On Tuesday, the Federal Reserve approved a stringent set of new global standards, known as Basel III, on capital and debt. The aim of the proposal is to prevent another financial crisis similar to the one that took place following the collapse of Lehman Brothers in 2008. FED officials also said that some of the larger banks, such as Goldman Sachs and JP Morgan, might face even stricter rules, due to the fact that they could pose a threat to the entire economy. The rules still have to be accepted by the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation.
Basel III rests on three main fundamentals:
1. Capital conservation buffer: Banks will be required to maintain a certain Tier 1 capital ratio, which is a comparison of a banking's core equity capital and total risk-weighted assets. Banks with more than $50 billion in assets would have to maintain a Tier 1 capital ratio of 7.5% until 2019, while bigger institutions in the U.S. could be required to raise up to another 2.5%. The rationale behind this is simple: it forces banks to keep a higher amount of capital reserves that they can conjure up in the event of a crisis.
2. Leverage ratio: This ratio is calculated by dividing Tier 1 capital by the bank's average total consolidated assets. Basel III introduced a minimum leverage ratio of 3%. FED officials, however, have shown interest in raising this limit to 6% for larger banks. In the financial crisis, many firms built up excessive leverage while still showing strong risk based capital ratios. The purpose of this ratio is therefore to supplement the capital ratio with a non-risk based measure.
3. Liquidity requirements: Basel III introduced the liquidity coverage ratio and net stable funding ratio. The first requires banks to hold enough high-quality liquid assets that can cover its total net cash flows over 30 days. The second requires a minimum amount of stable sources of funding at a bank relative to the liquidity profiles of its assets. Both these ratios stem from a desire to implement internationally harmonized liquidity standards, which are thus far nonexistent. They aim to prevent banks relying too much on short-term, interbank funding to support longer-dated assets. Such types of funding can rapidly evaporate in the face of a crisis.
Evidently, these new rules have not gone without criticism. For one thing, because banks get to decide their own risk-weights, there is room for manipulation of some of the ratios. Moreover, bankers have argued that the limits will stifle lending as banks adjust to the stricter standards, and will thus be harmful to the economy.
Nevertheless, I think the move represents a step in the right direction. While is true that less lending will likely be (slightly) detrimental in the short-run, slowing down the recovery of the American economy, in the long-run it will probably lead to better resource management, and create a safer environment for the economy. One the many things that the financial crisis has shown us is that many businesses have been dangerously relaxed about how they deal with their financial accounts. No one expected the financial crisis to hit, and few were prepared to deal with it when it did. This is precisely what Basel III is trying to fix, and it is particularly necessary for the systemic banks that can become a cause for concern for the entire economy in the face of a crisis. In the end, the new rules are a direct response to the need for a more stable and risk-averse economy. I therefore welcome them.