BASEL II LIMITATIONS

 It provided incentive to a bank’s management to underestimate credit risk. Basel II

norms allowed banks to use their own models to assess risk and determine the capital
amount required to meet regulations. Most banks chose models that were overly
optimistic to build risk models that allowed them to provide less capital for regulatory
norms and to increase return on equity.

 Basel II’s effectiveness depended a lot on a strong regulator. Basel II gave banks a lot
of room to decide how to implement the regulation’s spirit correctly. So it was always
going to be a tool for those bankers looking to circumvent the rules. This is where the
role of a regulator was necessary to ensure that rules would be implemented in the right
spirit. In countries like the U.S. where the regulator was often lax, this was a recipe for
disaster as we saw in the subprime crisis.
  Basel II norms were not adequate in covering market risk. This was especially true for
investment banks, which had large exposure to market-linked securities. Basel II often
allowed bonds issued as part of securitization to be treated as AAA securities.

Securitization is the process of selling various types of loans like government, mortgage, auto,
and card loans pooled together as bonds. However, most of these bonds contained assets that
were junk grade.

Investment banks like Morgan Stanley (MS) and Goldman Sachs (GS), banks with major
investment banking arms like JPMorgan (JPM) and Citibank (C), and other investment banks
in an ETF like the Financial Select Sector SPDR Fund (XLF) benefited from the lower
coverage on market risk under Basel II.

To mitigate the concern on market risk, Basel II.5 norms were introduced.

BASEL III

INTRODUCTION

To address the concerns, Basel Committee on Banking Supervision came out with Basel III
Accord in September 2010. Basel III Accord had a new capital framework. It revised and
strengthened the three pillars of Basel II.

 Introduced an additional common equity layer the capital conservation buffer of 2.5%
that when breached, restricts earnings pay-outs to help protect the minimum common
equity requirement.

 Introduced a buffer capital known as countercyclical capital buffer, which places

restrictions on bank participation during economic boom, with the aim of reducing their
losses in credit busts that generally follow in the economic cycle later on.
  It proposed additional capital and liquidity requirements that would be held by large
banks called systemically important banks whose failure would threaten the entire
banking system.

 Introduced a leverage ratio—a minimum amount of loss-absorbing capital relative to

all of a bank’s assets and off-balance sheet exposures, regardless of risk weighting.

 Placed liquidity requirements on banks a minimum liquidity ratio intended to provide

enough cash to cover funding needs over a 30-day stress period.

 Contains additional proposals for systemically important banks, including requirements

for augmented contingent capital and strengthened arrangements for cross-border
supervision and resolution.

The Federal Reserve implemented Basel III Accord on U.S. banks. It’ll be done in a phased
manner and will be completed by 2019. There’s been some criticism of Basel III Accord, and
it can be further improved.