Why Banks Should Care About Basel III

Though the final Basel III rules won't be implemented until late 2012, the Basel Committee's rules do more to cure the ills of the financial system than the finance reform bill Congress is trying to pass by July 4, indicated David Kelly, director of credit products at Quantifi (a vendor of analytics, trading and risk management software) last week at a Quantifi-sponsored event. "It's a very thoughtful, phased approach," he said. In former roles, Kelly managed the Chase Global Analytics group and the development of AIG Trading Group global derivatives trading systems.Basel III addresses many of the shortcomings of Basel I and II (which focus on market, credit and operational risk) and the excesses of the credit crisis. It demands that banks maintain more capital against their trading book and securitized loans. For example, banks will need to consider their "stress VaR," in other words, the effect of a market crisis across their entire investment portfolio, over 12 months and keep capital in reserve accordingly. It requires that banks take a wrong-way risk charge in case a derivative counterparty's troubles affect the bank adversely. It stipulates that banks value every asset underlying a securitized product when calculating capital. Re-securitizations (such as CDO squared products) need to be assigned higher risk weights. The one exception to many of these rules is a "carve out" for market makers.

Many of the changes Basel III would impose on U.S. banks would be unwelcome at first, Kelly noted. Adopting the new rules would result in a large capital shortfall - UBS analysts have estimated the largest banks would suddenly need to come up with $325 billion more in capital. Derivatives would need to mostly be traded through clearinghouses. Banks' ability to do off balance sheet financing would be curtailed. Unintended consequences of the rule could include tighter credit due to higher cost of capital and less liquidity, higher cost of hedging for corporates (as banks pass extra capital charges on to customers) and more high-risk banking activities shifting to hedge funds, which aren't covered in the rules.

But Basel III compliance would also do banks much good, Kelly believes. It should lead to better collateral management, better risk management and greater transparency. It could make the banking system more resilient and discourage non-beneficial financial engineering. Banks that work to adopt the standards before the end of 2012 could get first-mover advantages, such as the ability to offload high-risk securities before being forced to, potentially getting a better price. There could be opportunities to develop products that would fare well under the new rules, and a PR advantage in saying the bank is already compliant with the rules.