thorough overhaul an overriding necessity. The G20 approved the new Basel III solvency and liquidity rules at its Seoul summit in November 2010. In December 2010 and January 2011, the Basel Committee on Banking Supervision published its latest recommendations on bank solvency and liquidity 1 . Reflecting the orders of magnitude involved, joint quantitative impact studies carried out by the Basel Committee and the Committee of European Banking Supervisors (CEBS, now the EBA 2 ) and published in December 2010 highlight the unparalleled distortions in bank balance sheets and in the structure of financial savings and funding that would follow from the application of the new standards. Aside from differences that have more to do with form than substance, the various macroeconomic impact studies are reasonably consistent on the impact – negative – of the new rules on the economy. The extent of that impact is more controversial. It seems that only the assumed improvement to financial stability, with its (questionable) benefit for economic growth, has led the BIS to its favourable conclusions. From Basel II to Basel III: considerable quantitative impacts Basel III does not represent all the changes in banks’ prudential rules since the first version of Basel II; the Basel Committee significantly altered the framework for trading business in the meantime (“Basel 2.5”). Quantitative impact studies suggest that the new standards will make such a big difference to bank balance sheets that they will significantly affect the structure and volumes of financial savings and funding. Minimum common equity requirements multiplied by a factor of five The new Basel rules for calculating the solvency ratio’s numerator may be grouped under three headings: improving the quality of instruments eligible as prudential capital, increasing the regulatory deductions laid down in Basel II and raising the minimum solvency ratios. On top of that, a leverage ratio will be introduced based on the balance sheet and certain off-balance sheet items without any risk weighting. A tighter numerator The crisis revealed that certain Tier 1 capital instruments – classed, after all, as core capital – were unable to absorb losses 3 . This was particularly true of preferred shares in Anglophone countries. The Basel Committee has therefore tightened its definitions of regulatory capital. I

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